“Be precise. A lack of precision is dangerous when the margin of error is small.” Donald Rumsfeld
One sets up a business with the aim of providing prospective customers with superior products/services and in return, to be highly profitable. Operating margins tell us how much money the business makes on every $ of revenue. To calculate this metric we need to know the firm’s operating income, which is revenue minus cost of goods sold (COGS) and general and administration (SG&A) expenses. This figure needs to be further divided by the firm’s revenue, to arrive at the percentage value of the firm’s operating margin. For example if the operating income is $5 and revenue is $100 the operating margin of this business is 5%. If all the other firms in the same industry enjoy operating margins of 10%, then this particular business has major issues regarding their COGS and SG&A. There are a couple of things you should keep an eye on when evaluating this metric.
1. Revenue: Calculate where the majority of revenues is being generated from? Is there a particular product or service which contributes significantly to the overall figure? Is the revenue spread out evenly over many product or services? Each scenario poses potential opportunities and risks. Over reliance on any one product may be risky as a long term strategy. On the other hand, spreading the business over many products or services opens up the possibility of newer competition attacking the business on multiple fronts. A balance needs to be found where revenue can be maximized.
2. Fixed & Variable Costs: Pay attention to the cost structure of the business being evaluated. If the business has a high fixed cost structure with low variable costs, then insufficient revenue generation means operating on smaller operating margins. This can be both an opportunity and a threat to the business. If the industry in question is relatively untapped, there is larger potential in promoting it’s product/service with low variable costs. However if the industry is saturated with large entrenched players, it then becomes challenging to grow the business significantly. Alternatively with low variable cost structures, the business has more flexibility and can usually outmaneuver larger companies.
3. Industry Analysis: How does the company’s operating margin compare to its peers in the industry? Finding this data is usually quite challenging, however rough guidelines can be found with hard work. Once we have these guidelines, the business is bench marked on various factors compared to the competition. This gives us the ability to compare cost structures, revenue splits as well as overall operating margin comparisons.
This metric allows you to get an idea of how profitable the business actually is, and the potential to grow and scale the business further. Businesses which operate with low operating margins must strive to reach revenue levels where they can take advantage of economies of scale. However businesses with higher operating margins can focus on providing a core group of products or services really well to its target segment. As a business owner, keep a sharp eye on operating margins and continue to evaluate how you stack up against the competition.
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