Both internal and external stakeholders are interested in a company’s profitability. They want to know if the business can sustain operations on its own and still produce additional value to repay investors or pursue growth initiatives.
Among the various ways to gauge profits, operating margin is one common measure. In this guide, we’ll discuss the operating margin definition, how to calculate it, and ways for companies to improve profits.
Definition of operating margin
Operating margin is a commonly used metric to measure a company’s profits after accounting for all operating expenses.
It may also be referred to as the return on sales, representing the percentage of a company’s revenue that is left after operating expenses have been paid.
A company with a positive operating margin has earned a profit, while a negative value signifies the company is operating at a loss.
Importance of operating margin in business
In general, companies strive to earn a high operating margin, which means they can cover operating costs using the revenue they earn and still have additional cash flow left over.
It’s a value teams want to continue improving over time, demonstrating to stakeholders that they can improve their operating efficiency and generate more value.
Specifically, external stakeholders like investors and creditors are happy to see a positive operating margin, which means the company has earned enough cash to sustain operations and make repayments.
How to calculate operating margin
Operating margin is the ratio between a company’s operating income and its revenues for a given period. Continue reading below for tips on how to calculate it:
Components required for calculation
All the necessary components to calculate the operating margin are found on the income statements, which include:
In the simplest terms, the formula for calculating operating margin is as follows:
It requires knowing the operating income, also called earnings before interest and taxes (EBIT), which can be determined through the following calculations:
Step-by-step on how to calculate operating profit margin
We can break down the operating margin calculation into the following steps:
Step 1: Find the gross profit
The first step is to calculate the gross profit by subtracting the cost of goods sold from the total revenue, which is equal to:
Step 2: Find the operating profit
The next step is to subtract the operating expenses from the gross profit to find the operating profit:
Step 3: Calculate the operating margin
With the operating profit value, find the operating margin by dividing it by the total revenue and multiplying by one hundred:
Example calculation of operating margin
Though there are quite a few figures involved in the calculation of the operating margin, it’s a relatively straightforward process, which we’ll illustrate with the following example.
A company’s profit and loss statement shows it reported the following values in Q3:
- Total revenues: $565,000
- COGS: $190,000
- Salaries and wages: $125,000
- Office rent and utilities: $55,000
- Depreciation and amortization: $95,000
We can first find the gross profit:
Gross profit = $565,000 – $190,000
= $375,000
Then, we use this value to find the operating profit:
Operating profit = $375,000 – $125,000 – $55,000 – $95,000
= $100,000
Finally, we find the operating margin:
Operating margin = ($100,000 / $565,000 ) * 100
= 17.7%
Limitations of operating margin
A company’s operating margin helps provide a profitability measure to determine how efficiently it manages operations. However, there are some potential limitations to consider when using it to assess company performance.
No consideration for non-operating expenses
By definition, operating margin only considers the portion of a company’s revenue that remains after accounting for operating expenses.
Thus, it doesn’t take into account non-operating expenses like interest or taxes, which can result in significant cash outflows during the period.
So, even though operating margin provides one way to assess a company’s profitability, it still doesn’t paint the whole picture of what the business retains after all expenses are accounted for.
Focused on historical performance
Another potential limitation of operating margin is that it has a backward-looking view of a business’s financial performance. It doesn’t consider future growth prospects or demonstrate how the profitability has improved over time.
Stakeholders can compare a company’s most recent operating margin against previous periods to see how it has evolved. However, it won’t capture the benefits of any current cost-cutting measures or growth initiatives.
Industry variations
It can be helpful for companies to compare their operating margins against others in their industry to see how they stack up against competitors. However, it’s important to note that this is not universally applicable between sectors.
Operating margin benchmarks can vary widely between industries. For instance, retail and construction companies will typically have lower margins than businesses in the financial services, technology, or healthcare sectors.
Thus, it can be misleading for a company to compare its operating margin to businesses outside of its industry.
Operating margin vs. net profit vs. gross margins
Operating margin is just one metric for businesses to assess their profitability. Other similar metrics include net profit margin and gross margin; however, there are slight differences between each of them.
Net profit margin takes a broader view of the company’s profitability, as it also considers non-operating expenses in its calculation.
On the other hand, gross margin takes a more granular look at the company’s operating profitability. It only considers the profits after accounting for production costs, excluding selling, general and administrative (SG&A) expenses, maintenance costs, and other operating expenses.
Understanding the relationship between these metrics
Gross, operating, and net margins are interrelated and rely on many of the same components to gauge a company’s profitability.
However, the gross margin is typically always greater than the net or operating margin, as it takes into account the fewest expenses.
Between the other two, the operating margin is generally greater than the net profit margin since it still excludes non-operating expenses.
Strategies for improving operating margin
No matter the industry, company size, or stage of development, increasing operating margin is a common goal for business owners. The following are some of the key strategies to help achieve this:
Reduce operating costs
One lever for improving the operating margin is to lower operating costs. This strategy is easier said than done, but company leaders may be surprised to learn that even small changes in spending habits can make a meaningful difference over the long run.
For instance, companies may audit their software subscriptions, looking for any unused or underutilized licenses and tools that they can cancel to free up some cash.
The key is to focus on cutting costs in areas that will not impact employee productivity, which could have the opposite effect.
Raise prices
The other part of the operating margin equation is revenue. If reducing costs is not an option, businesses may need to focus on this aspect instead.
Companies can either increase revenues by selling more items or selling the same volume at a higher price.
Raising prices can lead to an instant increase in profits as long as costs remain the same. However, companies should do so only after careful consideration, as raising prices too high can affect customers’ willingness to purchase, given the perceived value of the item.
Upsell or cross-sell
It typically costs companies money to acquire new customers. Thus, teams that are concerned about profitability may want to focus on earning more sales from the customers they already have.
Upselling or cross-selling strategies can help make this possible. When customers are already making a purchase, companies can suggest they buy a better, higher-priced product or an additional product that complements their initial purchase.
This way, businesses can increase revenues without incurring additional costs to acquire new customers, thereby improving the operating margin.
Monitor financial performance with BILL
A company’s operating margin provides a snapshot of its profitability, helping key stakeholders gauge how much of its revenue it retains after covering operating costs.
Calculated as a percentage, this metric offers a straightforward way to compare companies against competitors and historical performance, even if there’s a large difference between revenues.
Even still, companies may want a way to track financial health on an ongoing basis, not just using historical data. An integrated financial operations platform, like BILL, can help. BILL gives you more control and transparency into key financial workflows, like payables, receivables, and expenses, in one location.
The platform helps automate critical processes so you always have up-to-date data at your fingertips without the tedious manual work to go with it.
