One of the most important measures of the performance of a business is profitability. Profitability is measured on various parameters. For example there are profits as a percentage of sales or as a percentage of assets or as a percentage of the net worth. Each of these measures has a distinct utility. The profitability as a percentage of sales itself can be broker into many sub-units. For example, there is net profit margin, the operating profit margin and the gross profit margin. Let us look analytically at gross margin versus operating margins. What is a good operating profit margin for a particular company or for an industry group? Obviously, service companies will have a better OPM compared to manufacturing companies. Let us also look at the relationship between gross margins and operating margins and how these can be used as an interpretative tool for measuring financial performance.
Gross margin versus operating margin
Gross margin measures the return on the sale of goods and services, while operating margin subtracts operating expenses from the gross margin. Gross margin is typically the variable costs that can be associated with production of goods. For example, the cost of raw materials used in manufacture and the cost of direct labour, electricity in the factor etc will be examples of cost of goods sold. Gross margin gives you an idea of the incremental profit that every additional unit of goods sold can generate and is a very useful tool for pricing go products. This is more so in case of competitive industries where the pricing is more in terms of incremental costs rather than total costs.
The operating margin goes one step further. When you deduct supporting costs like selling, general, and administrative costs from the gross profit you get the operating profits. Ideally, the two margins should be used together to gain an understanding of the inherent profitability of the product line, as well as of the business as a whole. If the gross margin is too low, there is no way for a business to earn a profit, no matter how tightly its operating costs are managed.
Understanding how gross profits and operating profits are calculated
Let us understand the concept of gross profit and operating profits with the help of an example of a company over a period of 2 years. This will also give us a time wise comparison of data.
Cost of Goods Sold
EBIT (Operating Profit)
Gross Profit Margin
Operating Profit Margin
Gross Profit Margin = Gross Profits / Net Sales
Operating Profit = (EBITDA – Depreciation) / Net Sales
In the above illustration we are considering a paint company where the cost of goods sold has gone up due to a sharp rise in the price of raw materials due to rise in global crude oil prices. As a result the gross profit margin has come down sharply over the previous year. However, the OPM has come down to really low levels because the Gross profit is not sufficient to cover the cost of SGA and depreciation, which are more fixed in nature. There is a small question here. Why do we consider OPM post depreciation? Although depreciation is a non-cash expense, it is a reserve that you create so that the tax shields on depreciation can be used to replenish the plant and machinery. To that extent, it does become an operating cost. The agenda for the company CFO must be to either explore if they have the pricing power to raise prices or alternatively look to cut down on costs.
What are the key takeaways from the Gross Margins vs OPM discussion?
There are 3 key takeaways from the above comparison.
Gross margin and operating profit margins help to determine how efficiently a company's management is in earning profits. In fact, they pinpoint the exact nature of the problem with the operations and help to create decision points.
Gross margin measures how efficiently a company manages its direct costs while operating margins measures how efficiently the company absorbs its fixed costs. Normally, fixed cost pay off better when there is scale.
Some of the most important decisions of a manufacturing company stem from 3 sources viz. managing the market price, managing the input cost and managing the office costs. This comparison of Gross margins versus operating margins allows the company to precisely focus on the action points