Bridging the gap between Gross and Operating margins

In this post, we’ll explore why some companies, despite having a low cost of goods sold (COGS) relative to their sales, see a significant gap between their gross margin and operating margin due to high operating expenses (OpEx). Operating expenses, typically include costs like salaries, rent, depreciation, marketing, distribution and administrative expenses. To illustrate, we’ll look at two companies:

Prada - A luxury fashion brand

Lululemon Athletica – A designer, distributor, and retailer of technical athletic apparel, footwear, and accessories.

As a starting point, we took the most recent three years of annual data for both companies. We created a common-size analysis focused on three key performance indicators: revenue, gross margin, and operating margin as shown in the table below.

Source: Annual Reports, Our Calculation

From this analysis, we observed a significant gap between gross margin and operating margin for both companies. For example, as shown in the table, Lululemon reported a gross margin of approximately 55–60%, while its operating margin was lower, at 16–24%. This suggests that around 35–40% of sales go into the operating expenses. Similarly, Prada has a gross margin of ~80%, but its operating margin ranges between 18–24%. Given the significant gaps between gross margin and operating margin, we tried to identify the operating cost components contributing to this disparity.

In the case of Prada, the OpEx (2024) is divided into four parts: 

1. Product design and development costs (5%) - Salary accounts for ~50% of the the cost

2. Advertising and communications costs (15%) - Salary accounts for 8% of the cost while other marketing related expenses (digital marketing (e.g. Instagram, WeChat etc.), Collabs, experiential marketing etc.) account for 92% of the cost. 

3. Selling costs (68%) - Salary accounts for ~30% of the the cost, while depreciation related to stores etc. accounts for the majority of the remaining ~70% of the cost. 

4. General and administrative services (11%) - Salary accounts for ~30% of the the cost, while depreciation related to stores etc. account for majority of the remaining ~70% of the cost. 

In the case of Lululemon, ~25% of the OpEx is advertising + transportation while the remaining ~75% is split into Depreciation, Employee salary (e.g. retail staff), and other G&A expenses. 

As an example, a 50% gross margin suggests that the product is sold at twice its manufacturing cost. However, as seen in the above examples, significant investment is often required to actually sell the product—such as marketing expenses, store staff salary, store location in premium areas with high lease costs. These substantial selling and operational expenses ultimately consume a larger portion of revenue compared to the product’s manufacturing cost.

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