Interested in the working principle of operating profit and how the calculation is made? Operating profit is the resulting profit made by a company after deducting cost of goods sold and operating expenses. It’s also known as EBIT “earnings before interest and taxes.” Calculating a company’s operating profit is necessary, as it’s a very efficient metric for evaluating a business’s profitability, and it requires deducting operating expenses and cost of goods sold from the total sales revenue.
This will give potential investors and shareholders a snapshot overview of how profitable your business really is. If your operating profit is strong, then you’ll almost certainly garner more interest from those looking to invest in your business.
Why Use Operating Profit?
Operating profit, among other performance metrics is an important key metric which cannot be ignored by businesses. It offers companies and businesses alike an insight into their performance and overall profitability.
Operating profit is a good indicator for providing insights on the profits made from core business activities, it also provides information on whether a business is achieving its main goals or needs to expand into other sources of income. Operating profits achieve its goal by exempting taxes, debts and others classified as non-operating factors. Therefore providing an important insight on the company’s financial health, activities and profitability.
Read further to get a deeper understanding on operating profit, and its role in accessing a company’s financial status.
What Is Operating Profit?
Operating profit is an impressive indicator for financial strategy and improvements utilised by businesses and companies alike to verify how effectively and efficiently their activities positively affect the business’s income.
Operating profit is also commonly known as EBIT (earning before interest and taxes) this means it only measures the processes and items a business has control over. Meaning that any interest payments, taxes and debt payments are ignored, since they depend on what rate the lender sets, which is something outside the control of the business.
Your gross profit, operating expenses, depreciation, amortization and purchasing of new assets will all have an impact on your operating profit figure except taxes and interest earned from cash, because it all changes.
There is a simple way to work out operating profit from your core business operations.
How To Calculate Operating Profit?
The formula for calculating operating profit involves costs of goods sold, operating expenses, depreciation and amortisation. Here’s how you work out if your have a positive operating profit or negative operating profit:
- Revenue – (COGS + Operating Expenses + Depreciation + Amortisation)
To analyse a company’s operating profit, all operating expenses directly related to generating profits including the cost of goods sold must be deducted from the total sales revenue. These expenses include expenses incurred to create, assemble, and sell the products or services the company set out to offer. It also includes other expenses like cost of raw material, salaries for employees who worked in producing the products, and cost of equipment used.
As stated before, operating profits excludes all non-operating factors made by the business. This includes non-operating expenses such as tax and debts and profits made from investments. Therefore, when analysing using operating profits, non-operating factors must be excluded to provide an accurate insight on the company’s financial performance.
The operating profit margin is the percentage of the operating profit accumulated by a business. It is evaluated by dividing the operating profits analysed by the total sales revenue it was analysed from, then multiplied by 100 to get the value in percentage.
A high operating profit margin indicates a high profitability and a business in good overall financial health.
Breaking Down The Operating Profit Calculation
- Revenue: The total income a company generates from sales of products or services, without any deductions.
- Cost of goods sold: This is the total cost of producing a product or service or assembling a product. It includes expenses such as overhead expenses, expenses made on raw materials and labour.
- Operating expenses: These are expenses made in respect to running the business.
- Amortisation: This is a method of spreading out the payment of an asset or property over its useful life.
- Depreciation: This is a method used in allocating the cost of an asset over its useful life.
- Interest income: Money earned from investments and interests alike.
- Taxes paid: Taxes accumulated for services rendered or products sold, which is usually calculated in respect to the company’s profit.
- Net profit: This is the total revenue left after necessary deductions have been made. It represents the actual profit of a company.
- Gross profit: The revenue left after deducting the cost of goods and services provided.
Exclusions From Operating Income
Operating income excludes all non-operating items such as interest expense, taxes, non-recurring events, gain or losses from investment, and foreign currency exchange gains and losses.
- Income from the sale of properties and assets
- Interest from accounts or similar sources
- Debt
- Investment income from other sources
- Uninsured losses as well as losses from write-offs
- Gains or losses due to changes or improvement in accounting tactics
The expenses should be categorised under a different section on the financial statements of a business and should also include extraordinary items such as gains and losses brought by sales or acquisitions, or charges such as legal fees or costs associated with restructuring or impairment costs.
By eliminating these exceptions before calculating operating income, businesses can use this tool to gain improved and better insights of how core operations generate profits and how to improve moving forwards.
For example, if a business is looking to tap into a new market and incurs a one time expense related to this expansion, the cost should be listed separately on the business financial statement to get an accurate idea of profitability.
How Do Businesses Use Operating Profit Figures?
Operating profit reflects a business’s improvement, growth and success. They provide the business with the insight the business needs to differentiate between the total revenue of their operations and the expenses required to generate such revenue, such as purchase cost, labour and rent.
Having a good insight on your operating profits helps determine how much revenue is being made based on growth and changes in certain areas like sales or product consumption.
By understanding these figures, businesses can realise their potential earnings while optimising costs to maximise profits. You can also use your example of operating profit to attract more interest from investors and banks if you’re looking to generate more income for your business to expand in other areas or develop a new product.
Paying enough attention to these figures gives businesses the chance to make informed decisions when it comes to managing operations such as setting prices based on product or service cost.
Who Uses Operating Profit?
There are a lot of factors and stakeholders responsible for the smooth process of a business, and providing the right performance metrics for each will ensure everyone gains access and insights on the information they need. Net profit reflects the total amount of profit that your business receives, but it doesn’t focus on expenses that are necessary to get that profit. Net income derived in this manner isn’t actually much use to a business. Operating profit is. And here’s who needs to know it:
- Business owners can use operating profit to gain useful insight on the performance of their business on an operational basis and track progress over time.
- Investors usually consider operating profit and other metrics alike when evaluating potential stocks to buy.
- Lenders analyse operating profits as part of their decision-making process when granting loans or other borrowing needs to businesses.
- Governments may also examine operating profit when determining business tax rates, and suppliers use it to evaluate whether a customer can meet payment obligations in the future.
What Factors Can Affect Final Operating Profit?
Factors like production costs, sales figures, cost of service rendered, and overhead expenses can all have an outstanding effect on operating profit. Furthermore, changes in the economy and purchasing power can also affect overall revenue and operating profits alike.
- Large overhead costs: items large enough to be regarded as large overhead costs such as utility expenses and others can have a major effect on the business operating profit.
- Running costs: continuous expenses such as employee payroll, taxes and other fixed costs such as equipment purchased, insurance and office spaces will also affect the operating profit.
- Sales: the number and value of sales made by a business are major contributors to its operating income.
- Competition: competition in the market can lead to marginalised profit and reduce individual price customisation which can affect operating profits.
- Taxes: the amount of taxes accumulated can affect operating profit, either in a positive or negative way.
- Inflation and Recession: inflation or deflation can have a significant influence on the cost of goods and services as well as other costs, causing a large impact on the operating profit.
Companies and businesses should be aware of the small processes and details related to business operations that can affect the business’s operating profit figures drastically either over a short period or long. Furthermore, knowing which factors that have substantial influence on the company’s operating profit is essential for maximising profits and reducing unexpected losses.
How To Improve Operating Profits
Once a business can grasp the key factors affecting and improving profits, the business can then take steps to maximise operational profits.
- The first step a business should take is to perform a thorough inspection and analysis of the company’s operations, as well as its financial performance. This will determine the key areas required to increase revenue and reduce costs. These key changes could include streamlining processes and reducing waste.
- Once a business gains insights on operational profits, applying this when reviewing and changing price structure can help to maximise profits from sales of goods and services.
- Improving investments made into the business, such as technology upgrades, can increase the bottom line by increasing efficiency or empowering employees with tools to do more work with less effort.
- Once a strategy is set up to improve operating profits, it should be regularly monitored and adjusted to ensure continuous improvement.
Are There Any Limitations Of Operating Profits As A Performance Metric?
Operating profits are an important metric every business requires. Whilst incredibly useful, it’s important to understand the limitations of operating profits when used as a performance metric.
This includes:
- Operating profits exclude and disregard any non-operating activities, such as investments or divestment.
- Operating profits also do not consider non-operating income and expenses such as one time sales or interest payments. It also doesn’t take into consideration any long-term investments or payouts that might have been made over the period of interest.
- Given the fact that its main focus is on short-term performance, operating profit does not have the ability to provide insights on the potential performance of the business in the future. Therefore broader indicators of business performance such as market share or customer satisfaction surveys are also needed for a rounded overall.
- Operating profits can be affected by wrong or subjective decisions on accounting for certain expenses. This could lead to inaccurate measurements and wrong performance insights.
As such, it is necessary to consider additional financial indicators when evaluating a business and its growth.
What Other Performance Metrics Can Be Used For Business?
Performance metrics are tools used to measure and evaluate a company’s performance. They can include financial indicators such as return on investment, revenue growth rate, and market share, but other performance metrics can provide businesses with insights into how well they are doing.
These can include customer loyalty metrics like retention and satisfaction, operational metrics like employee turnover rate, and development measures such as the number of new products or services brought to market over a given period.
The right set of performance metrics to use will depend on each business’s objectives and goals, but having access to reliable data across multiple business analysis streams can provide invaluable information to help companies reach their targets. Here’s how some of them compare to operating profit.
Operating Profit vs. Gross Profit
Gross profit is calculated as the difference between total revenue and cost of producing or assembling the goods or services sold. Operating profit is calculated by subtracting all operating expenses from total revenue, including both direct cost and overhead costs.
Gross profit doesn’t consider the general and administrative expenses of operating a business, such as salaries, utilities and rent, while operational profitability takes these expenses into consideration, since they’re subtracted from the total revenue.
Operating Profit vs. EBITDA
EBITDA is another performance metric which stands for earnings before interest, depreciation, taxes, and amortisation. It is an evaluation of a company’s operating performance. The main difference between operating profit and EBITDA is that EBITDA also considers one-time expenses such as legal fees or marketing campaigns to get a more accurate metric of a company’s financial performance, while operating profit does not incorporate these costs, making it less diverse than EBITDA.
Operating Profit vs. Net Profit
Net profit is the total profits made after accounting for all expenses made. These expenses include taxes and operating profits. While operating profits only include operating costs in its calculation, net profit indicates overall performance by including non-operating costs and income. Although, it doesn’t provide accurate insights of the success of a company’s operation.
Summary
This article has explained operating profit, how it is calculated, and its benefits for business. To recap, operating profit is a calculation used to assess the financial performance of a company or business. It can be worked out by subtracting all operating expenses from total revenue using the formula:
Revenue – (COGS + Operating Expenses + Depreciation + Amortisation).
This is a useful business metric for providing insight on how efficient and profitable a business’s operations are over a period of time. It can be compared to other metrics such as gross profit and EBITDA to get an overall picture of a company’s financial health.
