# Operating Margin

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Operating Margin equals Operating Income divided by Net Sales

Operating margin is the proportion of revenues remaining after paying the costs of operating the business. Operating costs include expenditures on labor costs (wages), raw materials, overhead, depreciation and amortization, selling, general, and administrative expenses, advertising, etc. Operating margin can be calculated by dividing Operating Profit by Net Sales. That is,

Operating Margin = Operating Profit รท Net Sales.

Example: In 2007, Firm B had \$100mm in Sales and, after all operating expenses are accounted for, records an Operating Income of \$45mm. Then Firm B's Operating Margin is \$45mm/\$100mm = 45%.

## Implications and Usage

Operating margin can be used both as a tool to analyze a single company's performance against its past performance, and to compare similar companies' performance against one another.

### Comparisons With Other Companies

Operating Margins typically require some specific circumstances to be significant. For example, it is useful when comparing two companies in the same industry with different debt structures. Because interest expense is not included in determining Operating Profit, debt is controlled across companies, so examining operating margins can demonstrate the operating efficiencies of the business without a company's debt obligations impacting this analysis.

Suppose we have Firm B from above (45% operating margins) and Firm C (with 28% operating margins). If B and C are in the same industry and are competitors, then B is clearly limiting its operating expenses. Put another way, every dollar that B uses in production of its goods, services, etc... is generating a greater return than every dollar C uses in operations.

If, however, B and C are not in the same space, then the differences in margins may not be so insightful. Suppose B is in an industry where operating margins are typically greater than 50%, and C is in an industry where margins are typically less than 25%, then C is likely more efficient.

A word of warning: Because of different capitalization structures (differing debt levels), different tax structures, and special one-time income events, an Operating Margin Comparison may have contradictory results with Net Profit Margin Comparison. The use of margins in analysis must be supported by other metrics.

### Single Company Growth Comparisons

Staying with company B, let's say that in 2007 it made \$45mm in Operating Income and \$100mm in Revenues. Also, let's say that in 2006, it made \$42mm in Operating Income and \$88mm in Revenues, and in 2005, it made \$37mm in Operating Income and \$75mm in Revenues. Then every year, both Operating Income and Revenues have had positive growth.

 B 2005 2006 2007 Revenues \$75mm \$88mm \$100mm Revenue Growth N/A 17.33% 13.36% Operating Income \$37mm \$42mm \$45mm OI Growth N/A 13.51% 7.14% Operating Margin 49.33% 47.7% 45%

As you can see above, despite positive Revenue and Operating Income growth, margins consistently declined. This could be indicative of many things, including increasing cost of goods sold, an expanding administrative workforce, etc... Declining operating margins would be especially distressing if other companies in the same industry are not experiencing similar effects, or there is no economic or otherwise compelling reason for such a decline.