It doesn’t take an MBA to know that a business needs to make a profit to keep going. You may have even seen some variation of the South Park-inspired meme: Phase 1: [basic business idea] Phase 2: ??? Phase 3: PROFIT!
But “profit” isn’t necessarily just one figure. There are different measures of profit margins, and they tell you different things about your company’s financial performance. Two of these important metrics are gross margin and operating margin.
What is gross margin?
Gross margin, also known as gross profit margin, is a ratio that measures how much money your business retains after paying direct costs of producing goods and services, such as raw materials and labor directly linked to making your products. Gross margin measures are usually referred to as percentages: If your gross margin is 30%, that means the company retains 30¢s for every $1 of sales.
Understanding gross margins helps your business respond to shifts in production costs like labor and materials—and can also highlight the need to make changes, such as increasing prices or switching suppliers.
You can calculate gross margin with this formula:
[(total sales revenue - cost of goods sold) / total sales revenue] x 100 = gross margin
It’s a relatively simple ratio based on two key metrics included on a company’s income statement. The first, total revenue (also called net sales), is gross sales minus any returns or discounts of the items you sell. The second is cost of goods sold (COGS), which is any direct costs of production including raw materials and manufacturing labor.
For example: A women’s apparel retailer generated $50,000 in total sales in the second quarter, and its direct production costs totaled $27,000.
[($50,000 - $27,000) / $50,000] = 0.46 x100, or 46%
This means the retailer retained 46¢ for every $1 of second-quarter sales.
What is operating margin?
Operating margin, or operating profit margin, also considers production costs as they relate to revenue, but this ratio encompasses more of those costs than gross margin does.
Operating margin accounts for all operating costs: not only COGS but also items beyond direct production costs—like rent, research and development, administrative costs, marketing, and salaries—as well as non-cash expenses such as depreciation and amortization. It does not account for non-operating costs like paying interest or taxes.
It’s also referred to as return on sales (ROS), which underscores why operating margin is a closely watched metric: It shows how efficient a company is at turning sales from core operations into profit.
In turn, operating margin highlights how well company leaders manage the expenses that are within their control. Although management may not have control over costs for items such as raw materials, their discretion when spending on other operating costs like rent and equipment may be the difference between a company turning a profit or being in the red. Investors often use this figure to compare the profitability of two companies in the same industry.
To calculate operating margin, you first need to know your business’s operating income. That’s total revenue minus all operating expenses, including COGS, as well as depreciation and amortization.
The operating margin formula is:
(operating income / total sales revenue) x 100 = operating margin
Gross margin vs. operating margin: Key similarities and differences
- How they’re similar: Both gross margin and operating margin are measures of financial health, because they show how efficiently a company can turn sales into profit. Both usually are expressed as percentages—the higher the number, the better—and each considers both total revenue as well as production costs.
- How they’re different: Gross margin shows profit by relating only the cost of goods sold (COGS), which are the business’s direct costs of manufacturing and distribution, to total sales. Operating margin considers all operating costs, including not only COGS but also operating expenses outside of manufacturing costs like rent and marketing, as well as depreciation and amortization.
Gross margin and operating margin FAQ
Are EBIT and gross margin the same?
No. EBIT stands for “earnings before interest and taxes,” or a company’s net income before accounting for the costs of paying interest on debt and of paying income tax. Gross margin is a profitability ratio that considers the cost of goods sold (COGS)—direct costs of production like direct labor and direct materials expenses—in relation to total sales.
What's the difference between gross margin and EBITDA?
Gross margin represents the percentage of revenue left after accounting for the cost of goods sold (COGS), or direct production costs. EBITDA is earnings before interest, tax, depreciation, and amortization, so it focuses on operational profitability because it considers only the day-to-day expenses to run the business.
Is operating margin the same as net margin?
No. Operating margin accounts for operating costs, including direct production and distribution expenses, depreciation, and amortization. Net margin, or net profit margin, considers all business expenses. This encompasses production and other operating costs, plus non-operating costs and revenue—like inventory write-downs or one-time payments—that are not core to the daily business.
How do you calculate net operating margin?
To calculate this profit margin, divide net operating income by net sales. Note that net operating margin is a non-GAAP figure, or a number some companies report that does not fall under the generally accepted accounting principles that US publicly traded companies must follow to ensure uniformity in reporting financial results. Non-GAAP numbers often include non-recurring and non-cash factors like restructuring costs or acquisitions.