What is Operating Margin?
How Does Operating Margin Work?
It is important to understand what expenses are included and excluded when calculating operating margin. The calculation starts with operating earnings, which is equal to minus cost of goods sold, labor and other day-to-day expenses incurred in the normal course of business. It typically excludes interest expense, nonrecurring items (such as accounting adjustments, legal judgments or one-time transactions) and other income statement items not directly related to a company's core business operations.
To see how operating margin works, consider Company XYZ's income statement:
Using this information and the formula above, we can calculate that Company XYZ's operating margin is:
Operating Margin = $150,000 / $1,000,000 = 0.15 or 15%
This means that for every $1 in sales, Company XYZ makes $0.15 in operating earnings.
Why Does Operating Margin Matter?
Operating margins are important because they measure efficiency. The higher the operating margin, the more profitable a company's core business is.
Several things can affect operating margin (such as pricing strategy, prices for raw materials or labor costs), but because these items directly relate to the day-to-day decisions managers make, operating margin is also a measure of managerial flexibility and competency, particularly during rough economic times.
It is also important tothat some industries have higher labor or materials costs than others. This is why comparing operating margins is generally most meaningful among companies within the same industry, and the definition of a "high" or "low" ratio should be made within this context.