What is Operating Margin?
The operating margin measures how efficiently a company converts the revenue it generates into operating profit. It is a key ratio as it shows the profits before tax that is available to capital holders.
Operating margin is a profitability ratio that measures how much profit a company makes per one dollar of sales after taking into account the variable costs of production, but before deducting interest expenses or taxes. It is a combination of pricing power, direct cost management and overhead cost management. To calculate the operating margin, divide the reported operating profit by the sales for that period. Alternatively, start with reported revenue and subtract the cost of goods sold, SG&A and other overhead costs to arrive at operating income.
Stakeholders of a company compare operating margins from different time periods to determine progress or erosion in improving a company’s profitability.
It’s important to note that the operating margin does not include all the expenses of a business. Transactions such as gains or losses from foreign exchange, income tax expenses and impairment are not part of the operating income total.
Figures are in ($) millions for the year-end 2019
In this example, we compare Amazon, an e-commerce company, and Apple, a multinational technology company. Both of these companies operate in the same industry. Apple’s operating margin is 24.6% (63,930/260,074). Amazon’s operating margin is only 5.2% (14,541/280,522). The ratio shows that for every $1 of revenue Apple generates, it converts $0.24 into operating earnings. Amazon generates only $0.05 operating earnings for every $1 revenue generated.
The comparison between the two margins shows that Apple is able to contribute a higher proportion of its revenues into operating profit compared to Apple. This shows that Apple is managing its costs more efficiently in order to generate profit. Amazon, who operates in a similar industry, should consider reviewing its pricing strategy, internal processes and direct material costs.
Why Calculate the Operating Margin?
The operating margin enables stakeholders to make comparisons of similar companies. It shows which company is more efficient at converting revenue into operating income. Pricing strategy and labor costs affect operating margin and stakeholders can use the ratio to measure managerial flexibility and competency. This helps analysts support decisions on which companies are taking better advantage of opportunities.