Gross Margin vs. Operating Margin
Why does Business Acumen help me understand Gross and Operating Margin?
Simple business terms such as gross margin and operating margin are very often confused. We often get asked to define them and relate it to a work setting. Here we have one of our very own Senior Financial Consultant's to explain it to us. Here is the transcript:
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Gross Margin:
If I'm owning an income statement maybe for the first time, there are really two parts that I really should key in on. The first one is gross margin. Now gross margin takes your revenue, whatever we're earning from our customers, subtracting the cost of producing our product or service. Gross margin is how much money we're making on our products and services. That's the first step, right? If we're not making any money on our products or services, do we really want to be in this business? Is it worth it? Or is there another more strategic reason why we're doing this? Is this a lot —loss leader for example. But we've got to understand what's happening with that top third of the P&L with gross margin. Is this business really worth it?
How does Business Acumen influence gross margin?
And the other reason why gross margin is so important is because it pays for everything else. I like to get paid, you like to get paid, we like sales commissions we like all that other stuff that we get to do. We like to invest in culture and into employees and things of that nature. Well, we have to be gross margin positive. We have to be making money on our products and services to be able to pay for all that stuff.
Operating Margin:
Which brings us to operating margin. After gross margin we're going to subtract all of our operating expenses, our selling general administrative expenses, maybe we've got some research and development. That all comes out of our gross margin. So, we subtract those operating expenses or OPEX from our gross margin and we get what's called operating income. Now operating margin is the percentage of revenue left over after we subtract not just cost of production, but also all of those support costs that we just talked about.
How does Business Acumen influence operating margin?
Now why is that important? Well again, if we're not making money on our operations is this really worth it? We know we're going to have some taxes, if we've got debt, we're going to have to pay interest. We might also have some other non-operating stuff that we just got to take care of. So, do we make money in our operations? That’s what our operating margin tells us. Now when you're looking at a P&L I think of the P&L as the statement of knowing what the heck we're doing. And two really really important and really good measures of knowing whether we know what we're doing is gross margin. Do we make money on our products? And operating margin - do we make money on our core operation?
Business Acumen in action:
So, the other day my 12 year old son asked if he could start a shoe reselling business. He wants to buy Jordans and sell them. I said great let's do it. Well, he obviously needs the money, so I'm thinking 'hey let's think about if this is a good business decision.' He said he wants to buy Jordans for $250 and sell them for 350 bucks. That's great! You know what if we sell Jordans for $350 and we bought them at $250, we're making a hundred dollar’s worth of margin. $100 worth of gross profit. We're making money on the product. That's great! However, there are other costs that we have to think about. There are packaging costs, perhaps there are shipping costs, and there are other costs that we just need to be aware of that support the selling of the Jordans.
Now if we take that hundred dollars worth of gross margin or gross profit and subtract all of the other support costs, we get what's called operating income. Operating margin is another word for it. You can look at it from both of these gross and operating as a percentage of sales or in a dollar amount. And we should look at both. How much money are we making on those Jordans? And after we subtract all the support costs, how much money are we making then? So gross profit and operating profit - two key measures that we've got to understand to understand the performance of our company.
Frequently Used Financial Acronyms:
For some of us...finance is complicated. If you don't specialize in finance (or...maybe even if you do...) it can sometimes feel like talking about different financial components is like speaking a different language — especially when you're having a conversation with your manager and she hits you with an acronym or financial abbreviation like "CAPEX." In our line of work, we commonly discover that communicators and hearers are not speaking at the same level. We know, that when you're dealing with a business, the possibility that team members aren't fully understanding each other can be scary. But don't worry - we're here to help bridge the gap.
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