Operating Margin: Calculation and Usage

Operating margin, also known as “operating profit margin” or “net profit margin”, is a ratio used to measure a company’s pricing strategy and operating efficiency. It is a measurement of what proportion of a company’s revenue is left over after paying for variable costs of production such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt.

It is calculated as:

      Operating margin=Operating income/Net sales

For example, in 2007, Firm B had $100mm in Sales and, after all operating expenses are accounted for, records an Operating Income of $45mm. Then Firm B’s Operating Margin is $45mm/$100mm = 45%.

Operating margin gives analysts an idea of how much a company makes (before interest and taxes) on each dollar of sales. When looking at operating margin to determine the quality of a company, it is best to look at the change in operating margin over time and to compare the company’s yearly or quarterly figures to those of its competitors. If a company’s margin is increasing, it is earning more per dollar of sales. The higher the margin, the better.

For example, if a company has an operating margin of 12%, this means that it makes $0.12 (before interest and taxes) for every dollar of sales. Often, nonrecurring cash flows, such as cash paid out in a lawsuit settlement, are excluded from the operating margin calculation because they don’t represent a company’s true operating performance.

The operating margin is another measurement of management’s efficiency. It compares the quality of a company’s operations to its competitors. A business that has a higher operating margin than its industry’s average tends to have lower fixed costs and a better gross margin, which gives management more flexibility in determining prices. This pricing flexibility provides an added measure of safety during tough economic times.

Operating margin can be used both as a tool to analyze a single company’s performance against it’s past performance, and to compare similar companies’ performance against one another.

Difference companies Comparisons

Suppose we have Firm B (45% operating margins) and Firm C (with 28% operating margins). If B and C are in the same industry and are competitors, then B is clearly limiting its operating expenses. Put another way, every dollar that B uses in production of its goods, services, etc… is generating a greater return than every dollar C uses in operations.

If, however, B and C are not in the same space, then the differences in margins may not be so insightful. Suppose B is in an industry where operating margins are typically greater than 50%, and C is in an industry where margins are typically less than 25%, then C is likely more efficient.

Because of different capitalization structures (differing debt levels), different tax structures, and special one-time income events, an Operating Margin Comparison may have contradictory results with Net Profit Margin Comparison.

Single Company Growth Comparisons

Keeping with B, let’s say that it was 2007 in which it made $45mm in Operating Income and $100mm in Revenues. Also, let’s say that in 2006, it made $42mm in Operating Income and $88mm in Revenues, and in 2005, it made $37mm in Operating Income and $75mm in Revenues. Then every year, both Operating Income and Revenues have had positive growth.

B 2005 2006 2007
Revenues $75mm $88mm $100mm
Revenue Growth N/A 17.33% 13.36%
Operating Income $37mm $42mm $45mm
OI Growth N/A 13.51% 7.14%
Operating Margin 49.33% 47.7% 45%

As you can see above, despite positive Revenue and OI growth, margins consistently declined. This could be indicative of many things, including increasing cost of goods sold, an expanding administrative workforce, etc… Declining operating margins would be especially distressing if other companies in the same industry are not experiencing similar effects, or there is no economic or otherwise compelling reason for such a decline.