What is Operating Margin?

Operating margin for a company is like the percentage of your income that you have left after paying your bills...

Each month you get a paycheck and have to use some of the money to pay essential bills. You might pay for things like your home, transportation, food, and so on. You’re free to use the money that is left over for unusual expenses, like going on vacation — or to save it for the future.

Operating margin is the percentage of each dollar of income that a company gets to keep after it subtracts out its operating expenses and some fixed expenses, such as depreciation. It doesn’t consider other costs, such as interest payments.

Operating costs include the variable costs related to producing goods. Things like raw material costs and employee pay are part of these variable costs. Other overhead costs, like rent and insurance costs, are also included.

Operating margin is affected by a business’s pricing strategies, its ability to set costs with suppliers, and how well it negotiates with employees. These are core aspects of a business’s operations, making operating margin a valuable measure to use.

To calculate a company’s operating margin, you need to know its revenue, operating costs, and depreciation and amortization costs. You can get all of this information from a company’s income statement. The operating margin formula is:

(Revenue - Operating Costs - Depreciation and Amortization) / Revenue

Earnings Before Income and Taxes (EBIT) is a shorthand for the amount that results from subtracting operating costs, depreciation, and amortization from revenue. This assumes that the company has no non-operating income.

Multiply the result by 100, and you’ll have the company’s operating margin as a percentage.

Operating margin is significant because it shows roughly how much a company gets to keep from each dollar of sales. Put another way: It shows how much it costs a company to make a sale. If a company’s operating margin is 60%, that means that it keeps 60 cents for every dollar it makes in sales.

The money that the company keeps can be used to pay expenses that aren't included in operating costs, such as interest on loans or taxes. It can also be invested back into the company to fuel future growth or returned to shareholders in the form of a dividend.

Companies want to keep their operating margins high because it makes it easier to pay non-operating costs. Higher margins indicate stability, as they help businesses pay down debts and return value to shareholders.

High operating margins can also show the efficiency of a business. Higher margins imply that the cost to produce sales is lower. That means that the company does not need to make as many sales to produce a profit or that it will produce an even greater profit if it is able to make a high number of sales. It also implies lower risk, as the company can handle unexpected increases in costs, whether those come from suppliers of raw materials or workers demanding higher pay.

When you’re using operating margin to gauge the strength of a company, there are a few limitations to keep in mind.

One is that the cost of doing business can vary widely across industries. That makes it difficult to get useful information by comparing the operating margins of companies in different sectors. A low operating margin in one industry may be considered a high operating margin for a different industry.

Another limitation of operating margin is that it brings some non-cash expenses into consideration. For example, operating margin includes depreciation costs, but depreciation doesn’t require the company to spend any money. Different companies also calculate depreciation differently, making it difficult to use that information to make comparisons between businesses.

Because of the inclusion of non-cash expenses, some investors look at alternative measures, such as Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), which does not include non-cash costs.

Operating margin also doesn’t provide investors with information about the specific costs that a company is incurring. Two similar companies might have similar operating margins, but very different costs. One could be overpaying its suppliers for raw materials, while the other is paying too much for labor. Investors wouldn’t be able to learn this by looking at operating margin alone, and some costs are easier to bring down than others. In this scenario, one company could have far more potential to reduce its costs and increase its operating margins.

Finally, a company’s operating margin won’t mean much if the company doesn’t bring in enough money to pay all of its expenses. No matter how good a company’s operating margin is, it still needs to cover loan interest and tax payments. This can be a problem if management borrows too much money. A high operating margin won’t help the business cover monthly loan payments if it doesn’t have sufficient sales volume.

There is no simple answer to this question that is applicable across different businesses and different industries. Different industries and different business models produce wildly different costs of doing business, meaning that a good operating margin will vary from industry to industry.

For example, a company that has a huge sales volume can have a low operating margin and still be doing well. If a company had $10 billion in sales and an operating margin of 5%, it would still be making $500 million each year after operating costs. Companies with smaller sales volumes need to have higher operating margins to keep up. For example, Louis Vuitton is a luxury brand that can’t make the same number of sales as other brands has an operating margin of 21.4%. To make $500 million after operating costs, it would need just $2.34 billion in sales.

Generally, the higher a company’s operating margin, the better. Looking for long or short-term trends in a company’s operating margin, or comparing operating margins of similar businesses can give insight into how well a company is performing and its potential for future growth.

Operating margin, gross margin, net margin, and profit margin are all different comparisons of a company’s income and its expenses.

Operating margin compares a company’s revenues and its operating costs. It lets investors see how much a company gets to keep for each dollar it makes in sales.

Gross margin measures a company’s revenue compared only to its cost of goods sold. It doesn’t bring things like depreciation, sales costs, or administration and marketing costs into the calculation.

Net margin is what people are usually talking about when they use the term profit margin. It measures a company’s net income as compared to its revenue. Once you take out all of a company’s costs, you're left with its net income. Net margin is the amount that the company gets to keep or return to shareholders after all is said and done.

Profit margin is a generic term that can be used to describe any of these margins. It is most often applied to the term net margin. Still, you’ll hear the terms operating profit margin or gross profit margin used by some investors when discussing the other profit margins.