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
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
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
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
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.