The difference between gross margin and operating margin

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The gross margin and operating margin are two calculations used to measure different aspects of a firm’s profitability. The expenses included in each calculation differ, as do the uses to which these margins are put.

What is Gross Margin?

Gross margin measures the return on the sale of goods and services. It is derived by subtracting the costs of direct labor, direct materials, and factory overhead from sales. It is designed to track the relationship between product prices and the costs of those products, and is closely watched to see if product margins are eroding over time.

What is Operating Margin?

The operating margin subtracts operating expenses from the gross margin. This means that all selling, general and administrative expenses are deducted from the cost of goods sold, which leaves the profit or loss generated by the core operations of a business. In essence, the operating margin is designed to track the impact of the supporting costs of an organization on its gross margin.

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Comparing Gross Margin and Operating Margin

There are several key comparisons to be made between the gross margin and the operating margin. They are as follows:

  • Combined usage. The two margins should be used together to gain an understanding of the inherent profitability of the product line, as well as of the business as a whole. If the gross margin is too low, there is no way for a business to earn a profit, no matter how tightly its operating costs are managed.

  • Reporting format. The two margins are typically clustered together with the net profit margin, which also includes the effects of financing activities and income taxes. All three margins can then be tracked on a trend line. If there is a spike or dip in these trends, management can delve into the underlying financial information to determine specific causes and take corrective action.

  • Influence of fraudulent manipulation. These margins are subject to manipulation. One business could classify certain costs as operating costs, while another might classify them within the cost of goods sold. The result is that they both may have the same operating margins, but different gross margins. Consequently, it is useful to have a knowledge of account classifications when comparing the financial results of two separate businesses.

Examples of Gross Margin and Operating Margin

As an example of how these margins are calculated, a business has $100,000 of sales, a cost of goods sold of $40,000, and operating expenses of $50,000. Based on this information, its gross margin is 60% and its operating margin is 10%.