Operating Margin

Operating margin measures how much profit a company makes from its core operations for each dollar of sales, after deducting production and operating costs but before interest and taxes.

Key takeaways

• Operating margin shows the percentage of revenue that remains after paying operating expenses (EBIT ÷ Revenue).
• It indicates operational efficiency and how well management converts sales into operating profit.
• Use operating margin to compare companies within the same industry or with similar business models — cross-industry comparisons can be misleading.

What it measures

Operating margin (also called return on sales) isolates profitability from normal business operations. It reflects the portion of revenue available to cover non-operating costs (interest, taxes) and to contribute to net profit. Because it excludes financing and tax effects, it helps assess management and operational performance.

How to calculate

Operating margin = Operating income (EBIT) ÷ Revenue

Expressed as a percentage:
Operating margin (%) = (EBIT / Revenue) × 100

Where EBIT (operating earnings) = Revenue − Cost of Goods Sold (COGS) − Selling, General & Administrative expenses (SG&A) and other operating expenses (excluding interest and taxes).

Example:
* Revenue = $2,000,000
COGS = $700,000
Administrative expenses = $500,000
EBIT = $2,000,000 − ($700,000 + $500,000) = $800,000
Operating margin = $800,000 / $2,000,000 = 40%

If COGS falls to $500,000, EBIT = $1,000,000 and operating margin = 50%.

Limitations and comparability

• Best used to compare companies within the same industry and similar scale/business models.
• Industries differ widely in cost structure; manufacturing and heavy industries often have lower margins than software or services.
• Operating margin excludes depreciation and amortization; for capital-intensive firms, EBITDA-based margins may give a more comparable view.
• EBITDA is not cash flow — it ignores changes in working capital and capital expenditures required to sustain operations.

Other profit margins (how they differ)

• Gross margin: (Revenue − COGS) ÷ Revenue — shows production efficiency only.
• Operating margin: EBIT ÷ Revenue — includes operating overhead and SG&A.
• Net margin: Net income ÷ Revenue — includes interest, taxes, non-operating items, depreciation, and amortization; the most comprehensive profitability measure.
• EBITDA margin: EBITDA ÷ Revenue — excludes non-cash charges and is often used to compare capital-intensive businesses.

Why operating margin matters

Operating margin reveals how much revenue is converted into operating profit and therefore how resilient a business is to cost pressures or revenue declines. Higher margins typically indicate stronger pricing power, better cost control, or a scalable business model.

Ways to improve operating margin

• Increase prices or improve product mix to raise revenue per sale.
• Reduce variable and fixed costs through supplier negotiations, process improvements, or automation.
• Scale up production or sales to achieve economies of scale.
• Optimize overhead and cut non-essential expenses without harming core capabilities.
  Note: Aggressive cost-cutting can harm quality, employee retention, or future growth if done poorly.

Industry patterns

• High-margin industries: software, digital platforms, and some consumer-branded businesses — low incremental cost to serve additional customers.
• Low-margin industries: transportation, automotive manufacturing, and retail — high operating costs, heavy competition, and capital intensity.

Practical tips for analysts

• Compare margins over time to identify trends in operational performance.
• Benchmark against industry peers and median industry margins.
• Consider EBITDA margins for asset-heavy firms and net margins for overall profitability assessment.
• Watch for margin volatility as an indicator of business risk.

Operating margin is a fundamental profitability metric that, when used appropriately and in context, provides clear insight into a company’s operational efficiency and competitiveness.