Let’s face it, profit is one of the most important metrics that you track in your business. Besides tracking your cash, understanding if your company is making money—and keeping it—is the key to long term success and growth.
Because of this, you’ll need to understand the various components of profitability, why it’s important, and how you can improve it.
While it’s tempting to just look at the raw number that is the infamous “bottom line” to determine profitability, it’s actually much more useful to look at profit ratios, otherwise knows as “margins.”
Margins are just earnings displayed as a percentage of total sales or revenue. Using profit-margin percentages lets you easily compare yourself to other businesses to see how you are performing compared to your peers. Are you as efficient at generating profits as other businesses like yours? Margins answer this question for you while absolute profit numbers do not.
For example, let’s look at Company X, which had sales of $5 million last year and profits of $300,000. Company Y had sales of $3.5 million and profits of $250,000. Comparing profits, Company X certainly earned more than Company Y. But, if you look at profit margins, or the profits generated from each dollar of sales, you’ll see that Company X made six cents for every dollar of sales, while Company Y made more than seven cents. Company X may look bigger, but Company Y is much more efficient and spends less for every dollar they make.
Now that you know what margins are and why they are important, let’s dig into one of the key profit-margin ratios: Operating Margin, also sometimes called Operating Profit Margin.
Operating Margin = Operating Income / Revenue
To calculate operating margin, you will need to know your operating income. Operating income is your company’s earnings before interest and tax expenses, also called EBIT. To calculate your operating income, just subtract your expenses (excluding taxes and interest) from your revenue.
So, if you have sales of $1 million and operating income of $100,000, your operating margin would be 10%.
Why is operating margin important?
Operating margin shows you how good your company is at generating income from normal operations of the business, after you’ve spent money on marketing, sales, product development, etc.
Over time, successful companies should develop a higher operating margin. This means that the company is making more on each dollar of sales. To assess whether or not this is happening, compare the company’s quarterly or yearly figures to those of the previous year or quarter, and to competitors, if possible.
What’s better? Higher or lower?
A higher operating margin is generally better. If operating margins are growing over time, that means that the company is growing sales faster than it is growing expenses. The company is figuring out how to be more efficient and is keeping costs under control.
But, startups and early stage companies may have a low operating margin as they invest profits back into the business to continue to fuel growth and expansion. As a business matures, it will usually start to grow its operating margin and generate additional profits.
How to improve your operating margin?
To improve your operating margin, you need to either spend less or bring in more revenue. There are a few ways you can go about doing this:
- Trim operational “waste.” For example, cut down on raw materials used during the production process.
- Make the most of your employees’ time. Synchronize production processes, avoid long delays between tasks, and organize time better to avoid bottlenecking. Give idle employees something to do that will cut down on operational waste.
- Consolidate processes. Spend some time evaluating and analyzing the various systems you use to run your business. If something is inefficient, change it or get rid of it. The goal is to increase efficiency.
- Review your expense budget. To understand how to improve your operating margin, you need to know where you are spending money. Take a look at your payroll expenses, marketing budget, at the cost of materials, and so on. Where is the money going? How can you cut costs?
- Compare your figures with industry averages. Once you’ve figured out where you’re spending your income, take a look at industry averages. How much is the industry spending on each part of their operations? Once you’ve figured this out, you will be able to look for more specific ways to improve your operating margin.
In simplest terms, operating margin is a measure of your profitability and of your operational efficiency. A higher operating margin means that you are generating more profits for every dollar of sales. Unless your focus is to reinvest as much as possible into growing your company, you will want to aim for a higher operating margin.
For more business concepts made simple, check out these articles on direct costs, cash burn rate, net profit, accounts payable, accounts receivable, cash flow, profit and loss statement, balance sheet, and expense budgeting.