A company’s operating margin is the percent of revenue it retains after operating expenses.
This can get complicated, so we're breaking it down piece by piece:
Operating expenses are the cost of goods sold, wages, salaries, benefits, marketing costs, rent, utilities, and so on. For cost of goods sold, let’s say an auto manufacturer is selling cars. It has to buy the materials like steel and leather to make the car. So its cost of the cars sold are those materials.
Revenue minus cost of goods sold equals gross profit.
When the rest of the operating expenses come in, we get operating income, or operating profit. That’s pretty much the same—with some very minor differences—as EBIT, or earnings before interest and tax. Operating profit is the earnings that come before interest to lenders and tax to the government.
So, let’s say a company had revenue of $200 for a year and had operating expenses for that year of $120. Its operating profit was $80. $80 is 40% of $200, so the company’s operating margin was 40%.
Let’s say two companies grow revenue at 10% year-over-year, but company 'X' achieved that result by increasing operating expenses, like added marketing dollars, and so the margin stayed the same. Operating profit will grow by around 10%.
Company ‘Y’ did not have to rely on much more spend to achieve the same revenue growth. Let’s say revenue grew 10%, but operating expenses grew at a slower rate. Company Y’s operating margin will expand and its operating profit will grow at a higher rate than 10%.
This becomes really important when comparing two companies and figuring out which deserves a higher valuation. To see how margins have been impacted by the coronavirus pandemic this year, watch the quick video above.
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