Operating margin is used to determine a company’s profitability by measuring how much a company earns from sales-related activity.
Operating margin, also known as operating profit margin, is usually calculated as a percentage and measures the ratio of a company’s operating profit to its sales performance.
Operating margin focuses on an intermediate stage in the financial statements, and you can use it to focus on the essentials of a business to see how profitable it is.
While gross profit margin, operating profit margin, and net profit margin are all measures that analyze business operations, operating profit margin focuses on indirect business expenses such as administrative costs, salaries, marketing costs and amortization costs.
Presentation: What is operating margin?
In simpler terms, operating margin measures a company’s profitability by determining how much of each revenue dollar received remains after certain expenses have been paid.
If you want to learn how to calculate the operating margin of your business, it’s simple: just take the operating profit of the business and divide it by its total revenue. The resulting percentage is the operating margin.
New business owners may struggle to grasp the many concepts in Accounting 101, but you or your accountant can easily calculate your operating margin.
Simple as the math may be, it doesn’t tell you Why operating margins are attractive. To understand this, it’s helpful to look at what moves you from total revenue to operating profit.
The first step in calculating operating margin is to find your operating profit, which is shown on your income statement. Your operating income is calculated by taking gross income and subtracting cost of goods sold, operating expenses, and depreciation and amortization.
For example, Walker Printing had revenues of $150,000, its cost of goods sold was $55,000, and its operating expenses such as payroll, overhead, and research expenses were $50,000. Walker Printing would calculate its operating profit as follows:
$150,000 – ($55,000 + $50,000) = $45,000
The operating income is then divided by the total income:
Operating Profit ÷ Total Revenue = Operating Margin
$45,000 ÷ $150,000 = $0.30 (or 30%)
This means that for every dollar in sales made by Walker Printing, he earns $0.30 after expenses are paid.
How to Calculate Operating Profit from Total Revenue
You need to calculate operating profit in order to accurately calculate your operating margin. If you’re still confused about what to subtract from total revenue to find your operating profit, keep reading.
Total revenue includes every penny a business receives from the sale of a product. It does not include any of the costs associated with setting up a business. Operating profit includes some, but not all, of these costs.
1. Calculate the cost of goods sold
The first thing the income statement does is calculate the gross margin or gross profit. You can do this by subtracting the direct cost of goods or services sold by the business. For example, if a business sells lemonade, the costs of lemons, water, and sugar are all part of the cost of goods sold.
2. Calculate Selling, General, and Administrative (SG&A) Expenses
Then you have to consider the incidental costs of doing business. All businesses have overhead costs, also known as selling, general and administrative expenses. Things like renting space for company offices, paying for utilities, and hiring contractors to ensure your business complies with regulatory requirements are all examples of what can be included in overhead.
3. Accounting for R&D and fixed assets
Companies also typically spend money on research and development. This expense is deducted from income. Additionally, if a business has fixed assets that need to be amortized or depreciated, appropriate allowances are taken at this stage.
Subtract all of these to find your operating profit, from which you can then determine your operating margin.
What operating margin does not tell you
Knowing your operating margin is helpful, but it doesn’t include all of a business’s expenses. For example, interest income and expense are not included in operating profit, although they are included in operating cash flow.
In addition, items of income or loss resulting from currency effects are also removed lower in the income statement. One-time restructuring, impairment and other charges are generally absent from operating profit, as are income tax charges.
Nevertheless, knowing your operating margin is useful for two purposes:
- Comparing the same company’s operating margins over two different time periods will give you an idea of any progress or erosion in improving profitability.
- Comparing operating margins between different companies in the same industry can be helpful in determining which company is making the most of opportunities.
Operating margin is a simple concept, but it contains a lot of information. By inviting you to dig deeper into your financial statement, especially your income statement, operating margins can serve a valuable purpose.
Why is operating margin important for small businesses?
Operating margin is an important metric for businesses of any size, including small businesses. Operating margin measures profitability, with a higher operating margin indicating that your business is performing well and is considered financially sound.
Additionally, a higher operating margin indicates that a business can better survive market challenges or an economic downturn.
Operating margin is also an important metric for creditors and investors, as it clearly illustrates a company’s financial strength and operating profitability.
A higher operating margin indicates that the company earns enough money from its business activities to pay all the costs associated with maintaining that activity.
For most companies, an operating margin above 15% is considered good. It is also useful to look at operating margin trends to see if previous years indicate that the operating margin is up or down.
For example, let’s look at the operating margin over the last three years for the Walker Printing example above:
- 2017 operating margin = $0.36, or 36% margin
- 2018 operating margin = $0.32, i.e. 32% margin
- 2019 operating margin = $0.30, i.e. 30% margin
While a 30% margin is good, you can see by looking at the past three years that Walker Printing’s operating margin has been shrinking. This indicates that Walker Printing needs to review operating costs to determine whether it needs to make any changes to prevent its operating margin from falling next year.
Operating margin and your business
Regardless of which accounting method you use, you can calculate operating margin. Calculating operating margin provides business owners with another measure of profitability and can flag potential trouble spots, making it an important metric for all business owners.
If you’re looking for accounting software that can help you produce accurate financial statements, be sure to check out The Ascent’s accounting software reviews.