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Oct. 23, 2020
What is an operating margin?
An operating margin is a ratio that measures the efficiency of day-to-day operations and pricing structures in a business. This margin indicates how much revenue a company retains after covering costs like payroll, taxes and materials.
Deeper definition
A company’s operating margin is a function of two things:
Operating income: the company’s gross income minus expenses like the cost of goods sold (COGS), wages, interest payments, and taxes. Such expenses must be categorized as either fixed or variable.
Net sales: the total value of all sales of the company’s goods or services, minus refunds or credits.
Divide operating income over net sales to find the company’s operating margin, expressed as a percentage or ratio to the dollar. The operating margin not only indicates the company’s financial health, but also how efficiently it’s using revenue: how much operating income was expended for each sale the company generated. Because of that, all figures must be from the same time frame, such as a fiscal year, in order to keep them consistent.
Companies with higher operating margins are less risky for investors and lenders, as they can cover their operational costs. However, operating margins are only useful in comparing businesses from the same industry, because those businesses often have similar expenses and sales numbers.
If you run a business out of your home, your mortgage might be factored into your operation margin. Make sure you’re paying the best rate.
Operating margin example
Monica’s company provides archival services for old books. Last year, her company made $1,000,000 in revenue, but also paid $400,000 in expenses like wages and raw material for book restoration. She had 256 clients, representing $3,000,000 in sales, but some of them were unhappy with the service and Monica issued $50,000 in refunds.
Monica’s company’s operating income, $1,000,000 minus $400,000, is $600,000.
Her net sales, $3,000,000 minus $50,000, is $2,950,000
Her operating margin will be calculated by $600,000 / $2,950,000, which gives a percentage of 20.3, meaning she’s earning about 20 cents for every dollar of sales.
