Understanding operating margin

Definition

Operating margin is operating income divided by sales, shown as a percent. On the books, this is a ratio read from the Income Statement, not a ledger account you debit and not a cash balance.

A bike cafe uses it to see how much of each sales dollar remains after product cost and the costs of staying open. A 20 percent reading means twenty cents of leftover from core work on every dollar of sales.

It is not a Balance Sheet line. The statement computes it each period from this month's leftover and this month's sales.

Stay with the percent when you read it. The dollar leftover can rise while this percent falls, if sales grew faster than that leftover.

Where it shows up

P&L: Related to how much of each sales dollar is left after operating costs.

Balance Sheet: Related to the working capital behind those operations.

See also: Operating Income · Revenue · Gross Margin

When you look at your Income Statement, this percent is not its own printed account. It is revenue and the operating leftover, restated as a rate.

When the percent is high, the cafe kept more of each sales dollar after running costs. When it is low, product cost or overhead ate more of each dollar.

The Balance Sheet does not print this rate. The cash, inventory, and unpaid bills behind the month sit there instead.

Gross margin is leftover after product cost, as a percent of sales. This rate is leftover after the keep-the-shop-open costs as well.

A planned percent set next to the actual percent shows whether the cafe kept the rate it meant to keep. The gap is a reading of this rate, not a new account.

On the Statement of Cash Flows, this percent does not appear as a line. Cash from operations is a different story from how much of each sales dollar the shop kept.

How it works

Take this period's operating income. Divide it by this period's sales.

Write the result as a percent. $8,000 left from $40,000 of sales is 20 percent.

Use the same period for both numbers. Mixing last year's leftover with this year's sales will not tell you this month's rate.

Stay with this rate when you read it. A dollar leftover that grew because the cafe opened a second window is not the same story as a rate that held steady.

Operating expenses are the keep-the-doors-open costs inside the leftover. A rent increase with flat sales will pull this percent down.

Gross profit feeds the leftover before those running costs. If product cost rises, both the dollar leftover and this percent usually fall.

Do not treat a single busy Saturday as the monthly rate. The percent uses the whole period's sales and the whole period's leftover.

After the month closes, this rate is part of the period's profit story. Next month starts the count again from zero.

Example

Spoke & Steam Cafe posts $40,000 of food and coffee sales this month. Operating income is $8,000 after product cost and the costs of running the room.

Divide $8,000 by $40,000. Operating margin is 20 percent.

Last month the cafe posted $36,000 of sales and $7,200 of leftover, also 20 percent. Dollar leftover rose this month, but the rate held.

If rent rose $800 and sales stayed $40,000, leftover would be $7,200. The rate would fall to 18 percent.

A catering week that adds $5,000 of sales at the same leftover rate will raise dollars and leave the percent near 20. A week of heavy overtime will lower the percent even if sales hold.

A second month at $44,000 of sales and $8,000 of leftover would be about 18 percent. Dollars held; the rate slipped because sales grew without more leftover.

Common mix-ups

Operating margin is not the same as operating income. Operating income is the dollar leftover; this reading is that leftover as a percent of sales.

Operating margin is not the same as gross margin. Gross margin stops after product cost; this rate also takes out the costs of staying open.

Operating margin is not the same as net margin. Net margin uses the leftover after interest and taxes, so it is usually a smaller percent.

Related terms

• Operating Income: Profit from core operations before interest and taxes.
• Revenue: The total value of goods and services the business earned in a period.
• Gross Margin: Gross profit expressed as a percentage of revenue.
• Net Margin: Net income as a percentage of revenue.
• EBITDA Margin: EBITDA as a percentage of revenue.
• Income Statement: A statement showing revenue earned and expenses incurred over a period, ending in net income.
• Operating Expenses: The ongoing costs of running the business that are not direct costs of sale.
• Budget Versus Actual: The comparison of planned amounts to what actually happened.