The formula
The operating margin is the business’s answer to one question: how much of each sales dollar survives the cost of running the business, before interest and taxes take their cut. Take the operating income — revenue minus operating expenses — and divide it by the revenue. A margin of 25.00% means the business keeps 25 cents of every sales dollar before interest and taxes. This guide works it in seven steps.
Step 1 — Find the revenue
Start with the revenue: the sales the business made over the period, before any costs come off. Use the same period for everything — a year, a quarter, a month. On the worked example the revenue is $1,000,000.00.
Step 2 — Find the operating expenses
Now find the operating expenses: the cost of goods sold plus selling, general and administrative costs — rent, wages, materials, marketing, the cost of running the business day to day. Do not include interest or tax — those come after the operating margin. On the worked example the operating expenses are $750,000.00.
Step 3 — Subtract to get the operating income
Subtract the operating expenses from the revenue. That is the operating income — what the business earns from running the business, before the lenders and the tax office take their cut. On the worked example it is $1,000,000.00 − $750,000.00 = $250,000.00.
Step 4 — Divide the operating income by the revenue
Divide the operating income by the revenue, and multiply by 100. That is the operating margin. On the worked example it is $250,000.00 ÷ $1,000,000.00 × 100 = 25.00%. The business keeps 25 cents of every sales dollar before interest and taxes.
Step 5 — Work out the revenue the target needs
Divide the operating expenses by one minus the target to find the revenue the target needs. On the worked example the target is 20.00%, so the revenue needed is $750,000.00 ÷ (1 − 0.20) = $937,500.00. At $937,499 the revenue is $1 short of the $937,500 needed — $937,500 is the smallest whole-dollar revenue for the margin to reach 20.00%.
Step 6 — Work out the most operating expense the target allows
Multiply the revenue by one minus the target to find the most operating expense the target allows. On the worked example it is $1,000,000.00 × (1 − 0.20) = $800,000.00. At $800,001 the operating expense is $1 over the $800,000 allowed — $800,000 is the largest whole-dollar operating expense for the margin to stay at or above 20.00%.
Step 7 — Check the result against the 20% strong line and the 5% thin line
Compare the margin with the lines: above 20% is strong, 10–20% is solid, below 5% is thin and leaves little room for a bad quarter. On the worked example the margin is 25.00%, so the business clears the strong line. Below 0% the business loses money on its core operations — with revenue of $600,000.00 and operating expenses of $750,000.00 the margin is -25.00%.
Three worked examples
The headline example: $1,000,000.00 of revenue and $750,000.00 of operating expenses. The operating income is $1,000,000.00 − $750,000.00 = $250,000.00, the margin is $250,000.00 ÷ $1,000,000.00 = 25.00%, the revenue needed for the 20.00% target is $937,500.00, and the most operating expense allowed at 20.00% is $800,000.00. Revenue of $1,250,000.00 instead: the operating income is $500,000.00 and the margin is 40.00%. Operating expenses of $900,000.00 instead: the operating income is $100,000.00 and the margin is 10.00%. Use the operating margin calculator for your own numbers.
Two reverses to check your answer
The smallest whole-dollar revenue for the margin to reach 20.00% is $937,500 — at $937,500 the margin is 20.00%, and at $937,499 the revenue is $1 short of the $937,500 needed. The largest whole-dollar operating expense for the margin to stay at or above 20.00% is $800,000 — at $800,000 the margin is 20.00%, and at $800,001 the operating expense is $1 over the $800,000 allowed.
What operating income is, and what it is not
Operating income is revenue minus operating expenses: the cost of goods sold plus selling, general and administrative costs, with interest and taxes left out. It is the earnings the business makes from running the business, before the lenders and the tax office take their cut. What it is not: it is not the profit after tax, and it is not the cash flow. A business can report strong operating income and still be short of cash, because operating income counts sales it has not yet collected.
Why a margin above 20% is strong
A margin above 20% is strong because costs move: a bad quarter, a lost customer, a price rise in materials, and the margin falls. At 25.00% the business can lose a fifth of its revenue and still sit above the 20.00% line; at 10.00% it can lose only a tenth before it is thin. Below 5% the business has little room for a bad quarter, and a single price rise can push it under.
What to do below target
A margin below target means the business keeps less of each sales dollar than the target allows. If the margin were 10.00% instead, the business would be at the bottom of the solid band. The fixes are the formula’s two levers: raise the revenue, or cut the operating expenses. Raise prices, cut operating costs, or drop the lines that lose money. The smallest whole-dollar revenue that reaches 20.00% is $937,500 — at $937,499 the revenue is $1 short of the $937,500 needed.
What a very high margin means
A margin above 20.00% does not mean five times as safe — it may mean the business is under-investing, not spending to grow. On $2,000,000.00 of revenue and $750,000.00 of operating expenses the margin is 62.50% and the most operating expense a 20.00% margin allows is $1,600,000.00. The 20.00% line is the line for keeping enough of each sales dollar; above it, the question is whether the business should spend more to grow faster.
How the operating margin differs from gross margin, net profit margin and the interest coverage ratio
Gross margin stops at the cost of goods sold: it asks how much of each sales dollar survives making the product, before the selling and administrative costs. Operating margin goes one step further and subtracts those costs too. Net profit margin goes further still and subtracts interest and taxes — the bottom line after everything. The interest coverage ratio asks a different question: whether the earnings cover the interest, by dividing EBIT by the interest expense. Operating margin is the operating test; the interest coverage ratio is the earnings test against what the business owes its lenders.