Operating Profit Margin is a profitability and performance ratio, which is the percentage of profit a company produces from its operations.

What Does it Signify?

The operating margin shows how much profit a business makes for each rupee of sale after paying for the variable cost of production such as wages, and raw materials. The operating profit is computed before paying interest or tax.

Operating margin is an indicator of how well a company is being managed, or how risky the operations of a company are.

The operating profit also shows how much money is available with a company to cover its non-operating costs such as interest payment, dividend, tax payment, and the likes. Thus, it is one of the most critical metrics that is looked at by investors or lenders.

Analysts also look at the trend of operating margins. If the operating margin is highly variable, it indicates the business risk.

Similarly, the trend analysis helps analysts gauge if the company’s past operating margin is likely to sustain or not.

How are Margins Computed?

Two components are required for computing operating margins – revenue and operating profit.

1.Revenue is the top line of a company and is found on the first line of a company’s income statement. The revenue represents the total sales generated by selling goods or services.

2. Operating profit is the profit that remains after taking care of the day-to-day expenses. The expenses here include wages and benefits for employees, contractors, rent, administrative costs, raw materials cost, selling and distribution expenses, and the likes.

The costs that are not included in operating profit are – interest on debt, taxes, profit/loss from the sale of assets (non-operating income). In simple words, any cost that is necessary to keep a business running.

Thus, the operating margin is calculated as –

Operating margin = Operating profit / Net sales

Why Is Operating Margin Necessary?

Operating margins are essential as they denote efficiency.

The higher operating margin shows how profitable a company’s operations are. Higher operating margins help in gauging the kind of returns an equity holder can expect. An equity holder gets a share from the profit after tax.

Factors that Affect Operating Margins

Several factors affect operating margins. This includes pricing strategy, particularly for raw materials, labor cost, and outsourcing cost (read subcontracting).

In sectors such as construction, heavy engineering, and the likes, some company employs different strategy towards outsourcing, whereas some have in-house manufacturing or are even backward or forward integrated. These factors also impact the margins.

These items are generally dealt with on a day-to-day basis. Thus, the margins also indicate of managerial flexibility and competency during tough times.

Operating Margin and EBITDA Margins are Different

Often EBITDA, also known as Earnings Before Interest Tax, Depreciation and Amortisation, is considered to be operating margins. But this isn’t true in all cases.

While operating margins indicate a company’s profit after paying for variable cost, the EBITDA margins shows a company’s overall profitability, without taking into account the cost related to fixed assets/capital.

Having said that, to make analysis easier, analysts use EBITDA as operating margins in asset lite sectors.

Limitation of Operating Margin

The operating margin is useful only when two companies in the same industry are being compared.

For example, two companies such as Hindustan Unilever Ltd and Marico Ltd can be compared with the help of operating margins as they both belong to the FMCG sector.

But HUL can’t be compared with Hindustan Construction Company while assessing which is a better organization as the sectoral dynamics differ, and thus the variable cost varies.

Other uses of Operating Margin

The metric is also used by managers to see the projects that add to the bottom line of a company. It also helps in overhead planning.

Let us now see an example.

A company ABC sells toothpaste to customers in Bangalore. The company reported the following numbers in the first year of its operations –

Sales Rs. 10,00,000
Cost of Raw Materials Rs. 5,00,000
Rent Rs.15,000
Employee Cost Rs.1,50,000
Administrative Cost Rs. 35,000
Selling and Marketing Cost Rs. 50,000

What is the operating margin of the company –

The operating margin is calculated as –

= operating profit / net sales.

So, operating profit is –

= net sales – operating expenses.

So, the operating margin is –

= (net sales – operating expenses)/ net sales.

or, [(10,00,000-(5,00,000+15,000+1,50,000+35,000+50,000)]/10,00,000

or, 2,50,000/10,00,000

= 25%

To conclude, we can say that operating margin is one of the most crucial ratios and helps in understanding about the operations of company including its efficiency and its position in the same industry.

Happy Investing!

Disclaimer: The views expressed in this post are that of the author and not those of Groww