Gross Margin and Operating Margin are two key financial terms to understand if you want
to evaluate the financial performance of a company on the income statement or P&L (profit
and loss statement).
In this video, we will discuss the definition of Gross Margin and Operating Margin, and
walk through the calculation of Gross Margin and Operating Margin for four well-known global
companies in different industries.
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below the video.
Gross Margin and Operating Margin are financial terms used in the income statement.
We will cover the income statement or P&L for a manufacturing company first, and then
show variations on the wording for companies in other industries.
The top line of an income statement is revenue: the sum of the invoices sent to customers
for the goods that you have delivered or the services that you have rendered, assuming
that all invoices meet revenue recognition criteria.
Manufacturing costs like material, labor and manufacturing overheads eventually end up
in the P&L as Cost of Goods Sold.
Revenue minus Cost of Goods Sold is Gross Margin.
SG&A is Selling, General and Administrative expenses, basically the costs of the general
manager, sales people, marketing team, customer service, human resources, finance, legal and
IT.
Research and development gets reported as a separate line item.
Gross Margin minus SG&A and R&D is Operating Margin or EBIT.
Operating Margin minus interest and taxes is net income, or the bottom line of the P&L.
This video focuses on Gross Margin and Operating Margin.
So what happens if you are not working in a manufacturing company, but in an industry
like services or software?
Most of the P&L looks the same, but your company probably has a term like "cost of sales",
"cost of services sold" or "cost of revenue" replacing the "cost of goods sold" that a
manufacturing-based company would use.
Now that you understand the definitions of Gross Margin and Operating Margin, let's get
a feeling for the relative size of these numbers as a percentage of revenue.
I will show you 4 names of companies that all happen to have a name starting with the
letter A. We will go through the calculation of Gross Margin and Operating Margin for each
of these four companies in the rest of this video.
Which of these companies has a Gross Margin as percentage of revenue of 39% and Operating
Margin as percentage of revenue of 28%?
Is it: A. Accenture, a leading global professional
services company providing a range of strategy, consulting, digital, technology & operations
services and solutions.
B. Adobe, a multinational computer software company.
C. Amazon, an electronic commerce and cloud computing company.
D. Apple, a multinational technology company that designs, develops, and sells consumer
electronics, computer software, and online services.
These companies operate in very different industries, and there are large differences
in absolute size of their key financial numbers, so it is useful to compare them on a relative
basis: by taking Gross Margin as a ratio of revenue, and Operating margin as a ratio of revenue.
You will see in this video that the gross margins of these four companies range from
31% to 86%, and the operating margins of these four companies range from 3% to 28%.
So which one of these four companies has the second highest gross margin at 39% of revenue,
and the highest operating margin at 28% of revenue?
Please vote now, and let's find out in the rest of this video how good your financial
intuition is!
To practice calculating gross margin and operating margin, we will go through the results of
each of these four companies in alphabetical order.
Accenture's financial year ended on August 31st 2016.
In the 12 months of their fiscal 2016, they generated $32.9B in net revenues, and $4.8B
in operating income.
Gross margin is not mentioned in this overview as a separate line item, but we can calculate
it by taking revenues minus cost of services.
Gross margin is $10.3B, or 31% of the net revenue.
Sales, marketing, general and administrative expenses take up 16% of revenue, therefore
Operating Margin is 15% of revenue.
Adobe's financial year ended on December 2nd, 2016.
In twelve months, they generated revenue of $5.9B, from 3 types of revenue streams: subscriptions,
product sales, services and support.
Subscriptions were 50% of revenue in 2014, and have now grown to 78% of revenue in 2016,
as the company transitions to the SaaS model.
Gross Margin is $5B, or a stunning 86% of revenue.
Every incremental dollar of revenue generates a lot of extra margin!
At a technology company like Adobe, sales and marketing expenses are very significant
at 33% of revenue, and research and development is large as well at 17% of revenue.
Due to the large operating expenses, even though Gross Margin is 86% (the highest out
of the four companies we are reviewing), the Operating Margin is 26% (second highest out
of the four).
What is very interesting for investors in Adobe, is that the $1.06B in incremental revenue
in 2016 versus 2015 has generated $983MM in incremental gross margin.
Despite the extra spending in R&D and sales and marketing, operating income has still
gone up by $591MM.
Adobe has a very high operating leverage: incremental revenue translates to a lot of
incremental margin.
Amazon had net sales of $136B. Gross Margin can be calculated by taking revenue and deducting
Cost Of Sales.
Gross Margin in $47.7B, or 35% of revenue.
Operating expenses like Fulfillment, Technology and content, Marketing, and General and Administrative
expenses take up 32% of revenue, therefore Operating Margin is only 3%.
The last company in our list is Apple.
In the financial year ended on September 24th 2016, Apple had revenues of $215.6B.
Gross Margin is 39% of revenue.
If you have revenues the size of Apple Inc, you can spend $10B on R&D and $14.2B on selling,
general and administrative expenses, and that still only adds up to 11% of revenue.
Operating Margin is the highest in our list of four companies, at a stunning $60B or 28%
of revenue.
In this video, we have gone through the definitions and calculations for Gross Margin and
Operating Margin.
Accenture's Gross Margin is 31% of revenue, and Operating Margin 15%
Adobe's Gross Margin is 86%, and Operating Margin 26%
Amazon's Gross Margin is 35%, and Operating Margin 3%
Apple's Gross Margin is 39%, and Operating Margin 28%
So the answer to our quiz question is D. Thank you for watching!
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