What is a Good Operating Margin? | Definition & Formula

When a company consistently sees stronger operating margins than its peers, it might indicate that the business has a competitive advantage and can outperform its peers and build wealth for its shareholders.

In this guide, we’ll cover everything you need to know about operating margins, including how to calculate them, why they matter, what a good operating margin is, and the factors that cause operating margins to rise and fall.

What Are Operating Margins?

The operating margin is a profitability ratio that shows the percentage of a company’s revenue that remains after covering operating expenses, such as wages, rent, and raw materials. It reflects how efficiently a company manages its core operations.

How to Calculate Operating Margins

Calculating operating margins involves two key components:

1. Revenue: The total sales generated by a business.
2. Operating Income: Gross profit minus operating expenses. Operating expenses are costs directly tied to running the business, such as salaries, rent, utilities, and administrative expenses.

Operating income, or operating profit, is calculated by subtracting operating expenses from gross profit. Unlike gross margin, which only considers direct costs, the operating margin accounts for all operating costs, which makes it a more comprehensive measure to show what percentage of revenue becomes profit after the cost of a business’s operations. This is the formula for calculating a company’s operating margin:

Operating Margin = (Operating Income ÷ Revenue) × 100

For example, Google reported roughly $307 billion in revenue for 2023 and about $88 billion in operating income. That means its operating margin for 2023 would be about 28.7%:

1. Revenue: $307B
2. Operating Income: $88B

($88B ÷ $307B) × 100 = 28.7%

That would mean that Google would retain about $290 in operating profit for every $1,000 the company makes in revenue.

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Operating Margins vs. Gross Margins vs. Net Margins

It’s important to understand the difference between a company’s 3 main Income Statement profitability metrics:

• Gross Margin: Measures profitability after deducting direct costs (e.g., materials, labor).
• Operating Margin: Measures profitability after deducting all operating expenses. This is often the best profitability measure for comparing profitability for different companies.
• Net Margin: Measures profitability after all expenses, including taxes and interest. The net margin shows the company’s bottom-line profitability.

Each metric provides unique insights, but the operating margin is particularly valuable for assessing a company’s operational efficiency.

Why Are Operating Margins Important?

Operating margins help investors evaluate a company’s profitability and operational efficiency. Here’s why they matter:

1. Measuring Efficiency: A high operating margin indicates efficient management and cost control, as companies have to manage costs to report higher operating margins.
2. Comparing Competitors: Operating margins allow investors to compare profitability across companies within the same industry. A company with consistently higher operating margins than its peers likely has a competitive edge.
3. Assessing Financial Health: Operating margins provide insights into a company’s ability to weather economic downturns. Businesses with low margins may struggle to stay profitable during challenging times, while businesses with high margins earn extra profit so the business can stand strong during difficult times.

Companies with consistently strong margins compared to their peers often have a competitive advantage, such as:

1. Cost advantages
2. Intangible assets (like a strong brand)
3. Network effects
4. High switching costs
5. Economies of scale

Conversely, companies with consistently poor margins may have operational inefficiencies, poor competitive positioning, or unfavorable industry dynamics. For example:

• A tech company with 10% operating margins might have worse competitive positioning and be more inefficient than its peers that average 20% operating margins.
• However, a retailer with 10% operating margins would be much more profitable than its peers and may have a competitive advantage.

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What Is a Good Operating Margin?

The definition of a “good” operating margin depends on the industry in which a company operates. Different sectors have unique cost structures, competitive dynamics, and pricing power that affect their margins.

Here’s a breakdown of some average operating margins by industry:

High Margin Industries:

1. Tech: ~20%-30%
2. Pharmaceuticals: ~20%-35%

Moderate Margin Industries:

1. Consumer Goods: ~10%-15%
2. Financial Services: ~15%-25%

Low Margin Industries:

1. Retail: ~2%-8%
2. Manufacturing: ~5%-10%
3. Airlines: ~3%-10%
   

High-Margin Industries

High-margin industries often enjoy scalable operations, pricing power, and intellectual property that drive profitability.

1. Technology

Industry Average Operating Margins: ~20%-30%.

Examples:

• Strong Operating Margins: Microsoft (MSFT) maintains operating margins of around 40%, benefiting from its software’s low variable costs and market dominance.
• Poor Operating Margins: Snapchat (SNAP) struggles with negative operating margins due to high competition and the cost of scaling user acquisition.
  

2. Pharmaceuticals

Industry Average Operating Margins: ~20%-35%.

Examples:

• Strong Operating Margins: AbbVie (ABBV) boasts operating margins of about 35%, driven by its portfolio of high-margin drugs like Humira and its strong pipeline of new treatments.
• Poor Operating Margins: Teva Pharmaceuticals (TEVA) operates with much lower margins of ~20% due to reliance on generic drugs, which are more price-competitive.

Moderate-Margin Industries

These industries tend to have some opportunities for companies to scale, but they also have higher cost structures or competition.

There are certainly wonderful businesses within these industries, but in general, companies in these industries tend to have average profitability.

1. Consumer Goods

Industry Average Operating Margins: ~10%-15%.

Examples:

• Strong Operating Margins: Procter & Gamble (PG) delivers ~22% operating margins, benefiting from strong brands and operational efficiency.
• Poor Operating Margins: Edgewell Personal Care (EPC) lacks pricing power compared to larger competitors and averages ~10% operating margins.
  

2. Financial Services

Industry Average Operating Margins: ~15%-25%.

Examples:

• Strong Operating Margins: Visa (V) consistently achieves operating margins of ~65%, thanks to its low-cost transaction processing business model.
• Poor Operating Margins: Robinhood (HOOD) has operated with margins below 10%, impacted by high customer acquisition costs and reliance on volatile revenue streams like payment for order flow. However, the tide may be turning for Robinhood, as the company has reported over 20% operating margins in the last twelve months.

Low-Margin Industries

Low-margin industries are characterized by commoditized products, intense competition, and limited pricing power.

Again, there are definitely wonderful businesses within these industries; this is just a generalization.

1. Retail

Industry Average Operating Margins: ~2%-8%.

Examples:

• Strong Operating Margins: Costco (COST) manages ~3% operating margins, leveraging high inventory turnover and membership-based pricing power.
• Poor Operating Margins: The Gap, Inc. (GAP) has experienced operating margins below industry averages, facing challenges such as declining sales and profitability issues across its brands.
  

2. Manufacturing

Industry Average Operating Margins: ~5%-10%.

Examples:

• Strong Operating Margins: Caterpillar (CAT) achieves operating margins of ~15%, benefiting from strong brand recognition and after-market services.
• Poor Operating Margins: General Motors (GM) often operates at ~6% operating margins because the company is impacted by high labor costs and cyclical demand.
  

3. Airlines

Industry Average Operating Margins: ~3%-10%.

Examples:

• Strong Operating Margins: Southwest Airlines (LUV) maintains ~10% operating margins by focusing on cost efficiencies and a simplified fleet.
• Poor Operating Margins: American Airlines (AAL) operates with slim or volatile operating margins of ~5% due to high competition and debt burdens.

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Factors That Affect Operating Margins

Operating margins are influenced by various internal and external factors:

Internal Factors:

1. Cost Structure: Companies with low fixed costs often have higher margins.
2. Pricing Strategy: Businesses with pricing power can maintain high margins by charging high prices even during downturns.
3. Operational Efficiency: Streamlined operations and effective cost management can boost margins.

External Factors:

1. Market Conditions: Economic booms often result in temporarily higher profit margins.
2. Competition: Intense competition can force companies to lower prices, which reduces margins.
3. Regulations: Increased compliance costs or tariffs can eat into profits.

Understanding these factors can help investors identify companies poised for margin expansion or contraction.

How Companies Can Improve Operating Margins

Improving operating margins often requires strategic adjustments:

1. Revenue Growth: Increasing sales through pricing power, market expansion, or product diversification can boost margins.
   • Example: Apple (AAPL) has consistently grown revenue by expanding its ecosystem, launching subscription-based services like Apple Music and iCloud, and leveraging pricing power with premium products like the iPhone. This diversification has helped sustain high operating margins.
2. Cost Reduction: Companies can renegotiate supplier contracts, reduce waste, or automate processes to cut costs.
   • Example: Walmart (WMT) renegotiates supplier contracts and invests in supply chain automation, such as using robotics in warehouses, to reduce costs and improve operating efficiency. These measures help maintain its low-cost leadership and protect margins.
3. Operational Efficiency: Streamlining operations and adopting technology can significantly enhance profitability.
   • Example: Amazon (AMZN) has optimized its fulfillment centers and logistics with advanced technologies like AI and robotics. These efficiencies reduce delivery times and costs, enhancing operating margins even in a competitive retail environment.
4. Focus on Higher-Margin Products: Shifting focus to premium or high-margin products can drive margin improvement.
   • Example: Coca-Cola (KO) has shifted focus to premium products like Coca-Cola Zero Sugar and smaller, higher-margin packaging sizes. This strategy has driven margin improvement in recent years, especially in competitive beverage markets.

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Why Do Operating Margins Sometimes Fall?

Operating margins can decline due to various challenges, including shifts in revenue, cost pressures, or operational inefficiencies. Operating margins can decline for several reasons, which often signal underlying challenges:

1. Revenue Decline: Lower sales or reduced pricing power can pressure margins, especially in competitive markets.
   • Example: Peloton (PTON) experienced a sharp decline in operating margins as demand for its fitness equipment waned post-pandemic. The company had to slash prices to attract buyers, eroding profitability.
2. Rising Costs: Increases in raw materials, labor, or other operating expenses can shrink margins.
   • Example: Starbucks (SBUX) faced margin pressures due to rising input costs on cost items like coffee beans and higher wages for employees.
3. Operational Inefficiencies: Inefficient processes, outdated technology, or a lack of scale can hinder a company’s profitability.
   • Example: Bed Bath & Beyond (BBBY) struggled with supply chain inefficiencies and excess inventory, which led to higher operating costs and shrinking operating margins.
4. Mix Shift to Lower-Margin Products: A shift in product mix toward lower-margin offerings can reduce overall profitability.
   • Example: Ford (F) saw operating margins decline as it prioritized higher production volumes of lower-margin vehicles, such as Sedans, instead of focusing on premium SUVs or trucks with higher profit margins.

Frequently Asked Questions (FAQs)

1. What is a good operating margin for a business?

A good operating margin for a company depends on its industry. For example, tech companies may aim for 20-30% operating margin, while retail businesses often settle for 5-10%.

2. How is the operating margin calculated, and what does it mean?

Operating margin is calculated by dividing operating income by revenue. It measures how efficiently a company generates profit from its operations and shows the profitability a company sees after its operating costs.

3. Why do operating margins vary by industry?

Margins vary for businesses due to differences in cost structures, pricing power, and competition. For instance, capital-intensive industries often have lower margins.

4. How can a company improve its operating margin?

Companies can improve margins by reducing costs, increasing revenue, and optimizing operations.

5. What is the difference between gross margin, operating margin, and net margin?

Gross margin focuses on direct costs, operating margin includes all operating expenses, and net margin accounts for all expenses, including taxes and interest.

TIKR Takeaway:

Companies with stronger operating margins than their peers tend to have competitive advantages that can help the business sustain profitability through varying market conditions.

Understanding why operating margins rise or fall and why it’s important for a company to have strong operating margins can help you uncover high-quality stocks that might make good investment opportunities.

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Disclaimer:

Please note that the articles on TIKR are not intended to serve as investment or financial advice from TIKR or our content team, nor are they recommendations to buy or sell any stocks.  We create our content based on TIKR Terminal’s investment data and analysts’ estimates. We aim to provide informative and engaging analysis to help empower individuals to make their own investment decisions. Neither TIKR nor our authors hold any positions in the stocks mentioned in this article. Thank you for reading, and happy investing!