Operating margin is one of several metrics that shed light on a company’s profitability from its core operations. Expressed as a percentage, operating margin measures how much a business has made on every dollar of sales, minus its operating expenses – such as marketing, payroll, and administrative expenses – and cost of goods or services sold (COGS).
Business leaders track operating margin for insights into the health of the business and to keep costs under control. Additionally, lenders and investors view a company’s operating margin as a key metric when deciding whether to offer financing to the company.
What Is Operating Margin?
“Operating margin” has several names, including "operating profit margin" and "return on sales." "Operating margin" is the most common.
Typically, a company with a high operating margin is considered healthier and better managed than a one with a low operating margin because it is generating more profit on every dollar of revenue. For example, a company with a 15% operating margin earns $15 of operating income for every $100 of revenue, while a company with a 5% operating margin earns only $5 of operating income for every $100 of revenue.
Since companies in the same industry often have similar expenses, operating margin helps compare how businesses stack up competitively and against industry benchmarks.
Conversely, companies in different industries have different expenses, so comparing their operating margins would be like comparing apples to oranges. For example, the main cost of developing cloud-based software is labor. Aside from that, it costs a software company the same amount to sell one program as it does to sell 1 million programs – resulting in a high operating margin.
The opposite is true for a car manufacturer. To produce five cars, a car company needs to buy five times as much steel as it would need to make one car. As the number of cars sold rises, cost for materials typically rises too. As a result, the manufacturer doesn’t benefit from the same operating leverage as a software company.
Department-Level Operating Margins
In addition to calculating the operating margin for an entire company, operating margins can be calculated for individual divisions or product lines within a company. This can help business leaders determine which areas of the business are most – or least – profitable, informing decisions about where to invest, expand, or address inefficiencies. In most cases, decision makers opt to grow divisions with higher operating margins.
How to Calculate Operating Margin
The formula to calculate operating margin relies on two data points: operating income and net sales revenue.
Operating income is what remains of a company’s net sales revenue once operating expenses and COGS are deducted. Net sales revenue is the company’s total sales revenue minus returns, allowances, and discounts.
With those two figures at hand, you – or your financial software – can calculate operating margin. The formula is (operating income / net sales revenue) x 100.
Operating Margin vs. Gross Profit Margin
Operating margin is related to another profitability metric called gross profit margin.
Gross profit margin measures profit as a percentage of sales revenue after subtracting COGS, whereas operating margin subtracts both COGS and operating expenses. Overall, gross profit margin more generally measures how efficiently a product or service is created, while operating income measures how efficiently an entire company is run.
Analyzing Operating Margins
Companies with steady or improving operating margins are likely managing their businesses better than companies with operating margins that are shrinking or volatile.
But operating margins are just a starting point when evaluating a company. More questions must be asked to paint a full picture of a business’ health. Consider the following scenarios and possible causes.
Steady operating margins may indicate that:
- A company’s revenue and expenses are growing at the same pace.
- Neither the company’s revenue nor its expenses are growing.
Rising operating margins may indicate that:
- A company’s revenue is growing faster than its expenses.
- A company is cutting expenses while revenue is flat.
Shrinking operating margins may indicate that:
- Revenue is rising, but expenses are rising faster.
- Revenue is falling while expenses are flat or rising.
- Expenses are rising while revenue is flat or falling.
- Expenses are falling, but revenue is falling faster.
Some fast-growing companies may opt to spend more to capture business opportunities and put themselves in a stronger position for the future, even if it decreases their operating margins in the short term. This is why operating margin is just one important data point among several to understand a company’s overall health and profitability.
How to Boost Operating Profit Margin
There are a variety of ways that business managers can improve their companies’ operating margins.
One way is to focus more on growing revenue, whether by increasing sales volume or raising prices to outpace expenses. Good inventory management is also key, ensuring there’s enough product on hand to avoid out-of-stocks, but not so much that markdowns are needed to sell excess inventory.
Managers can also increase operating margins by trimming expenses. Limiting overtime expenses and using technology to automate processes whenever possible can help. Buying materials in bulk can keep costs down, as can comparing prices from various vendors to find the best deal. Scaling down on unused office or retail space can reduce the cost of rent or lease payments, especially as companies increasingly shift to remote or hybrid work.
The Takeaway
Operating margin is the percentage of profit a business makes from every dollar in sales it generates from core operations. It is an important measure of how well a company manages its operations and contains costs, as well as how it compares to other companies in the same industry. But it's not the only piece of the puzzle in understanding a business' current health and how it can expand efficiently into the future.
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