What is the Operating Margin Ratio?

The operating margin ratio shows the proportion of operating income to the net sales of a business. The ratio is commonly used when comparing the profitability of different firms within the same industry, since they should all have roughly the same cost structures. Those firms with better cost controls and higher-margin products will score better in this comparison.

How to Calculate the Operating Margin Ratio

To calculate the operating margin ratio, divide operating income by the net sales of the business. Operating income excludes all financing costs and expenses associated with non-operating activities. Net sales is the gross sales of the organization, minus all sales returns and allowances. The formula is as follows:

Operating income ÷ Net sales = Operating margin ratio

Example of the Operating Margin Ratio

For example, a business generates $100,000 of net income, and has $20,000 of financing costs. It generates $1,050,000 of gross sales, and also experiences $50,000 of sales returns and allowances. In this case, its operating income is $120,000, while its net income is $1,000,000. Therefore, it has generated an operating margin of 12%.

Understanding the Operating Margin Ratio

This is one of the most important income statement ratios, since it reveals the profitability of the core operations of a business, excluding any impact of its financial structure. A high operating margin ratio is needed by a business that is highly leveraged, since it must spend more money on interest expense than a firm that is funded with a lesser amount of debt.

The operating margin tends to decline as a business increases in size, for two reasons. First, it tends to expand into business lines that are less profitable as it pursues increased sales. And second, organizations tend to increase in complexity as they grow, which results in more corporate and administrative overhead expenses.