Learn how to calculate operating margin the easy way. Gain clear insights into your business's profitability and efficiency in managing operational costs.
As a business owner, understanding your financial metrics is crucial for long-term success. One thing that can make or break your growth trajectory is knowing how to calculate operating margin. This seemingly complex ratio can provide invaluable insights into your company's profitability and operational efficiency.
In this article, we'll demystify this essential metric, breaking down its components and explaining how to calculate it in a way that's easy to understand and remember.
What is operating margin?
Operating Margin is your business's EBIT—Earnings Before Interest and Taxes—expressed as a percentage of total revenue. Simply put, it shows how much profit you make from each dollar of sales after covering variable costs like wages and raw materials but before paying interest or taxes.
Why operating margin matters
This metric is a crucial indicator of your company's operational efficiency. A higher percentage means you're effectively converting sales into profits, which is key for both management and potential investors.
Fluctuations in Operating Margin can signal business risks, while a stable, high margin indicates effective management and resource use. It's a metric closely watched by lenders and investors.
Operating margin vs profit margin
Gross profit margin focuses solely on the revenue after accounting for direct production costs like raw materials and labor. It's a snapshot of how well a company manages these immediate costs. On the other hand, the operating margin goes a step further by including all operating expenses—think rent, marketing, and administrative costs—in its calculation. This gives a more comprehensive view of a company's efficiency in turning sales into profit.
How to calculate operating margin: formula & example
Let’s get down to business. You’ll see that calculating operating margin isn’t as bad as it sounds. The formula is quite simple:
Great. Now, what is EBIT, and how do you get it?
How to calculate EBIT
EBIT stands for Earnings Before Interest & Taxes. It’s more commonly known as Operating Income. To get this number, we need to gather some information first:
- Revenue: This is the total amount generated from selling your products or services.
- Cost of Goods Sold (COGS): These are the direct costs of producing the goods or services you sell.
- Gross Profit: Simply put, Gross Profit = Revenue - COGS.
- Operating Expenses (OpEx): These are indirect costs that aren't directly tied to production, such as administrative expenses and marketing costs.
Having these numbers, we can get the EBIT quite easily using the following formula:
Now that we have found EBIT, calculating operating margin is a piece of cake.
Calculating operating margin example
Let’s order our thoughts with a visual example of how you should tackle operating margin calculations. Let's say your business has:
- Revenue of $100,000
- COGS of $40,000
- Operating Expenses of $20,000
First, calculate the Gross Profit:
$100,000 (Revenue) - $40,000 (COGS) = $60,000
Next, find the Operating Income (EBIT):
$60,000 (Gross Profit) - $20,000 (OpEx) = $40,000
Finally, calculate the Operating Margin:
$40,000 (EBIT) ÷ $100,000 (Revenue) = 0.4
0.4 x 100 = 40%
Your operating margin would be 40%, which means for every dollar of revenue, $0.40 is your operating income. Not too bad, right?
Checkpoint
If you feel like learning more about metrics that can help you run your business, you should take a look at How to reduce DSO and overdue payments with these 4 steps.
What is a healthy operating margin?
The truth is that a healthy operating margin is a bit of a chameleon; it changes its colors depending on many factors.
First off, your industry plays a significant role in determining what a healthy operating margin looks like. Service, software, gaming, and luxury are examples of industries with high profit margins. Services don’t have manufacturing costs, software has minimal ongoing expenses, and luxury uses premium prices to set them apart from operating and manufacturing costs.
Not only that, even within the same industry, what's healthy for one business might not be for another. Your operating margin is also influenced by factors unique to your business—like your customer base, operational efficiency, and business model.
There's no universal benchmark for a healthy operating margin. It's best understood in your industry and your business context. Aim for a margin that is both sustainable and competitive.
Wrapping up
We've walked you through the ins and outs of operating margin. From its basic formula to what constitutes a healthy operating margin in various industries. Armed with this knowledge, you're better equipped to make informed decisions that can propel your business forward. So, take the time to crunch those numbers; your business's growth depends on it.
If you are ready for a bigger math problem, check out How Much Should You Spend on AR Customer Communications?
How to calculate operating margin FAQs
Is operating margin the same as EBIT margin?
Yes and no. Both terms measure the same thing (profit after expenses but before interest and taxes), but operating margin is expressed in percentage (%), while EBIT margin is in dollars ($).
Is it better to have a higher operating margin?
The general rule is that a high operating margin translates to having an efficient business, but it’s not that simple. Too high of an operating margin can also indicate that your company isn’t taking advantage of opportunities to expand its business or is not investing enough in its employees, research and development, marketing, or capital expenditures, which could hurt its long-term growth prospects.
What does 30% operating margin mean?
A 30% operating margin means the company earns 30 cents of profit from each dollar of sales after covering variable costs like wages and raw materials but before paying interest or taxes.
Is 10% operating margin good?
Operating margin highly depends on the industry your business operates in and many other company-specific factors such as customer base, operational efficiency, or business model. So, show me your business, and I’ll show you what a good operating margin is.