Every cost-effective business operation must have a healthy operating margin. It not only allows the company to remain financially solvent, but it also permits owners to reinvest in the business.
Operating margins are an important financial metric used to measure the profitability of a company relative to its total revenue. Operating margins reveal how much of every dollar earned by the business is converted into profit.
It helps owners to make sound decisions and craft strategies that maximize profits. Additionally, investors use this metric to assess the financial health of a company and determine their investments’ chances of success.
What is Operating Margin
Operating margin is a financial ratio that measures the percentage of each dollar earned by the company that turns into profits after paying all operating costs such as wages, manufacturing costs, and other expenses.
One key point is that the operating margin excludes taxes as it is calculated before taxes are taken out.
In simple words, it is the measure of how much a company makes from its core operations before paying for any taxes or interest.
The higher the operating margin, the better a company is doing. It indicates that the business is efficiently running its operations and generating higher profits with fewer expenses.
How Operating margin Works
Understanding how operating margin works is very simple, the key is to get an accurate picture of the company’s costs associated with its operations.
Every business that involves the production and sale of goods or services has operating expenses. Some of the expenses include
- Wages (salaries and benefits)
- Manufacturing costs
- Raw materials or parts used to produce goods
- Office expenses, such as rent, supplies, and utilities
- Shipping costs for the delivery of those goods and services
- Any other related expenses associated with operating the business, etc…
Once all of these expenses are accounted for, the operating margin can be calculated.
How to Calculate Operating Margin
The formula for calculating the operating margin is
Operating Margin = Operating Income / Revenue
Where,
Operating Income: This is the money left after deducting operating expenses from total revenue. This is the money that the company makes from its core operations.
Revenue: This is the total income earned by a business over a certain period. It is important to note that revenue is calculated before taxes are taken out.
By dividing the operating income by the total revenue, we get the percentage of each dollar earned by the company that turns into profits after paying all operating costs.
Example of Operating Margin
Let’s say a company sells widgets for $200 each and has total revenues of $10,000. The company also incurs operating expenses of $7,000 from wages, manufacturing costs, raw materials, office expenses, shipping costs, etc.
Operating Income = Revenue – Operating Expenses
So,
Operating Income = $10,000 – $7,000
Operating Income = $3,000
Now calculate the operating margin
Operating Margin = Operating Income / Revenue
Therefore,
Operating Margin = $3,000 / $10,000
Operating Margin = 0.3 (30%)
This means that for every dollar earned by the company, it makes $0.30 in profits after paying all operating costs.
Conclusion
The operating margin is a very important financial ratio as it reveals how efficient and profitable a company is with its core operations. It assists owners and investors to make decisions that maximize profits and assess the financial health of a company.
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