Operating Profit: How to calculate Operating Profit and Use it to Make Informed Business Decisions

Research suggests that data-driven managers experience year-over-year growth in operating profit by 86%. According to the study, 32% agree that they have improved financial budgeting accuracy. They also achieved a two times greater year-over-year increase in the operating cash flow. This explains the importance of calculating operating profit.

What is operating profit? Operating profit is an accounting statistic. It calculates the company’s profit from its core business operations. This is before excluding the deduction of interest and taxes.

It also ignores the profits from the company’s subsidiary investments. For example, the business revenue from another company which has your firm as its shareholder.

Operating profit helps understand how well you are managing costs. An operating profit calculator helps in understanding whether you have a sustainable business model. Comparing your business’s performance with your competitor’s is also made easy with operating profit.

Here, you will learn how to calculate operating profit using the operating profit formula. You will also come across advantages of operating profit and examples of financial performance.

Let’s Understand What Is Operating Profit

As a business, making money is crucial. Generating business revenue alone cannot decide your firm’s financial performance. It needs to keep a track of its margin. Now, a margin is a difference between a good’s selling price and the cost of production. The costs related to the making and selling of goods are called “cost of goods sold”.

The operating profit margin is an essential financial margin to track. It is a useful financial KPI. Everything used for the company’s operating profit calculation is relevant to its financial health.

Operating profit is a trusted indicator of a business’s health. The main reason is that it eliminates external factors from the calculation. All the expenses required to carry out the business operations are included. Include depreciation and amortisation related to properties for that reason. These are accounting tools developed from the corporation’s activities.

The non-operating income that operating profit excludes is as follows:

1. Sales of capital assets
   
2. Profits gained from foreign exchange transactions
   
3. Dividends and investment gains

Apart from that, operating profit also removes non-operating expenses such as:

1. Interest payments on company debts
   
2. Costs related to acquisitions, mergers and restructuring
   
3. Lawsuit settlements

Operating profit is also known as operating income. Sometimes, people also refer to it as Earnings Before Interest and Tax (EBIT). However, operating profit is different from EBIT.

Unlike operating profit, EBIT can also contain income from non-operational activities. Let’s say, your company doesn’t have any non-operating income.  Then, your operating profit will be the same as EBIT.

Operating profit only considers the revenues and costs linked with a business’s core activities. Thus, it is a more reliable measure of operating profitability than similar KPIs like EBIT.

How to Calculate Operating Profit

Before understanding the operating revenue formula, you should be aware of two components. They are as follows:

Gross Income

Gross income is the total amount of money that your business makes after sales. This is the total income before reducing the interest payments, taxes and other business expenses. Make sure to measure gross income accurately. This is because it is the first step of calculating operating profit as well as taxes.

The gross income formula is as follows:

Gross Income = Gross Revenue – Cost of Goods Sold (COGS)

Here, gross revenue is the total revenue made in sales before any deduction. COGS is the amount spent in the production stage. COGS depends on the working activities of the industry you are working in. Some expenses under COGS are:

1. Money for purchasing raw materials
2. Labour costs
3. Costs for packaging material
4. Shipping charges

Operating Expenses

Operating expenses are the money spent on the daily working activities of the business. This depends on various factors such as:

1. The industry your business is a part of
2. The product or goods you are selling
3. Various departments within your business

However, here are some of the most common operating expenses:

1. Rent
2. Maintenance fees
3. Employee payroll
4. Marketing fees
5. Supplies and utilities

Please note that capital and non-operating expenses are not a part of this category. Capital expenses are the high-value investment made by your business. They offer benefits for over a year. Purchasing fixed assets like equipment, machines and buildings are examples. It can be non-physical assets like trademarks or patents as well.

Non-operating expenses, as you already know, are expenses connected with daily operations. These include costs of relocating buildings, interest payments etc.

So, how to calculate operational profit or loss? The operational profit or loss formula is as follows:

Operating Income = Gross Income – Operating Expenses
Or
Operating Profit = Gross Revenue – (Operating Expenses + Cost of Goods Sold)

Example of Operating Profit

Let’s say, you run a pastry shop. Apart from that, you also take delivery orders for customized birthday cakes. Now, you are planning to expand your business. For that, you need a business loan. You will have to produce operating income to the investors and creditors for availing loan.
Looking at your finances, you realise that your business has made a total income of Rs.5,00,000. The expenses you made were as follows:

Expenses	Amount
Insurance	Rs.50,000
Power	Rs.15,000
Property	Rs.30,000
Wages	Rs.40,000
Transit	Rs.30,000
Supplies	Rs.15,000
Repairs	Rs.20,000
COGS	Rs.1,00,000

Gross Income = Gross Revenue – Cost Of Goods Sold
= Rs.5,00,000 – Rs.1,00,000
= Rs.4,00,000

Operational Expenses = Rs.50,000 + Rs.15,000 + Rs.30,000 + Rs.40,000 + Rs.30,000 + Rs.15,000 + Rs.20,000
Operational Expenses = Rs.2, 00,000

Operating Income = Gross Income – Operational Expenses
= Rs.4,00,000 – Rs.2,00,000
= Rs.2,00,000

You can now present to investors that your business made a profit of Rs. 2,00,000 last year.

High-profit income is a good sign. However, that may not always guarantee profitability. There is another case that you should consider. Your company can still be running at loss despite making money through sales.

For example, your company generates good revenue by selling products. But, you lose a large portion of profits because of high-interest payments and taxes. Or it can also be due to the company’s poor financial decisions and unwanted expenses.

Also Read : Net Profit: Understanding Its Significance for Your Business

Advantages of Using Operating Profit

Operating profit is the money left with the company to meet needs such as:

1. Paying taxes
2. Clearing debts
3. Taking care of liabilities
4. Paying dividends

Thus, it benefits company managers and third-party entities like investors in many ways. Here’s how:

Managers

It provides insights into cost management. It tells you the efficiency of cost control. This is compared to the operating profit, working expenses and revenue costs of previous years.

Managers can make a number of important financial decisions with this information. You can correct many financial mistakes. You can develop plans to increase the profitability of the business.

Investors

Investors can analyze a company’s management decisions by looking at operating profits. You can also learn whether the company can carry out its everyday operations efficiently. Based on this, you can make wise decisions about investing in the business.

Other than profitability, operating profit can reveal a few things about a company. The trends in operating income decide a company’s responsiveness and flexibility to changes. Flexibility and responsiveness are two determining factors of management efficiency.

Operating income and net income are different from each other. Operating income excludes interest payments and taxes. On the other hand, net income includes them. Thus, operating income is a better and more reliable measure than net income. That is if analysing the core profitability of your firm is your aim.

You can also use the operating income to make comparisons with competitors and draw insights. This is if factors like business models, market capitalization and operations’ scale remain similar.

Related Read: Business to Business: What Is B2B

Key Takeaway

The income statement notes your operating profit. You can get an idea about this and expenses incurred by analyzing the statement. This will help in assessing the company’s working efficiency. It gives insights into the financial health of a firm.

You can compare it with the financial performance of other years. Based on this, make a note of potential and mistakes to make better decisions. Operating profit also facilitates comparisons with the profitability of competitors.

Let’say, you are looking for a company’s core in-service income. Then, you should first separate non-operating profits and expenses from net income. Operating income is a significant part of our daily lives. It is used for creating both household budgets and company balance sheets.

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