In this article
- What is Operating Profit?
- How to Calculate Operating Profit?
- Advantages of Operating Profit as a Measure
- Limitations of Operating Profit as a Measure
- Operating Profit in Relation to Operating Margin
What is Operating Profit?
Operating profit is the revenue a company generates in excess of the operational costs and depreciation & amortization recorded in an accounting period.
In other words, it accounts for all the income and expenses stemming from an organization’s core business operations that are essential to keep the company functioning.
Therefore, operating profit does not include any income or expense born out of ancillary activities like investments, loans, debts, etc. It presents a clear picture of a company’s efficiency, both administrative and managerial, in handling its core business operations.
Analysts and investors utilize a company’s operating profit to determine its profitability through operational activities.
In some cases, operating profit is also cited as Earnings before Interest and Tax (EBIT). However, EBIT includes income arising from non-operational activities as well. Thus, the terms EBIT and operating profit can only be used interchangeably if a company does not have any non-operating revenue like interest earned from investments.
How to Calculate Operating Profit?
In the calculation of operating profit, only costs, directly and indirectly, related to a company’s net sales are taken into consideration. On that note, such expenses that are deducted from net sales to compute operating profit can be primarily be categorized as –
- the cost of goods sold or manufacturing overhead,
- administrative overhead, and
- depreciation & amortization
Calculation of net sales
Net sales is the total income that a company generates from its operational activities minus all relevant expenses against it – allowances, sales returns, and discounts.
The net sales formula is expressed as –
Net sales = Gross sales – (Discounts + Sales Returns + Allowances)
Calculation of COGS
The cost of goods sold involves all expenses directly related to production and sales revenue. Therefore, it includes –
- Labor cost
- Inventory purchase
- Raw materials
Since these costs are directly related to production and vary with changes in scales of production, they are also called variable costs.
Under some practices, fixed costs are also included on a per-unit basis to COGS, according to absorption costing. It is a GAAP guideline that requires companies to adopt absorption costing for external reporting.
Nevertheless, COGS is the aggregate of all costs recognized to directly impact and be impacted by the scale of production. In accounting practice, cost of goods sold is expressed as –
COGS = (Opening inventory balance + Purchases) – Closing inventory balance
Calculation of Administrative overhead
Administrative overhead involves all expenses stemming from a company’s operational activities but not directly related to production.
Therefore, such expenses do not witness change even when there is a shift in production scales.
Expenses under administrative overhead typically include –
- Employee benefit expenses
- Office rent
- Warehouse rent
Calculation of Operating Profit
The operating profit formula is written as –
Operating Profit = Net sales – (COGS + Administrative overhead + Depreciation & Amortisation)
It is also expressed as –
Operating Profit = Gross profit – (Administrative overhead + Depreciation & Amortisation)
Example: An excerpt from Netflix’s Income Statement for the accounting period 31st December 2018 – 31st December 2019 is presented in the table below.
|Particulars||Amount (in $)|
|Cost of revenue||12,440,213|
|Research & Development||1,545,149|
|Sales, General, and Administrative expenses||3,566,831|
|Other operating expenses||Nil|
|Net additional income||84,000|
From this income statement, net additional income, interest expense, and income tax shall be excluded in operating profit calculation. This is because these did not arise from Netflix’s core business operations.
Therefore, Operating Profit = Total revenue – (Cost of revenue + Research & Development + Sales, general, and admin. expenses)
Or, Operating Profit = $ [20,156,447 – (12,440,213 + 1,545,149 + 3,566,831)] = $2,604,254
Advantages of Operating Profit as a Measure
As mentioned previously, operating profit represents the amount of money left with an organization to service debts, pay taxes, meet liabilities, and also pay shareholders their share of dividends.
Therefore, it is of particular interest to managers working in the company in question and third-party entities like investors and creditors.
Operating profit provides managers with a critical understanding of the efficiency behind cost-controlling. It can be viewed in the context of other years’ operating profits as well as costs of revenue and other operational expenses.
Based on such intelligence, managers can take necessary correctives or measures to enhance their profitability.
Investors can gain an understanding of the managerial decisions of a company through its operating profits. In line with that, investors can also assess how efficiently a company carries out its daily activities by studying the operating profit.
Furthermore, in the context of related business conditions, operating profit trends can reveal the responsiveness and flexibility of such companies to changes.
Responsiveness and flexibility are crucial indicators of management efficiency.
Lastly, all other factors like market capitalization, the scale of operations, and business models being similar, operating profit can facilitate comparison between companies.
Limitations of Operating Profit as a Measure
- Profit not profitability
A primary drawback of operating profit as a metric for assessing a company is it reveals a company’s profits and not its profitability. Profit is an isolated figure, while profitability is a metric in relation to a company’s revenues.
- Does not facilitate comparison between companies from different industries
Secondly, investors cannot rely on operating profit as a sole metric for comparison between companies from different industries. Different industries exhibit different levels of operating profit and therefore, contrasting their profits is not an accurate understanding of their potential.
- Exclusion of interest and other extraneous costs
Operating income does not account for interest on varying financial instruments. It may not give a true picture of a company’s financial footing. For instance, a company could be suffering net losses even when it shows positive operating income.
In such a case, it can be concluded that the company in question has a significant amount of debt. Additionally, operating profit also does not account for extraneous costs that can significantly affect a company’s net profits.
Operating Profit in Relation to Operating Margin
Operating margin, also known as operating profit ratio, is the ratio between a company’s operating profit and revenue. Therefore, in other words, it indicates the profitability of an organization.
The operating profit ratio formula is given below:
Operating margin = Operating profit / Net sales
Let’s consider the example of Netflix mentioned above. It recorded an operating profit of $2,604,254 for an accounting period stretching from 31st December 2018 – 31st December 2019. For the same period, its net sales stood at $20,156,447.
Therefore, its operating margin = 2604254 / 20156447 = 0.1292 or 12.92%
A key usage of operating margin in relation to operating profit is that it facilitates understanding of profit trends across periods more efficiently. For instance, a company might record a significantly higher operating profit in one particular period compared to others. In this case, a look at the operating profit ratio might reveal that such a company in question could maintain the margin in line with other years’ profits, even though the original figure is much higher.
Operating profit vs. Net Profit and Gross Profit
Net profit tells a company’s leftover profit after all kinds of expenses have been deducted. On the other hand, gross profit indicates a company’s profits solely from its manufacturing activities. Therefore, each provides a different understanding of a company’s managerial competency and fiscal footing.