Operating Margins Explained

The term “margin” is tossed around in board rooms as well as chat rooms when discussing the performance of a company. Rarely, however, does anyone take the time to explain it. In fact, in some instances the type of margin being discussed isn’t even specified! Gross margins, operating margins, and profit margins are three common ways to measure a company’s performance. In essence, a company’s margin measures some level of profit relative to total sales. This is particularly useful when comparing one company against another. For example, to say that Company A earns $1 million per year and Company B earns $2 million per year is not has useful as saying that Company A has profit margins of 30 percent and Company B has profit margins of 35 percent. While scale is ignored in margin analysis, profit performance becomes the focus.

 

The operating margin is particularly useful since it provides an effective indicator of a company’s overall operating efficiency. Usually defined as operating income divided by sales, the operating margin enables company decision makers to determine profit enhancing strategies which generally revolve around expense management. For example, if Company A produces operating income (sales less cost of goods sold less operating expenses) of $1.5 million on total sales of $3 million, it would produce operating margins of 50 percent. Now, suppose the industry average operating margin hovers around 55 percent. Company A’s managers can look at individual operating expenses such as salaries, marketing, rent, utilities, etc. and determine which ones might be due for a reduction. If workforce redundancies exist, layoffs could lower salary expenses and in turn boost operating margins. The goal would be to bring the company in line with the industry average. On the other hand, a simple reduction of marketing expenses could make more sense and avoid other problems associated with layoffs.

 

Regardless of what management opts for, operating margins offer a solid understanding of relative operating performance. This allows management to take necessary steps to make the company more efficient and align it with its peers.

 

Reuben Advani is the president of The BARBRI Financial Skills Institute and the author of two finance books. More information on this and other topics can be found at http://legalpractice.barbri.com.

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