Margins & profitability
Gross margin vs. operating margin: where did the profit change?
The short answer
Gross margin is gross profit divided by revenue. Operating margin is operating profit divided by revenue. The gap reflects operating expenses that sit below gross profit in the company’s income statement. Compare the accounting basis and expense classifications before drawing conclusions across businesses.
Each margin stops at a different line
For a typical nonfinancial company, gross profit is revenue less the costs classified as cost of goods sold or cost of revenue. Gross margin expresses that profit as a percentage of revenue. Operating profit then deducts the relevant operating expenses shown below gross profit.
Operating margin therefore reflects more of the cost structure than gross margin. It is still different from net margin, which uses net income after the additional items below operating profit, such as interest and income taxes. The exact presentation can differ by company and industry.
Read the source: Fidelity: Management and Growth Ratios
Walk down a small income statement
The invented company below reports $200 million of revenue and $120 million of cost of revenue. Gross profit is $80 million, so gross margin is 40%. Another $50 million of operating expenses leaves $30 million of operating profit, or a 15% operating margin.
The $50 million is not deducted twice. It represents the expenses classified below gross profit in this simplified example. Nor is the $30 million the final profit available to shareholders: interest, taxes and other nonoperating items have not been shown.
| Income statement line | Amount | As a share of revenue |
|---|---|---|
| Revenue | 200 | 100% |
| Cost of revenue | −120 | 60% |
| Gross profit | 80 | 40% gross margin |
| Operating expenses below gross profit | −50 | 25% |
| Operating profit | 30 | 15% operating margin |
Read the source: SEC: Beginners’ Guide to Financial Statements
Margins can move in different directions
Imagine revenue remains $200 million, but cost of revenue falls to $110 million and operating expenses rise to $65 million. Gross profit improves to $90 million and gross margin reaches 45%. Operating profit nevertheless declines to $25 million, producing a 12.5% operating margin.
The arithmetic tells you where to investigate. Better product economics can coexist with heavier research, sales or administrative spending. That does not establish whether the spending is wise. Read what changed, what management expects to gain and whether the costs are temporary or recurring.
Expense classification can complicate comparisons
Two companies can put similar costs in different income-statement categories. Business models also differ: a retailer, a manufacturer and a software company do not have interchangeable cost structures. Compare the definitions, business mix and reporting basis before ranking gross margins.
Adjusted margins require a second check. An adjusted operating margin that excludes stock compensation or restructuring is not directly comparable with another company’s GAAP margin. Read the reconciliation and preserve the distinction in a table or headline. A larger percentage is not automatically a better business.
Read the source: SEC: Non-GAAP Financial Measures (including free cash flow) · Fidelity: Management and Growth Ratios
Distinguish percentage points from percentage growth
A margin moving from 20% to 25% has improved by five percentage points, or 500 basis points. Relative to the old 20% margin, that is a 25% increase. Those are different ways of describing the same arithmetic, and mixing them creates an exaggerated or ambiguous headline.
Tie the percentage back to dollars. Higher revenue can increase operating profit even if the margin declines, while a better margin may not offset a large sales drop. Show both revenue and operating profit before deciding how much the business improved.
Read the bridge, then the explanation
Begin with the income statement and management’s discussion of the period. Identify which costs changed relative to sales and whether product mix, pricing, capacity or spending provides a supported explanation. Keep cash flow alongside the accounting result when considering what the change means for funding the business.
- Which margin changed: gross, operating or net?
- How did revenue and the corresponding profit dollars change?
- Are both periods and peers on the same accounting basis?
- Which cost category explains the difference?
- Is the explanation supported by the filing and management’s commentary?
Read the source: Investor.gov: How to Read a 10-K