Treasury Practice

Operating margin

Published: Jul 2013

Operating margin, sometimes referred to as operating profit margin, is used for measuring a business’s pricing strategy and operating efficiency. It should not be confused with net profit margin, as it does not take into account cash expenses, such as interest payments or tax, for example. Instead, operating margin is the proportion of a company’s revenue that remains after the costs associated with operating the business have been deducted. These include payments such as wages, raw materials, etc. A good operating margin is required to cover other costs, such as interest payments on company debt.

Operating margin provides a measure of profit (before interest and taxes) on each dollar of revenue. For example, if a company has an operating margin of 16%, it makes a profit of $0.16 for every dollar of sales.

How is it calculated?

Operating profit margin is expressed as a percentage of total revenue. It is calculated as follows:

Operating margin = Operating profit net sales x 100 %
  1. Operating profit.

    Also referred to as operating income or EBIT (earnings before interest and taxes).

  2. Net sales.

    Net sales is the amount of sales generated after the deduction of any returns or discounts – may also be referred to as net operating revenue.

Example

Income statement for company ABC
Net sales/revenue ¥2,000,000
Cost of goods sold ¥1,000,000
Labour costs ¥600,000
Administration expenses ¥100,000
Operating profit ¥300,000
Operating margin = 300,000 2,000,000 x 100 % = 15 %

The calculation can give an indication of the effectiveness of a company’s pricing strategy, particularly when measured over a period of time, or in comparison to competitors. For the operating margin to improve, there must be an increase in the difference between the price at which goods are sold and the operating cost. This increase in difference may be due to factors such as improved competitiveness in the company’s pricing strategy, improved operational efficiency and lower cost of raw materials.

Points to consider

Generally, the higher a company’s profit margin, the better the return it will be able to provide its shareholders. Operating margin can be a useful way to determine the potential a company has to improve its profits by expanding its margins. Conversely, operating margin can provide an indication of how much profits may be threatened by price competition. It should be noted, however, that the excessive expanding of margins, particularly if this is achieved through price increases to the consumer, may dent profits by damaging the company’s competitiveness.

As with most financial metrics, operating margin is best compared in conjunction with other financial ratios and measures. It is also best to stick to comparisons between companies within certain industry sectors as benchmark margins may vary between different industries.

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