Operating margin is a profitability ratio that measures how much profit a company makes on each dollar of sales after paying for variable costs of production, such as wages and raw materials, but before paying interest or taxes. It reflects the percentage of revenue that is left over after all operating expenses have been deducted from sales.

Formula

Operating Margin = (Operating Income / Revenue) x 100%. Operating Income (also known as Earnings Before Interest and Taxes or EBIT) is a company's profit after subtracting operating expenses (like cost of goods sold, administrative expenses, and selling expenses) from its gross revenue. Revenue (or Sales) is the total amount of money generated from a company's primary business activities.

Why is it Important for Investors?

Investors care about operating margin because it provides a clear picture of a company's operational efficiency and core business profitability, stripping away the effects of financing decisions (interest) and tax rates, which can vary. A consistently high or improving operating margin indicates that a company is effectively managing its day-to-day operations, controlling costs, and has a strong pricing strategy. Conversely, a declining operating margin might signal increasing costs, pricing pressures, or inefficiencies that could impact future earnings and cash flow, making it a critical metric for assessing a company's fundamental health and competitive advantage.

What is a Good Operating Margin?

Operating margins can vary significantly across different industries. Generally, a higher operating margin is better, as it indicates a company is more efficient at converting sales into profits from its core operations. For instance, industries with high fixed costs like manufacturing might have lower typical operating margins than technology or software companies, which often boast very high margins (e.g., 20% or more) due to lower variable costs. Retail and consumer goods industries might see margins in the 5-15% range, while some service-based businesses could be higher. It's crucial to compare a company's operating margin against its historical performance and its direct competitors within the same industry to determine if it's considered good or bad.