Operating margin definition
/What is Operating Margin?
The operating margin reveals the percentage of profit generated by operating activities. This percentage is useful for determining the productivity of the basic underlying operations of a business, excluding all financing considerations. The measurement can also be used to determine that portion of sales dollars that remain after all operating expenses to pay for financing costs, such as the cost of interest on loans. This is a particularly important measurement when a business is deriving a large part of its income from financing the sales of its products. In these situations, an analyst wants to know if the underlying operations of the business are still generating profits, or if the entity is relying upon its financing activities to stay afloat. The operating margin is useful for constructing a cross-industry analysis, since doing so strips away the effects of the differing financial structures of competing businesses, so that attention can be centered on their operational results.
The operating margin should be tracked on a trend line, to see if there is a long-term positive or negative trend in the ability of a business to continue earning a profit from its operating activities.
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Disadvantages of the Operating Margin
There are several problems associated with the use of the operating margin, which are as follows:
Not an inclusive margin. The main problem with the operating margin is that it does not include every possible expense. Therefore, an undue focus on this measurement could lead you to believe that a business is quite profitable, when in fact its financing costs are so high that it is generating a loss.
Ignores capital structure. A business might present a sterling operating margin to investors, who may not realize that it also has such an overloaded capital structure that it cannot pay its debts in a timely manner. The result could be a bankrupt entity with an attractive operating margin.
How to Calculate Operating Margin
Operating activities are comprised of the following expenses:
The operating margin is calculated by subtracting all operating expenses from sales, and then dividing the result by sales. One-time events, such as the proceeds from or payouts for lawsuits, are not included in operating activities for the purposes of this calculation. The formula is:
(Sales - Operating expenses) ÷ Sales = Operating margin
Example of Operating Margin
ABC International generates $5,000,000 of sales in its latest quarter, and incurs $4,800,000 of cost of goods sold, selling, and administrative expenses during that time. Its operating margin is:
($5,000,000 Sales - $4,800,000 Operating expenses) ÷ $5,000,000 Sales
= 4% Operating margin
Terms Similar to Operating Margin
The operating margin is also known as the operating profit margin.