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What is the Operating Margin?
The Operating Margin represents the residual profits once a company’s cost of goods sold (COGS) and operating expenses are subtracted from the revenue generated in the period.
The operating margin establishes a relationship between the operating income of a company (i.e. earnings before interest and taxes, or “EBIT”) and revenue to estimate the profits made prior to paying off non-operating expenses.
- What is the formula used to calculate the operating margin?
- Why is the operating margin among the most widely used metrics for comparisons?
- What is the main shortcoming of the operating margin metric?
- How does the operating margin compare to the gross profit margin and net profit margin?
Table of Contents
Operating Margin Definition
The operating profit margin, often referred to as “operating margin,” answers the question, “For each dollar of revenue generated, how much trickles down to operating income (EBIT)?”
The operating income of a company can be calculated by subtracting operating expenses (OpEx) from gross profit, which has already been reduced by the cost of goods sold (COGS) in the period.
With that said, operating income is the remaining earnings once all expenses related to core operations are accounted for (i.e. inclusive of both COGS and OpEx).
Operating Margin Formula
The formula for the operating margin consists of the company’s operating income (i.e. EBIT) divided by the revenue generated in the same period, as shown below.
Operating Margin Formula
- Operating Margin = EBIT / Revenue
To facilitate comparisons across historical periods as well as against industry peers, the operating margin is typically denoted in percentage form, which is calculated by multiplying the value in decimal form by 100.
For example, if a company has generated $10 million in revenue with $4 million in COGS and $2 million in OpEx, the operating profit is $4 million.
To arrive at the operating margin, we’ll divide the $4 million in EBIT by the $10 million in revenue and multiply by 100, which comes out to an operating margin of 40%.
In this case, the company earns $0.40 in operating income for each $1.00 of revenue generated.
Another way to interpret the $0.40 is that for each $1.00 of revenue generated, the company has $0.40 left to cover non-operating expenses.
For a given period, the accrual accounting-based revenue and operating income of a company can be found on the income statement.
- Revenue
- Less: Cost of Goods Sold (COGS)
- Gross Profit
- Less: Operating Expenses (OpEx)
- Operating Income (EBIT)
The COGS line item refers to direct costs such as materials and direct labor, while OpEx consists of expenses related to selling, general & administrative (SG&A) expenses, research & development (R&D) expenses, and more.
Apple Operating Profit (EBIT) Example
Apple Operating Profit (Source: WSP Financial Statement Modeling)
Interpreting the Operating Margin – High or Low?
For comparisons of operating margins to be practical, the companies selected should ideally operate in the same (or adjacent) industries since there are industry-specific factors that can affect operating margin.
In general, higher operating margins are more favorable relative to lower margins, since this means that the company is creating more profits from its operations to pay for its variable costs and fixed costs.
High operating margins relative to the industry average, or margins trending upward across time, demonstrate management’s efficiency at increasing operating profits.
On the other hand, low operating margins and declining margins could be a sign of underlying weaknesses in the company’s future trajectory caused by ineffective growth strategies and inefficient capital allocation.
Operating Margin vs Gross Margin and Net Margin
The operating margin line item on the income statement separates the operating and non-operating line items.
By definition, earnings before interest and taxes (EBIT) exclude non-operating income and expenses, which are said to be “below the line.”
The non-operating section could be comprised of non-operating activities and one-time gains/(losses), such as interest income from marketable securities, gains on the sale of assets, impairment related to assets like inventory, and income taxes.
In effect, the operating margin can be viewed as being the middle ground between the gross profit margin and net profit margin, as the gross margin only accounts for direct costs (i.e. COGS) whereas the net profit margin accounts for all operating expenses and non-operating expenses.
The effects of certain discretionary financing decisions, accounting policies, and tax structures are neglected from the operating margin, which allows the metric to be more informative for peer comparisons.
Drawbacks to Operating Margin
One frequent area of criticism for the operating margin is that the metric includes non-cash expenses such as depreciation and amortization (D&A) and stock-based compensation.
Additionally, EBIT fails to account for capital expenditures (CapEx), which can have a significant impact on the actual free cash flow (FCF) of a company.
Operating Margin Calculator – Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Operating Margin Example Calculation
In our operating margin modeling exercise, we’ll be calculating and comparing the operating margin of three companies.
We’ll assume that all three companies are close competitors operating in the same industry and that this peer group has relatively similar financial profiles related to their “core” operations.
The calculation process is as follows:
- First, we must find out each company’s revenue, cost of goods sold (COGS), and operating expenses (OpEx) from their income statements.
- Next, we’ll calculate the operating income (EBIT) by subtracting OpEx from gross profit.
- Lastly, we’ll divide the operating income of each company by the corresponding revenue amount to arrive at the operating margin.
We’ll first list the financial assumptions related to the three major inputs:
- Revenue
- Cost of Goods Sold (COGS)
- Operating Expenses (OpEx)
Model Assumptions
Income Statement – Company A
- Revenue: $250m
- Cost of Goods Sold (COGS): –$150m
- Operating Expenses (OpEx): –$50m
Income Statement – Company B
- Revenue: $200m
- Cost of Goods Sold (COGS): –$120m
- Operating Expenses (OpEx): –$40m
Income Statement – Company C
- Revenue: $300m
- Cost of Goods Sold (COGS): –$180m
- Operating Expenses (OpEx): –$60m
Using the provided assumptions, we can calculate the operating profit (EBIT) for each company by subtracting OpEx from gross profit.
- Company A – EBIT: $100m – $50m = $50m
- Company B – EBIT: $80m – $40m = $40m
- Company C – EBIT: $120m – $60m = $60m
In the next step, the operating margins for each company can be calculated by dividing EBIT by revenue.
- Company A – Operating Margin: $50m ÷ $250m = 20.0%
- Company B – Operating Margin: $40m ÷ $200m = 20.0%
- Company C – Operating Margin: $60m ÷ $300m = 20.0%
The operating margin for all three companies comes out to 20.0%, but as we can see from the expenses “below the line”, the companies have made different financing decisions, as implied by the different interest expense amounts.
The effects of the differences in financing as well as the different tax rates are not incorporated into the operating margin metric, which allows EBIT to be among the most widely used profitability measures for comparison purposes.
