Operating Margin

A profitability ratio

What is Operating Margin?

Operating margin is equal to operating income divided by revenue.  Operating margin is a profitability ratio measuring revenue after covering operating and non-operating expenses of a business.  Also referred to as return on sales, the operating income indicates how much of the generated sales is left when all operating expenses are paid off.

Operating Margin

In the above example, you can clearly see how to arrive at the 2018 operating margin for this company.  2018 starts with Revenue of $5 million, less COGS of $3.25 million, resulting in Gross Profit of $1.75 million.

From there, another $1.3 million of Selling General & Administrative SG&A expenses are deducted, to arrive at Operating Income of $437,500.

By taking $437,500 and dividing it by $5.0 million you arrive at the operating margin of 8.8%.

What is the formula for Operating margin?

Operating Margin = Operating Income / Revenue  X 100

Another example:

DT Clinton Manufacturing company reported on its 2015 annual income statement a total of $125 million in sales revenue. Operating income before tax netted to $45 million after deducting all $80 million in operating expenses for the year. As a result, an operating margin of 36% was generated, or in other words for every dollar in sales achieved, $0.36 cents is retained as operating profit.

What is Operating Income?

Operating income is the profit of a business after all operating expenses are deducted from sales receipts or revenue.  It represents how much a company is making from its core operations, not including other income sources not directly related to its main business activities. It differs from net income in that it does not include the expenses of taxes and interest.

This gives investors and creditors a clear indication as to whether a company’s core business is profitable or not, before considering non-operating items.

What is Sales Revenue?

Sales revenue or net sales is the monetary amount obtained from selling goods and services to business customers, excluding any merchandise returned and allowances/discounts offered to customers.  This can be realized either as cash sales or credit sales.

Why is Profit Margin important in business?

A business that is capable of generating operating profit rather than operating at a loss is a positive sign for potential investors and existing creditors. This means that the company’s operating margin creates value for shareholders and continuous loan servicing for lenders. The higher the margin that a company has, the less financial risk it has  – as compared to having a lower ratio, indicating a lower profit margin.

Continued increases in profit margin over time shows that profitability is improving. This may either be attributed to efficient control of operating costs or other factors that influence revenue build-ups such as higher pricing, better marketing, and increases in customer demand.

The drawbacks of looking at operating margin/profit

Operating profit is an accounting metric, and therefore not an indicator of economic value or cash flow.  Profit includes several non-cash expenses such as depreciation and amortization, stock-based compensation, and other items.  Conversely, it doesn’t include capital expenditures and changes in working capital.

In conjunction, these various items that are included or excluded can cause cash flow (the ultimate driver of value for a business) to be very different (higher or lower) than operating profit.

To learn more, read all about business valuation.

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Additional Resources

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