Operating Margin: Meaning & How to Calculate
Operating margin refers to the operating income divided by the total revenue. You can also say that the operating margin is a profitability measuring revenue after considering operating and non-operating expenses in a business. It also tells about the return on sales, the operating income indicates how much of the sale is remaining and how much expense is clear till date.
In simple words the meaning of operating margin can be stated as a company’s operating margin, it tells us about the return on sales (ROS) and indicates the company function in terms of how efficiently it is managed and how it generates profit from sales. It shows the debt and interest rate which any investor needs to look at before making any investment decisions.
Operating margin formula tells about the prime indicators of business risk such as looking in the past of company operating margin is a good way to tell about a company’s performance and whether to buy that company stocks or not. There are different reasons which can improve the operating margin of a company : good management, more efficient resources and less production cost and better marketing strategies.
More about operating margin is that it establishes a relationship with the operating income of a company interest and tax liability and altogether demonstrates profit to the stock buyer, potential investor the profits are calculated before paying for the non-operating expenses.
To clear the meaning of operating margin you can tell that the operating margin differs from the net profit margin, the reason for this is that the net profit subtract the expanses, taxes and interest to calculate the business profit or loss. The operating margin is more consistent with the reporting period rather than the net profit of a company. It’s a better track record of the company and displays the health of the business. You can also call operating margin as the operating profit margin.
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How to Calculate Operating Margin?
When calculating the operating margin formula, you need to divide operating earnings with revenue.
operating margin = operating earning/Revenue x 100
The operating earnings can be earned before tax or interest, it is calculated by revenue minus the costs of goods sold. The calculation excludes the interest and taxes.
We can take an example of a company ABC which data we can use to calculate operating margin formula.
How to Calculate Operating Margin of Company ABC?
| Revenue | 111.4 crores. |
| Cost of Goods Sold | 67.1 crores. |
| Gross profit | 44.3 crores. |
| Gross margin | 39.8% |
| Operating expenses | |
| R&D | 5.2 crores. |
| Selling, general and other expenses | 5.6 crores. |
| Operating earning | 33.5 crores |
| Operating margin | 30.2% |
In the above data of company ABC, we had to use the operating margin formula where we divide the operating earning of 33.5 Crore rupees by the revenue cost that is 111.4 Crore rupees and multiply by 100. The operating margin for ABC is 30.2% .
The operating earnings provide a clear sign for an investor whether the company’s business is profitable or not, and can directly affect the decision of the investor whether to buy or not the stock of that particular company.
You should know that the sale revenue or net sales is the funds obtained from selling goods or services of a company. It excludes any return order or discount offer to the customers. It can be either cash sales or credit sales.
Limitations of the Operating Margin
Everything has some drawbacks. The operating margin has two major limitations, one is the company. One is the company industries and the other is the growth rate.
The operating margin should be applicable to compare companies that operate in the same industry. These types of companies have the same business models . Companies with different sectors that have different types of business models will have different operating margins and comparing these operating margins will not be proper practice.
rnTo understand the concept we need to compare the profitability between companies and various industries, which analysts use a profitability ratio that eliminates the effects of accounting and taxes policies which can be earned before interests, taxes, depreciation and amortization (EBITA). You can check operating margin by adding back depreciation, and the operating margin for manufacturing firms will be comparable.
A company growth rate does not comply with the operating margin. The reason for this is that faster growing companies often have low or even negative operating margins because of their aggressive expansion and expansion of business. Sometimes good advertising can also cost a company a good capital of company revenue. But in some cases like a cement company XYZ, the low growth business will still have a high operating margin as the industry is mature and demand is high. Still, you can calculate operating margin to sense a company business and probability of your investments.
Other Profit Operating Margin
A profit operating margin expresses a percentage of profits margin and indicates how much profit margin a company makes. The type of profit operating are as follows:
The gross profit margin is a take out cost of raw material, labor and cost of goods sold and cost of product sold on the income statement. The gross profit margin shows the product analyzing and gross margin shows the rawest profit of a company.
Formula for gross profit margin is:
Gross profit margin = Net sales – Cost Of Goods Sold / Net sales
Pretax Profit Margin
In this type of operating margin we take operating income and subtract it with the interest expense and add any interest income balance between gains or losses from any discontinued operating. You have to take a pre-tax profit or earnings before taxes then divide it by the revenue of the company to get the pretax profit margin.
Net Profit margin.
The net profit margin is the most significant measure of profit margin. In the Net profit margin we have to divide the profit by net sales or divide the net income with the total revenue over a given time. Just like the profit margin calculation uses the ratio profit and net income interchangeably, you can also use the sales and revenue interchangeably.
The formula of net profit margin is:
Profit Margin = The Net Profits or income / the Net sales or revenue
NPM = (R- COGS – OE – O – I – T) / R x 100
= ( The Net income / R) x 100
Where the formula terms are:
NPM stands for Net profit margin
R is for revenue
COGS is Cost of goods sold
OE is operating expenses
O is for other expenses
I stand for interests
And T is for the Taxes
How is the Operating Margin Different From Other Profit Margin Measures?
Let us first know the meaning of the profit operating margin which is the percentage of sales that a business makes removing all the expenses of the business. The profit operating margin formula is the sales minus the total expenses, which is divided by sales of the product or service.
The key difference between the both margins is the non- operating activities which are excluded in the operating margin. If you understand the meaning of operating margin then you know that this is related to the financing transaction in which including or excluding discontinued operations expansion or taxes.
A business that is capable of generating higher operating profit rather than loss. This is the sign for every potential investor to invest and grow their money. The operating profit margin creates value for its shareholders and provides continued loan repayment for its lenders. If there is continued growth in the profit margin over time that the profitability of the company will also improve and give a factor to influence the market and increase the customer demand.
The profit margin is more used to evaluating the entity completely to include both operating results and the whole financial activity of a company. The result of operating margin should be tracked over a long term with a regular interval. One difference between both margins is that the profit margin tends to fluctuate more than the operating margin, because the profit margin includes the financial fluctuation and the volatile interest rates.
Conclusion
Operating margins is a simple calculation, but it conveys essential information. It gives you an understanding of income, and operating margins and serves as valuable data for all the potential investors.
In order to successfully assess company evaluation most investors grasp the ability to calculate the cash flow from daily operations. As the financial analysis and numerical comparison of the company operating income. It can tell us about the ability of a company to generate profit in a competitive environment.
To reduce the cost of production and other expanse without any compromise on the quality of the product. The best idea is to scale the number of products as most large companies tend to do. More production means less cost of each item. As an example you can purchase raw materials in a bulk order which will be negotiated and often save your penny in the production phase of the product.
Frequently Asked Questions (FAQs)
An operating margin is way to understand how much profits a company generates after getting subtracted for variable costs of production like raw materials, wages, etc. There is a need for a healthy operating margin for every company to make payments for its fixed costs like interest on debt or taxes.
Operating margin considers all operating costs except for any non-operating costs. While net profit margin considers all costs involved in a sale, making its profitability’s not only comprehensive but also a conservative measure. On the other way, gross margin considers the costs of goods sold (COGS) by avoiding overhead, fixed costs, interest expenses, and taxes.
Higher operating margins are better when compared with lower operating margins.