What Is Operating Margin? A Basic Guide

Jason Torres, Senior Credit Analyst, First Republic Bank
November 30, 2021

When running a small business, business owners can easily get wrapped up in day-to-day concerns, often at the expense of the big picture. However, along with paying attention to the details, keeping on top of high-level metrics is important to do. These figures will give you a larger sense of whether your business is succeeding and whether you can invest in future opportunities that require significant income.

Business owners can use many metrics, such as cash flow, to help understand the financial health and profitability of their business. One of these highly important figures is operating margin.

Understanding what operating margin is and how to calculate operating margin is important to gaining a full picture of your business’s financial health and viability. Ultimately, knowing the ins and outs of operating margin, as well as how operating income, operating expenses and profit margin factor in, can help set you up for future growth and good business decision-making. 

What is operating margin?

Operating margin describes the ratio of operating income to net sales for your business. Your operating margin compares how much money you make from a dollar’s worth of sales, less the costs of production and raw materials. This figure gives an idea of the profitability of your core business operations.

Your operating margin, sometimes referred to as return on sales, helps you keep track of the money you’re bringing in on sales before taxes and expenses (think: overhead and cost of goods sold, as well as indirect costs, such as marketing, research and development or administration). 

Measuring operating margin provides you with one of the most basic ways of understanding what money you’re actually making per sale and whether that figure is as high as you need it to be to run a profitable business. It will also help you understand whether you have the capital to invest in future projects for growth or whether you'll potentially need a cash infusion down the line.

Along with measuring your own growth as a business, understanding your operating margin can also help you benchmark your performance versus that of your industry peers. For instance, you can get a sense of whether your margins are thinner than your competitors and subsequently look into adjusting parts of your business operations to be able to create higher margins that are more comparable to your industry peers.

Luckily, learning how to calculate your operating margin is fairly simple to do.

How to calculate operating margin

Since knowing your operating margin is so important for both understanding your business itself and having a sense of where you stand relative to others in your business, being able to calculate your operating margin is essential.

At the highest level, you can calculate your operating margin by dividing your operating income (also known as earnings) by your net sales. Importantly, some income is not included in the figure you use for your operating income (like investments). This income will need to be subtracted from operating income before making the final calculation.

Operating Margin Formula

Operating margin = Operating income / Net sales

Important definitions:

●  Operating income: The amount of profit from your business’s operations, after deducting operating expenses, such as payroll, overhead, cost of goods sold (or COGS) and depreciation

●  Net sales: The sum of your business’s gross sales minus your returns, allowances and discounts

Operating margin is important, of course, but business owners also should be aware of several other margins that cover other aspects of a business’s financial health.

Operating vs. net profit vs. gross margins

Along with operating margins, both net profit margins and gross margins are key figures to be aware of as a business owner. 

These are different figures than operating margin, and it’s important to know and use all three, since you need more than one figure to get the full picture of your business finances. Combined, these three margins will give you a stronger, more complete picture of your financial situation and profitability.

  • Net profit margin: The amount of profit a business makes per dollar of revenue gained. This figure tells you how much net income your business makes with your total sales 
  • Gross margin: Net sales, minus COGS. This figure explains how much your business retains after incurring the direct costs of producing the goods you’re selling. This helps shed light on how efficiently a company is producing its product

These are the three main factors businesses use to analyze their income activities. Together, these figures help paint a holistic picture of business operations relative to the product your company is producing.

Why operating margins are important for small businesses

Having an accurate, frequently updated picture of your small business’s profitability from core operations is key. It’s not only critical for day-to-day operations and planning long-term investment opportunities but also especially important when looking to involve investors or financial institutions.

Along with knowing other financial figures well, being able to speak to your business’s operating margins can be helpful when seeking financing tools like a small business line of credit to cover foreseeable gaps or invest in opportunities for growth. A financial institution will use margin information to understand how you’ll use requested funds, as well as to get a general sense of your financial health.

Of course, while operating margins are an important component in interpreting a business’s financial wellness, they’re not the only factor. Along with monitoring your operating margin, as well as net profit margin and gross margin, be sure to keep detailed financial statements and records to get a clear picture of your business’s well-being. 

Together, these metrics can help you run your business better and can paint a clear picture of your financial inner workings for other parties, such as banks and investors.

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