FOOL SCHOOL
Profit Margins - Part II

August 17, 2005

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

Operating margin

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

	Year 2	Year 1
Sales	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 is defined as follows:

Operating margin = Operating profit / 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 divided by 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 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:

Costs	£
Michael's annual salary	12,000
Stationery & postage	2,000
Depreciation	500
Shop rental	1,000
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%.

Net margin

The final piece of the jigsaw is net margin. This is calculated as net profit divided by sales, Where net profit is the profit attributable to shareholders. This is almost the last number you will see in a typical profit and loss statement. Almost, but not quite.

	Year 2	Year 1
Sales	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
Net interest payable	(5,000)	(4,000)
Pre-tax profit	25,000	22,000
Tax	(8,250)	(5,500)
Post-tax profit	16,750	16,500
Dividends	(10,000)	(10,000)
Retained profit	6,750	6,500

The net profit margin in 'Year 1' was 18.33% (16,500 / 90,000) and fell to 16.75% in 'Year 2'. As you can see, it is calculated on a company's net profit rather than retained profit. Calling net profit "profit attributable to shareholders" makes more sense. From its net profit, a company can choose to pay a dividend to shareholders, like most UK companies, or choose to keep all the profits in the business, as a lot of the younger US companies do.

Recapping using the above example:

	Year 2	Year 1
Gross margin	40.0%	38.9%
Operating margin	30.0%	28.9%
Net margin	16.8%	18.3%

With both gross and operating margins on the increase, 'Year 2' is looking rosy. But wait, look at the net profit. It has only increased by £250 from 'Year 1'. The company was forced to maintain its dividend at the 'Year 1' level, even though they thought they'd had a bumper year. The thorn in their side was the increased tax rate. It jumped from 25% in 'Year 1' to 33% in 'Year 2', causing the net profit to remain almost static.

Gross and operating margins are important to investors, as they give us an insight into the progress of the company and its control on costs and selling prices. However, net profit and therefore net margin are what really count. Quoted companies are (or at least ought to be) in the business of creating shareholder value. The only way to do that is to increase the profit attributable to shareholders, or net profit. That is why earnings per share (EPS) is calculated on that figure, and why it is considered so important to investors. Companies are ultimately valued on a multiple of net profits, or earnings. If you wanted to buy this company, you would consider offering a price that is, say, 10 times their profits. You might offer more, if you thought its chosen market was about to take off. That is why the net margin figure is so important.