How to Use Financial Reports to Calculate Operating Margin - dummies

How to Use Financial Reports to Calculate Operating Margin

By Lita Epstein

The operating margin takes the financial report reader one step further in the process of finding what’s left over for future use and looks at how well a company controls costs, factoring in any expenses not directly related to the production and sales of a particular product. These costs include advertising, selling, distribution, administration, research and development, royalties, and other expenses.

Selling and advertising expenses aren’t factored into the cost of goods sold, which were subtracted out before calculating gross margin, because these expenses usually involve the sale of a number of products or even product lines. These expenses can rarely be matched to a specific sale of a specific product in the same way that the cost of actually manufacturing or purchasing that product can be matched.

Divide operating profit by net sales or revenues to calculate the operating margin:

Operating profit ÷ Net sales or revenues = Operating margin

You can find net sales or revenues at the top of the income statement and find the operating profit at the bottom of the expenses-from-operations section on the income statement.

Using numbers from Mattel’s income statement, you can calculate the operating margin:

$1,021,015 (Operating profit) ÷ $6,420,881 (Net sales) = 15.9% (Operating margin)

Mattel made an operating margin of 15.9 percent on each dollar of sales. Compare this number with Hasbro’s operating margin (using numbers from its income statement):

$551,785,000 (Operating profit) ÷ $4,088,983 (Net sales) = 13.5% (Operating margin)

Hasbro made an operating profit of 13.5 percent on each dollar of sales.

You can see that the tables have turned. Now that all indirect expenses are factored into the equation, you can see that Hasbro lost its big advantage over Mattel on costs. Hasbro’s operating profit is 2.4 percent lower than Mattel’s.

One key expense factor that hurts Hasbro is that its royalty expenses (more than $302 million) are much higher than Mattel’s. Hasbro buys the rights to toys instead of developing them in-house, so it must pay royalties on its toys.

Mattel traditionally develops more of its toys in-house and has much lower royalty payments. In fact, when you look at Mattel’s income statement, you don’t even see royalties separated out from other selling and administrative expenses.

Companies with an operating margin that’s higher than the industry average usually can better hold down their cost of goods sold and operating expenses. Maintaining a higher operating margin means the company has more price flexibility during hard times. If a company with a higher operating margin must lower prices to stay competitive, more room is available to continue earning profits even when they must sell products for less.