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Discussion on operating margins

Apr 16, 2009

In the previous article of this series on investing, we had briefly looked at how one could analyse a company's expenses over a particular period. In today's article, we will discuss the operating margins, which is a residual profit a company has after deducting its operating expenses from sales. Before we go further into 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 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 that of wages. A company needs to pay its labourers a fixed amount, even if there is very little production or no production activity taking place. However, if and when production activity accelerates, the staff may tend to work overtime. Subsequently, they will get paid for the same. The overtime wages, in this case, is the semi-variable cost.

Operating margin: It is a measurement of what proportion of a company's revenue is leftover after paying for 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 an operating margin is, we shall take a look at some factors that determine a company's or an industry's operating margin.

It may be noted that 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. It may be noted that operating margins differ for companies within a particular industry. This is basically what ascertains the leaders from the inefficient players.

To give an idea of how margins differ within each industry, we can take a look at the table below.

Sector Operating margin range
Engineering 10% to 20%
Cement 13% to 33%
Retail* 7% to 11%
Pharma 10% to 24%
FMCG$ 13% to 15%
IT 26% to 30%
Telecom 27% to 37%
Hotels 18% to 40%
Power 15% to 20%
Automobiles# 8% to 16%
Steel^ 9% to 28%
Construction 12% to 23%
Source: CMIE, Equitymaster Research; * Trading companies;
^ Finished steel; # Including 2- and 4- wheeler manufacturers;
$ Non-food items

From the above table, we can notice that broadly, sectors such as telecom and IT earn the highest operating margins, while sectors such as auto and FMCG garner the lowest margins.

The telecom industry garners one of the highest margins mainly on account of the advantage of operating leverage. As telecom companies need a selected amount of mobile subscriptions (in turn, revenues) to cover its costs of networks, licences and spectrum, any subscriber additions above that level will largely translate as profit for the company.

On the other hand, the auto industry garners 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 pass on the rise in raw material cost to its customers to the full extent as it would end up its car sales as customers would choose a cheaper alternative (stiff competition). 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 on their sales. But when compared to IT services, 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.

It may be noted that these differences are largely intra-industry and not inter-industry.

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. In the next article of this series, we shall take a look at interest and depreciation costs and how one could view them.

Investing: Back to Basics Article Series - Previous article | Investing: Back to Basics Article Series | Next article

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