Gross margin measures the return on the sale of goods and services, while operating margin subtracts operating expenses from the gross margin. These two margins have entirely different purposes. The gross margin is designed to track the relationship between product prices and the costs of those products, and is closely watched to see if product margins are eroding over time.
Gross Margin is a company’s total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. The gross margin represents the percent of total sales revenue that the company retains after incurring the direct costs associated with producing the goods and services sold by a company. The higher the percentage, the more the company retains on each dollar of sales to service its other costs and obligations.
Operating margin is a margin ratio used to measure a company’s pricing strategy and operating efficiency.
Operating margin is a measurement of what proportion of a company’s revenue is left over after paying for variable costs of production such as wages, raw materials, etc. It can be calculated by dividing a company’s operating income during a given period by its net sales during the same period. “Operating income” here refers to the profit that a company retains after removing operating expenses (such as cost of goods sold and wages) and depreciation. “Net sales” here refers to the total value of sales minus the value of returned goods, allowances for damaged and missing goods, and discount sales.
Operating margin is expressed as a percentage, and the formula for calculating operating margin can be represented in the following way:
The operating margin is designed to also track the impact of the supporting costs of an organization, which includes selling, general, and administrative costs. Ideally, the two margins should be used together to gain an understanding of the inherent profitability of the product line, as well as of the business as a whole. If the gross margin is too low, there is no way for a business to earn a profit, no matter how tightly its operating costs are managed.
As an example of how these margins are calculated, a business has $100,000 of sales, a cost of goods sold of $40,000, and operating expenses of $50,000. Based on this information, its gross margin is 60% and its operating margin is 10%.
The two margins are typically clustered together with the net profit margin, which also includes the effects of financing activities and income taxes. All three margins can then be tracked on a trend line. If there is a spike or dip in these trends, management can delve into the underlying financial information to determine specific causes.
These margins are subject to manipulation. One business could classify certain costs as operating costs, while another might classify them within the cost of goods sold. The result is that they both may have the same operating margins, but different gross margins. Consequently, it is useful to have a knowledge of account classifications when comparing the financial results of two separate businesses.