Operating Margin: How to Calculate It and What It Tells You

The formula and its parts

Operating margin equals operating income divided by revenue. Operating income is revenue minus cost of goods sold and operating expenses.

Operating margin = (Revenue - COGS - Operating expenses) / Revenue x 100

Operating expenses include rent, wages, utilities, insurance, marketing, software and depreciation. They do not include interest on loans or income taxes, and they usually exclude one-time items such as the sale of an asset.

Pull the numbers from your income statement. See the income statement if you need a refresher. If you do not yet track cost of goods sold separately, our guide to calculating cost of goods sold explains how. Using the same method month after month matters more than perfection, because the trend tells you the most.

A worked example

A business with $500,000 of revenue, $300,000 of cost of goods sold and $150,000 of operating expenses has $50,000 of operating income, a 10 percent operating margin.

Here is an illustrative landscaping company:

Each dollar of sales leaves 10 cents after the costs of operating. The owner still has to pay interest and taxes from that money. If margin is 10 percent and a funding payment takes another 4 percent of revenue, only 6 percent remains, and that is why margin matters before you borrow.

Operating margin versus gross and net margin

Gross margin ignores operating expenses, net margin includes interest and taxes, and operating margin sits in between. Each answers a different question.

• Gross margin. Revenue minus COGS, over revenue. It shows how profitable your product or service is before overhead. See what is gross profit.
• Operating margin. Adds overhead. It shows how well the whole operation performs.
• Net margin. After interest, taxes and other items. It shows what the owners actually keep. See calculating net profit.

A business can have a strong gross margin and a weak operating margin if overhead is too high. Another can have a healthy operating margin but a poor net margin because of heavy debt payments. Looking at all three shows where the problem is. For related formulas, read how to calculate profit margin and profitability ratios.

What is a good operating margin

It depends on the industry. Labor-heavy and low-price businesses run thin margins, while software and specialty services run higher. Compare to your history and peers.

There is no single target. A grocery or a distribution business may operate on thin margins and rely on volume. A professional services firm or specialty manufacturer might aim higher. Using a general number from the internet can mislead you.

Better benchmarks:

• Your own margin over the past 12 to 24 months
• Industry data from trade associations or your accountant
• The margin required to cover your debt payments and still pay you

Margin by itself also does not show cash. A 15 percent margin on $200,000 of revenue is $30,000, which may not support an owner and a loan payment. Look at margin together with revenue scale and cash flow. The article on how much of revenue can go to loan payments shows how margin limits what you can afford.

Ways to improve operating margin

Raise prices where justified, reduce direct costs, trim overhead that does not serve customers and focus on your most profitable work.

Work on both sides of the fraction:

1. Raise price. A 3 percent increase with no loss of volume can lift operating income sharply, since the extra goes straight to profit. See small business pricing.
2. Reduce direct costs. Renegotiate with suppliers, cut waste and rework, and improve scheduling.
3. Drop unprofitable products or customers. Track margin by product or job, not just overall.
4. Control overhead. Review subscriptions, insurance, space and discretionary spending line by line.
5. Increase productivity. Better tools or processes allow more output from the same labor.

Measure margin monthly and by segment. Even a two-point improvement on $500,000 of revenue is $10,000 a year. Pair these efforts with a small business budget to hold the gains.

Using margin to decide how much funding you can afford

Your operating margin sets a ceiling on payments your business can carry. Funding only works if the new revenue adds enough margin to cover the new payment.

Say your business earns a 10 percent operating margin on $50,000 of monthly revenue, or $5,000 a month of operating income. A new payment of $4,000 a month would take 80 percent of that cushion, leaving little room for a slow month. If the purchase adds $20,000 of monthly revenue at the same margin, that is $2,000 of new operating income, still short of the $4,000 payment. In that case, either a smaller amount or a longer term, or a different use of funds, may be wiser.

Run the numbers with the extra revenue and margin the money should create, then stress-test with a revenue drop. The article stress-test payments if revenue drops shows how. ROI Funder shows true cost, payback and monthly-equivalent payments before you sign. Products include term loans with fixed payments and revenue-based financing where repayment rises and falls with sales.