Operating margin, also known as operating profit margin, is a percentage that expresses how much of a business’ gross revenue is left over as operating profit, that is, its profit reduced by cost of goods sold and operating expenses (Ex: overhead, salaries, and depreciation).

Operating profit is not reduced by interest and taxes, since these expenses are not operating expenses. While these expenses obviously affect the company as a whole, they do not pertain to the everyday, regular operations of the business and thus do not affect a company’s operating margin.

Is operating profit the same as EBIT?

You may have heard of a related concept to operating profit—earnings before interest and taxes (EBIT). But is operating profit the same as EBIT? Well, for some companies, operating profit is the same as earnings before interest and taxes. But what if a company has non-operating income (i.e., income from sources that are not a part of the company’s normal business’ operations)? In this case, this income and related expenses would reduce the company’s earnings before interest and taxes, but would not reduce its operating income.

Calculating operating margin.

Operating margin is calculated by dividing a business’ operating profit by its revenue and expressing the result as a percentage. Here is the formula for operating margin:

(Operating Profit / Revenue) x 100 = Operating Margin

Operating margin example.

Operating margin, like all profitability ratios, is calculated based on items from a business’ income statement. For example, let’s say your business’ income statement looks like this:

Gross Revenue$1,000,000
Discounts and Allowances-$40,000
Net Sales$960,000
Cost of Sales-$200,000
Gross Profit$760,000
Research and Development Expenses-$100,000
Salaries-$200,000
Overhead-$50,000
Other Operating Expenses-$50,000
Operating Income$360,000
Interest Payments-$10,000
Income Taxes-$40,000
Net Income$310,000

By dividing this company’s operating income ($360,000) by its gross revenue ($1,000,000) and multiplying the answer by 100%, you would arrive at its operating margin of 36%. 

Sometimes, a company uses its net sales—revenue less discounts and allowances—rather than gross revenue in calculating its operating margin. If this is the case, the company’s operating margin would be calculated by using $960,000 (rather than $1,000,000) as the denominator, resulting in an operating margin of 37.5%.

Operating margin vs. net margin.

While operating margin is a measure of the profitability of a business’ operations, net margin is a measure of a business’ overall profitability since it takes into account all expenses, including interest and taxes.

You may wonder why a company needs to specifically monitor its operating margin when it is already monitoring its net margin. At the end of the day, isn’t overall profitability all that really matters?

While this line of thinking sounds temptingly simple, a business owner who only considers their business’ net operating margin does so at their own peril.

For example, a company’s accountants may devise a tax strategy to significantly reduce the company’s overall tax burden.

This may cause the company’s net profit margin to increase from one year to another, since its tax expense affects net profit margin.

However, this increasing net profit margin may give the business owner a misleading picture of the state of their business.

The fact that the company’s accountants came up with a way to reduce the company’s tax burden has little to nothing to do with the efficiency of the company’s core business—its operations.

The same is true if the company’s CFO negotiates a restructuring of the company’s long-term debt that results in a significant reduction to interest expense.

While these cost-saving measures are obvious wins for the business, their positive effect on the company’s net margin could mask the effects of growing operational inefficiencies, if the business owner is concerned about only the bottom line without isolating operations.

However, monitoring the company’s operating margin alongside net margin will give the business owner a more complete picture of the health of their company.

Operating margin vs. gross margin.

Gross margin is an even simpler calculation than operating margin in that it measures only the profitability of a business’ core revenue-producing activity and does not consider the administrative expenses that are included in operating margin.

Gross margin is calculated by dividing a company’s gross profit (i.e., gross revenue less discounts and allowances less cost of sales) by its gross revenue or net sales.

Operating margin, on the other hand, takes into account all costs included in gross margin, as well as other operating costs (Ex: administrative salaries).

Similar to the importance of monitoring both net margin and operating margin, it’s also important to distinguish between operating margin and gross margin in assessing a company’s financial health.

For example, if a company’s gross margin has remained steady but its operating margin has been steadily decreasing over time, the company’s owner may want to examine any bloat or unnecessary expenses in the general and administrative expenses that affect operating margin but not gross margin.

On the other hand, a decreasing gross margin but a steady operating margin could mean that the company’s administrative and overhead expenses are well managed, but that its material and direct labor costs may be due for examination and possibly renegotiation.