Mastering Operating Income Margin And How To Calculate It
When you’re running an early-stage startup, investor relations are fundamental. You want to radiate confidence in how you speak about your finances and have a plan to bring in revenue. This article will dive into one of many ways to do that. Spoiler: it has to do with bookkeeping, financial statements, and operating income margins.
If you’re not sure what any of those things are or how to do them, don’t worry. We’ll explain operating income margin, how to calculate it, and why how it relates to your financial statements. We’ll also talk about how you can leverage these things to improve investor relations.
What Is Operating Income Margin?
Variable operating costs can include things like wages, raw materials, and any other expenses tied to your core business operations that might vary over time.
For example, you could include sales commissions in your variable costs. Sales cycles eb and flow with the changes in markets and seasons, so your sales team might be closing less or more deals (therefore commissions change) depending on the time of year.
But, back to operating income!
Why Is Operating Income Margin Important?
Operating income margin is a measure of how efficiently you use the resources you have. For every dollar you spend, the operating income margin demonstrates how much money you make off that dollar. It tells you if you're charging enough for your product and operating within your means, and it's a strong indicator of profitability.
Here are two key reasons you should always keep a pulse on this metric:
1. For better insight into your financial health – Knowing your operating income margin can help you decide on proper product pricing to reflect your product or services’ actual value. It also allows you to see where you may be overspending on either labor or raw materials so that you can rework your budget to reflect your needs and circumstances.
2. For explaining your business to investors – Investors will use this metric to see how your startup stacks up against your competitors. They will also want to know how much money you have after operating expenses to pay for non-operating costs, like the interest you’ll owe them.
How To Calculate Operating Income Margin
Simply find your operating earnings or EBIT and divide that by your revenue (see how to calculate EBIT here).
Operating income margin = Operating earnings/revenue
For example, imagine a company with an annual revenue of $1 million. The company's total operating expenses, including Cost of Goods Sold (COGS), total $500,000. Therefore, its operating income margin is $1 million - $500,000/$500,000, which is 50%.
What Is A Good Margin For A Startup?
If you calculate your operating margin and find it’s too low, you should take action. Maybe it’s time to increase your prices or find a way to reduce labor costs. You may also want to find lower-cost raw materials for your products.
But what is too low?
In general, 5% is considered a low operating margin. 10% is a healthy margin, while 20% is considered a high operating margin, especially for a startup. This can vary by industry, so factor in your unique business needs when considering your margin.
How To Improve A Poor Operating Income Margin
There are a number of ways to improve a poor operating margin. Here are some of the best approaches:
- Reduce your COGS by cutting labor costs.
- Eliminate waste in your production cycle.
- Reduce unplanned downtime or slowdowns in your workflows.
- Introduce automation wherever possible.
- Reduce the cost of raw materials used in your production cycle.
- Overhaul your inventory management process to ensure that none of your materials are going to waste.
- Increase prices. Exercise caution here, being careful not to exceed reasonable levels.
- Increase the average size of each customer's average order.
Factors Affecting Startup Operating Income Margin
Several factors can impact your startup’s operating income margin. Here are a few to keep in mind.
1. Changes in COGS or Your Operating Expenses
Before you increase any expenses related to keeping your business running (OpEx) or building your product or service (COGS), think twice! Even small changes to these two types of expenses can have a drastic effect on your operating income margin.
However, sometimes COGS and operating expenses are beyond your control. For example, your web hosting provider might increase its fees. This directly impacts the service that you deliver to your customers, so you have to keep on hosting!
These types of expense increases are also often unexpected, so it’s a good idea to evaluate your COGS and OpEx monthly, even daily in real-time to understand how they might affect your margins.
2. Increase or decrease in sales volume
Changes in your startup’s volume of sales can also change your operating income margin. If, for example, you see a decrease in sales, but the COGS and operating expenses associated with your product remain the same, you’ll have less sales revenue to divide against operating expenses.
Since operating income margin requires the total sales revenue from a startup’s products, increases or decreases in the volume of the sales of these products will change variables that go into the operating income margin calculation.
3. Pricing strategies and changes
Many startups pursue pricing strategies to attract new customers and stand out in a potentially crowded market. However, pricing changes like these will affect a startup’s operating income margin, even if these changes result in increased sales revenue.
If a SaaS startup lowers its prices, it may increase its sales as more customers flock to the cheaper product. However, if the operating costs associated with this product (such as data hosting, subscriptions, and communication costs) remain the same, then the company will incur a lower operating income margin. This drop in operating income margin will occur even if the pricing change strategy results in higher sales.
4. Changes in production or supply chain efficiency
Any startup that sells products will be affected by fluctuations in the global supply chain or by changes in production costs for raw materials.
Even software startups are affected by changes in the global supply chain, despite the fact that they may not sell products that require physical manufacturing. For example, your company may sell APIs designed for 5G mobile phones.
However, 5G phones rely on raw silicone for production. Changes in the global silicone supply chain can alter the price of 5G phones. This will create a ripple effect that changes the operating income margin of the SaaS company, even though its products do not directly use raw silicone.
5. Economic conditions and competition in the industry
Economic conditions in your startup’s particular industry always affect your startup’s annual revenue. Technology startups are particularly sensitive to small changes in economic conditions.
For example, during the height of the COVID-19 pandemic, much higher numbers of consumers around the world found themselves stuck in lockdowns or remote work. With more time on their hands and nowhere to go, millions of these people purchased new subscriptions to digital software, streaming services, mobile games, and so on. This new economic condition increased the annual revenue of the software companies selling these products.
However, as the pandemic waned and fewer people were stuck at home, these consumers began to cancel their subscriptions. The economic phenomenon (known as “churn”) caused SaaS companies to lose significant amounts of revenue in a short period. These unique economic conditions cause revenues to drop and negatively affected the operating income margin of countless businesses.
6. Mergers, acquisitions, or divestitures
Finally, mergers, acquisitions, and divestitures can also affect a startup’s operating income margin by changing the shape of the market. Mergers between competitors can provide them with adequate revenue to lower the price of their products.
If your startup provides a competing product, you may need to lower your own prices in order to compete. If your operating costs remain the same, this drop in price will change your operating income margin.
Other Types Of Profit Margin
In addition to operating income margin, two other types of profit margin warrant consideration when you are trying to get a comprehensive picture of your company’s financial standing.
Gross Profit Margin
Gross profit margin is a percentage of your total revenue representing the revenue left over after you subtract your company’s COGS.
Net Profit Margin
Net profit margin looks at every single cost incurred by your business, including interest payments on loans, debt servicing, and other costs that have no direct connection to the product whose cost you are considering.
Adding It All Together
Each of these margins provides a single piece of the puzzle when it comes to calculating your company’s complete financial standing. However, these metrics, while useful in their way, are not as direct an indicator of the specific success of each product.
The gross profit margin doesn’t consider costs, making it ineffective as a way to assess your true profit. On the other hand, the net profit margin doesn't give you as much information about each product.
Operating margin gives you a unique insight into how much profit you realize on a particular product. The best practice is to consider these profit margins together and individually for the clearest picture of your financial standing.
Making Your Financial Data Work For You
Calculating your operating income margin can help reduce the stress of starting your own business. It can help you see exactly where your business needs to improve in terms of inventory, labor and material costs, and pricing.
Tracking your finances and paying close attention to key metrics like operating income margin makes a tremendous difference. It reassures investors and makes it easier for them to measure your business against competitors. It also gives you an easy way to assess and improve your company's success.