Operating margin is a measure of profitability that can indicate how well a company is managing its core business operations. Like all financial metrics, it's important to understand what operating margin tells you about a company as well as its limitations. As with all financial metrics, a company's operating margin should be viewed as part of the overall financial picture of the company.
What Is Operating Margin?
Operating margin refers to the amount of profit that a company makes from the sales of its product after deducting variable costs of production such as the cost of the raw materials that go into making the product as well as the salaries incurred in making the product. Operating margin is calculated before deducting interest and taxes.
How Does Operating Margin Work?
Operating margin is calculated by dividing operating earnings by sales or revenue, Operating earnings are also known as earnings before interest and taxes or EBIT. This represents revenue less the cost of goods sold and less the general and administrative expenses of running the business. In other words, the profit the business earns from its core business operations.
To get to the company's net income, operating income is reduced by any interest charges the business incurs on its debt plus its tax liability. Operating income also typically does not include expenses for depreciation or amortization of long-term assets such as buildings, machinery or land.
For example, let's look at a hypothetical company:
- Revenue $3 million
- Cost of goods sold $1.2 million
- Cost of labor $700,000
- General and admin expenses $200,000
Operating earnings would equal revenue less the total operating expenses listed of $2.1 million or $900,000.
The form's operating margin would be $900,000 divided by $3 million, or 30%. This means that the company makes 30 cents in operating earnings from each dollar of revenue.
Whether this is good or bad must be considered in context. How does this compare to the company's operating margin for past years? What is the trend line? How does this compare to other firms in the same industry?
Why Does Operating Income Matter?
Operating income is an important metric because it measures a company's profitability from its core business. It's an indicator of how efficiently the company manages its core business. Operating margin also tells investors how much is left over to cover non-operating expenses. Expenses such as interest charges are reflective of the firm's financing activities and do not reflect how well or how poorly the company runs its core business. This also applies to expenses like depreciation, amortization and taxes.
Operating margin can be impacted by a number of factors including:
- Pricing strategy. Are the company's prices appropriate for their industry, too high or too low? If a company underprices its product or is in an industry where intense competition limits pricing options, operating margin will suffer all else being equal.
- Cost of labor. If a company produces its products or has distribution facilities in locations where wages are high, this can impact operating margin, especially if the company cannot adjust its price to offset these higher costs.
- Operating efficiency. Has the company invested in systems and processes that streamline production and distribution costs? These investments will likely show up in the form of lower operating costs and a higher level of operating income. The costs of financing these improvements might serve to lower the company's net income in the form of higher costs for interest and/or depreciation on capital expenditures to make these operating improvements.
It's important to look at operating income in the context of the company's industry. Some industries have higher operating costs or are more price-sensitive than others.
For example, a company that operates in an industry where its products are unique and there are few competitors or alternatives will have more flexibility to increase its price than a company where there are many options for its customers to consider. This same principle applies to companies with regard to materials used for production and other factors.
Comparing the operating margins of a steel producer to a manufacturer of high-tech devices is like comparing apples to oranges. The industry factors are different, the costs of materials and labor are vastly different and so on. Comparing the operating margins of two companies in the same industry is much more meaningful.
What Are the Limitations of Operating Margin?
Like all types of financial metrics, operating margin has its limitations.
Because of what operating margin typically excludes, a company's operating margin might show a much different picture of a company's finances than looking at its full income statement and balance sheet. For example, a company's operating margin might look stellar compared to its competitors due to recent investments in technology or other types of equipment to improve efficiency and lower operating costs.
These cost reductions do come with a price tag. To make these investments, perhaps the company was forced to borrow money. If the cost of servicing this debt is a strain on the company's net income, and more importantly on its cash flow, the company's ongoing viability might be in question.
Operating margin can also be impacted by the company's business strategy. For example, two companies in the same industry might have different philosophies regarding the manufacturing of their product. One company might do all manufacturing in-house, while the other might outsource its production. This could result in different operating margins due to differing cost structures.
Like any measure of profitability, operating margin is just one factor to look at when evaluating the profitability of a company, and when comparing two or more companies in the same industry. Gross profit margin, net income and others in combination with operating margin will help shed light on the company's full value as a business and a potential investment.
In calculating profit and loss, companies do have some discretion within the accounting rules on how to classify certain types of revenue and expense. An example could be how to allocate business overhead to a portion of the business.
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