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. 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.