Operating Margin Formula: How Gross, Operating and Net Margin Fit Together

The three margins

Gross margin = (revenue − cost of goods sold) ÷ revenue
Operating margin = operating income ÷ revenue
Net margin = net income ÷ revenue

Each line of the income statement removes a layer of cost. Cost of goods sold is what it took to make or buy what was sold; what remains is gross profit, the money available to run the company. Operating expenses, meaning selling, administration, research and depreciation, come next; what remains is operating income, the profit from running the business. Interest and tax come last; what remains is net income, the shareholders' share. The margins are these profits as a share of revenue, which makes companies of different sizes comparable and makes one company comparable with its own past.

Two conventions matter when comparing figures. Use the same period, since quarterly margins swing with seasonality and a holiday quarter is not comparable with the one before it. And use reported, not adjusted, figures as the base: companies define adjusted operating income differently, and a margin that excludes stock-based pay for one company and includes it for another is not a comparison.

Worked example: Northfield Tools (illustrative)

Northfield Tools, a fictional industrial company, keeps 35 cents of each dollar after making its products, 14 cents after running the company, and 10 cents after paying its lenders and the government. The gaps between the three are as informative as the levels: a 21-point gap between gross and operating margin means operating expenses consume most of the gross profit, so the company's profitability depends on controlling them; a 4-point gap between operating and net margin means financing and tax are a modest burden, consistent with the light leverage its net debt to EBITDA shows.

What each margin tells you

• Gross margin is the economics of the product: pricing power against input costs. A rising gross margin means the company is raising prices faster than its costs or shifting to better products; a falling one means the reverse, and it is usually the first margin to signal trouble.
• Operating margin is the economics of the business model: how much of the gross profit survives the cost of selling, administering and developing. It is the best single measure for comparing operations, because it is before interest, which depends on how the company is financed, and before tax, which depends on where it operates.
• Net margin is what shareholders get, and it feeds directly into earnings per share. It is also the most easily distorted, by a one-off tax benefit, a gain on a disposal or a change in interest costs. The what is a good EPS article shows how a change in net margin from 10.0% to 10.6% contributed six points of Northfield's earnings growth.

EBITDA margin, operating income plus depreciation and amortisation over revenue, is a fourth that lenders use; it flatters capital-heavy companies by ignoring the cost of the assets they depend on.

Operating leverage: why margins move faster than revenue

Many operating costs are fixed in the short run: rent, salaried staff, depreciation. When revenue rises, those costs do not, so the extra revenue arrives at a higher margin than the average. Suppose Northfield's revenue grows 9% to $1,635 million, gross margin holds at 35%, and operating expenses rise only 5% to $331 million:

Revenue grew 9% and operating income grew 15%. The incremental margin, the extra operating income divided by the extra revenue, is 31 ÷ 135 = 23%, well above the 14% average. That is operating leverage, and it runs both ways: when revenue falls, the fixed costs stay and the margin collapses faster than sales. Knowing a company's incremental margin is the fastest way to estimate what a change in revenue does to its earnings, which is the question the earnings surprise article turns into a price reaction.

Comparing margins, and the traps

Margins are only meaningful within an industry. Software companies with few costs of sale can run gross margins above 70% and operating margins above 25%; grocers run gross margins near 25% and operating margins of 2% to 4%, and both can be excellent businesses, because margin is only one of the factors in return on capital, as the what is ROIC article shows. Within an industry, a persistently higher operating margin usually marks pricing power, scale or a better cost structure, and a widening gap against peers is worth understanding.

• Adjusted margins. Companies report operating margins that exclude stock-based pay, amortisation and restructuring. The gap between adjusted and reported widens as the adjustments become habits; read both.
• One-offs in operating income. A gain on a sale or a legal settlement can sit in operating income and lift the margin for a year. Strip it out.
• Capitalised costs. Moving development or customer-acquisition spending from the income statement to the balance sheet raises margins without changing the cash.
• Mix shift. A margin can rise because the company sold more of its higher-margin products this quarter, not because anything improved. Segment disclosures in the 10-Q show which.
• Cost classification. One company puts delivery costs in cost of sales, another in operating expenses; their gross margins differ for no economic reason. Operating margin is more comparable.

The earnings analysis guide places margins among the other things to read in a quarter's results.