Gross margin vs. operating margin: Key differences

Two financial metrics businesses use to measure how well their company generates profit are gross margin and operating margin. You can use these metrics to make informed company decisions. Furthermore, lenders, analysts and creditors that do business with you might also request these figures. 

Gross margin and operating margin differ in how they’re calculated, what’s included in their calculations, how they’re used and how they’re analyzed. Keep reading to learn more about how gross margin and operating margin compare. 

What you’ll learn:

• Gross margin—expressed as a percentage—measures how much revenue a company retains after accounting for the direct costs of production.

• Operating margin can also be expressed as a percentage, but it measures how much profit a company retains from every dollar after subtracting the variable costs of production.

• You can use both gross margin and operating margin to better understand your company’s profits, but these metrics differ in how detailed their calculations are, as well as how they are used and analyzed.

Gross margin—sometimes referred to as gross profit margin—measures a company’s total revenue after the cost of labor and materials has been accounted for. Gross margin is expressed as a percentage and is used to help businesses determine (1) how profitable they are and (2) how their gross profit—the revenue made from sales minus the cost of goods sold (COGS)—compares to their overall revenue. 

A lower gross margin might mean your costs of production are too high or that you need to adjust your pricing strategy. A high gross margin typically indicates that your company is profitable and you can use its revenue to generate more profit or pay down debt.

Here’s how to calculate gross margin:

Gross margin = (Net sales − COGS / Net sales) ✕ 100

When calculating gross margin, note that net sales refers to your company’s revenue. If your company sells merchandise that can be returned or discounted, you can also factor this into your net sales. 

COGS refers to the direct costs of producing goods or services and is typically listed on a company’s income statement. COGS could include the cost of labor, materials or business supplies used when manufacturing a product.

For example, if a company has $350,000 in total sales revenue and spends $150,000 on the company’s total cost of goods and services, the gross profit would be $200,000 once COGS is subtracted from the revenue. The company’s gross margin would be 57% when you use the following gross margin formula:

57% = ($350,000 − $150,000 / $350,000) ✕ 100

Operating margin, sometimes referred to as return on sales or operating profit margin, measures a company’s profitability ratio after variable production costs—such as utilities or raw materials—have been accounted for but before interest and taxes have been paid. Operating margin can be used to show how well a company’s sales are generating profit on every dollar. It can be a good indicator of efficiency within a business. 

A business with a stable operating margin tends to be less risky than one with a variable operating margin. You might use your business’s previous operating margins as a benchmark to measure current performance.

Here’s the formula for calculating a company’s operating margin:

Operating margin = Operating earnings / Revenue

Operating earnings refer to earnings before interest and taxes (EBIT), which are calculated by subtracting COGS and other operating expenses from the company’s revenue.

If a company spent $400,000 on COGS and $150,000 on other operating expenses and generated $900,000 in revenue, the EBIT would be $350,000. From there, you can divide the $350,000 EBIT by the $900,000 in revenue to yield an operating margin of $0.39. This means the company retains $0.39 in operating profit for each dollar in sales revenue.

$0.39 = $350,000 / $900,000

To express operating margin as a percentage, you can simply multiply the formula by 100.

Gross margin and operating margin have different formulas. Gross margin can be found using this formula: Gross margin = (Net sales − COGS / Net sales) ✕ 100. Operating margin can be calculated using this formula: Operating margin = Operating earnings / Revenue. 

Gross margins are higher than operating margins because you’re not subtracting as many costs from the gross profit.

Gross margin can be a more useful metric when looking for more specific details of a company’s performance. On the other hand, operating margin is less detailed but provides a broader view of the company’s overall performance.

Gross margin shows how profitable a business’s products are. But it doesn’t necessarily provide a complete picture of overall company performance. On the other hand, operating margin measures how profitable a company is from its sales. This is why investors and lenders may look at a company’s operating margin rather than its gross margin, as operating margin provides more insight into the business’s bottom line.

Knowing your business’s gross margin can help inform business decisions by showing how much of your revenue remains after factoring in COGS. For example, once you know your company’s gross margin, you might decide to use the money to:

• Pay interest fees

• Reduce debt

• Manage business expenses

• Cover administrative or general fees

• Distribute dividends to shareholders

Your business’s operating margin is an important metric because it shows how much of your revenue is left over to cover nonoperating costs, like interest or periodic legal expenses. Once you know your business’s operating margin, you might make decisions to improve it, such as:

• Develop your pricing strategy

• Improve marketing efforts

• Reevaluate how you use your business’s resources

While gross margin and operating margin are both useful financial metrics, they do have some limitations. For example, gross margin isn’t a true picture of how profitable a company is because not all costs are included. Operating margin measures profit by including noncash expenses, but it doesn’t account for working capital changes and capital expenditures. This means operating margin can’t be used to measure cash flow or as an indicator of economic value.

Measuring your business’s gross margin and operating margin can give you more insight into its operations and help you make more informed business decisions. If you’re looking for an effective way to track and manage your business’s finances, you might consider getting pre-approved for a business credit card from Capital One. It’s quick and easy—and won’t impact your credit scores.