Before we begin to discuss the details, we should broadly take a look at the various expense components that determine a company's operating margin. These include variable expenses, semi-variable expenses and fixed costs.
Variable expenses are those expenses that change in proportion with the sales or business activity. Fixed costs are expenses that a company incurs regardless of the business activity. Semi-variable expenses are a mixture of fixed and variable components. For most of the manufacturing companies, costs are fixed until production is at a certain level. If production exceeds that level, the costs tend to become variable.
Example of fixed costs include interest costs, salaries (office employees), electricity (office), amongst others. Examples of variable costs are raw materials, sales and marketing costs, amongst others. A very common example of a semi-variable cost is wages. A company needs to pay its labour a fixed amount, even if production levels are low or if there is no production activity taking place at all. However, if and when production activity accelerates, the staff may work overtime. Subsequently, they will get paid for the same. The overtime wages, in this case, is the semi-variable cost.
Operating margin: Operating margin is a measurement of the proportion of a company's revenue leftover after paying for the variable costs of production. A healthy operating margin is required for a company to be able to pay for its fixed costs. The higher the margin, the better it is for the company as it indicates its operating efficiency. Operating margin is calculated by subtracting the operating expenses from sales, and then dividing the balance by the sales figure. The formula is shown below -
Operating margins = (Net sales - Total operating expenses)/ Net sales * 100
Now that we have a basic idea of what operating margin is, we shall take a look at some factors that determine a company's or an industry's operating margin.
As you would be aware, operating margins differ for each industry. The reasons behind the same are various. Some of them may include the regulatory nature of the business, the intensity of competition, the phase of the industry (life cycle), segmental presence within an industry (niche businesses), geographical presence, brand power, bargaining power of buyers and suppliers, raw material procuring policies and their impact on realisations, amongst others. Many a times, these factors coincide and complement each other. Operating margins also differ significantly for companies within a particular industry. At the end of the day, how a company manages the above (in addition to many others) aspects are essentially what differentiate the leaders from the inefficient players.
Companies forming part of sectors such as telecom and Information Technology (IT) tend to earn the highest operating margins, while sectors such as auto and FMCG garner the lowest margins.
Companies forming part of the auto industry garner one of the lowest margins mainly on account of stiff competition and high dependence on raw material costs (in turn, realisations). An auto manufacturer may not be in a position to fully pass on the rise in raw material cost to its customers as it would end up impacting its car sales as customers would choose a cheaper alternative (considering that there is stiff competition within the industry). For these reasons, the auto industry remains a high-volume, low-margin business. Similar would be the case for FMCG companies.
An example of a low-volume, high margin business would be that of software products or heavy engineering. As software companies develop products in-house, they are able to earn higher margins as sales volumes increase. But when compared to IT services, the quantum of the revenue is relatively much lower. Similarly, for engineering companies, when the component of pure engineering is high on a particular project, the company tends to earn higher margins (on that particular project) as opposed to pure construction or project activities.
Conclusion: We hope that you may have got a better understanding of operating margins and their key determinants after reading this article. As we mention time and again, we recommend investors to study and analyse operating performance of companies from a long term perspective to get a better understanding. In the next article of this series, we shall take a look at interest and depreciation costs and how one could view them.
Equitymaster.com is India`s leading independent equity research initiative
How to interpret key expenses of a company
How to gauge and analyse revenues of a company
No comments:
Post a Comment