FOOL SCHOOL
Operating Margin

June 25, 2003

In the first article in this mini-series, we looked at gross margin. Now we move on to look at another measure of a company's profitability -- operating (or trading) margin.

A company's profit and loss account will typically start something like:

                           'Year 2'     'Year 1' 
Sales (aka Turnover)       100,000       90,000 
Cost of  Sales             (60,000)     (55,000)
                          --------      ------- 
Gross Profit                40,000       35,000 
Operating Expenses         (10,000)      (9,000)
                          --------     -------- 
Operating Profit            30,000       26,000 

In 'Year 2' the gross margin was 40% (40,000 / 100,000) compared with 38.8% in 'Year 1'.

Operating (or Trading) Margin:

                         Operating Profit 
Operating Margin =     --------------------
                             Sales 

In the above example, the operating margin for 'Year 2' was 30% (30,000 / 100,000) and 28.9% for 'Year 1'. Whilst gross margin measures profitability based on the direct costs of getting a product ready for sale, operating margin takes into account the profit after deducting the other running costs of the business.

The operating margin is a useful tool when comparing one year's results to another. In the above example it has improved by 3.8% from 'Year 1' to 'Year 2'. That coupled with the improvement in gross margin will almost certainly lead to net (after interest & tax) profit growth. Companies that can increase turnover and margins, and keep on doing so, are often worth their weight in gold.

In fast growing companies, operating costs can sometimes run way ahead of themselves, causing potential problems in the future. For example, recruiting a whole load of new sales staff in anticipation of a product release date can add a lot of new operating costs. If the product is subsequently delayed, or worse still a flop, the company will not only have to pay the sales staff whilst they're sitting around waiting for launch date, but it may also ultimately have to pay expensive redundancy costs. Using the operating margin as an analytical tool can sometimes help an investor spot this type of situation.

Whilst we're on the subject of operating expenses, and connected to the operating margin, is the operating expenses to sales ratio. This is simply:

  Operating Expenses 
------------------------
       Sales 

In the above example, this ratio is 10% (10,000 / 100,000 or 9,000 / 90,000) for both years. Any substantial rise in this percentage may be reason for some concern. Ideally, as an investor you'd like to see this ratio coming down as a company expands and its head office costs are spread over a larger revenue base.

When looking at gross margin, luxury mug manufacturer Mugs Away (LSE: MUG) kindly agreed to let us analyse its books. We will do so again today to find out the types of expenses that will typically be included in the catch-all "Operating Expenses."

You will remember that Mugs Away has one employee, Mavis, who does nothing else but make mugs. Her salary, the raw material, the factory costs, in fact the total costs of producing the mugs were included in cost of sales. But what about the other employee, her husband Michael? He runs their Maidenhead shop and head office, right next door to the factory, which is chock full of Mavis' mugs. His, and the shop's costs are included in "Operating Expenses." They would be something like:

                                              £
Michael's annual salary                  12,000
Stationery & postage                      2,000
Depreciation                                500
Shop rental                               1,000
Shop light, heat & power                    400
Computer depreciation                       700
Packaging costs (boxes & bubble wrap)     1,000
Research & Development (plastic mugs)       400
                                         ------
Total                                    18,000

In the article on gross margins, we found the cost of producing 365 Mugs in a year was £25,550. Now, we know the Operating Expenses, or the day to day running costs of the shop and head office functions. Adding the two together gives total costs of £43,550 or £118.99 per mug. These luxury mugs sell for £150 each so Mugs Away is making an operating profit of £11,200 on total sales of £54,750 - assuming it sells all its mugs it produces in a year. That's an operating margin of 20.4% (£11,200/£54,750). Operating margins of 20% plus are relatively rare. That means Mugs Away has, at first sight anyway, a fairly strong competitive advantage.

Some industries have much lower operating margins. Retailers typically have operating margins of less than 10%, with supermarkets coming in at around 5% at the moment. Construction companies have some of the lowest margins around, usually around 1% to 2%.

Once again, as with gross margin, any decrease in costs can improve a company's operating margin and therefore usually its net profit margin. Companies that can consistently do this are usually rewarded with a rising share price. And that's what we're all in this for.

> Gross Margin | Net Margin