Gross profit and operating margin are critical performance measures for small and large companies alike. Whether you are running a grocery store or a multi-million dollar operation, you need to master these concepts for success.
What Is Gross Profit?
Gross profit is the simplest measure of your profit margin. Let's say you run a grocery store and buy a bag of potato chips for $1 from the manufacturer. Then you sell them for $1.50. Your gross profit from the sale of one bag of chips is 50 cents. The formula is:
Gross profit = Net sales – Cost of goods
Net sales refers to the net sale figure after accounting for all returns and discounts. In other words, this is how much money you were actually able to charge. Cost of goods sold, sometimes abbreviated as COGS, is what you paid for the goods you have sold, or, if you have manufactured them yourself, how much they cost to make. Your total gross profit for all the goods you have sold will of course not equal the net profit for your business.
But you must also deduct costs of salaries for your staff, rent for your store, insurance and so on.
What Is the Operating Margin?
Operating margin takes into account all of those additional costs. One operating profit margin interpretation is:
Operating Margin = Operating Income / Net Sales
Operating income is the difference between income generated from your operations minus all expenses you must incur to run your business. In other words, you would take into account not only the cost of the potato chips and the soap and bread, but also such expenses as your electric bill, rent, salaries paid to staff and every other cost you must incur to keep your business going (however, interest expense on your loans and tax expense are not included in this calculation). So operating income refers to how much money you are making from your business when all costs are subtracted from your net sales.
Now divide your operating income by your net sales and the result is your operating margin.
Which One Is More Important?
The short answer is that both measures are critical. However, operating margin is more of a "bottom line" type of figure and will give you a better idea of what you can take home at the end of the day or week, or distribute to your shareholders. Note the emphasis on give you an idea.
A positive operating margin does not necessarily mean that you are making a profit, because you must still deduct interest expenses and taxes from this figure and you may very well end up with nothing, or even a negative number, after you account for those two items. Operating margin, however, tells you whether you are keeping those costs that you must incur to run your business under control.
Businesses With High Gross Profits
Some examples of businesses with high gross profits are jewelers and high-end restaurants. In both cases, you can sell the item in question for much more than it costs you to buy or produce. However, you may very well end up losing money when you account for all expenses necessary to make that gross margin possible. Rent, decoration, salaries for the staff and upkeep are usually a major drag on such luxurious businesses and may eat up all the profits from sales.
Businesses with High Operating Margins
On the other hand, it is quite possible to sell each item at a small profit, but run an efficient operation and make a relatively large operating margin as a result. Fast food chains sell each hamburger or bag of fries at only a little above cost, but they sell very large quantities and keep their other costs under control. As a result, their operating margins can be impressive.
Why Both Metrics Are Critical
When evaluating a business, make sure to look at both of these measures. To maximize profits, you must increase gross profit, by buying lower and selling higher or both, and to ensure that you can take more of those gross profits home, you have to ensure that not too much of this profit is eaten up by secondary expenses.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.