Operating profit — or operating income — is a profit your company gets from its core business activity. It is calculated before you deduct interest and the taxes you must pay.
Operating profit is one of the key figures in accounting for a business person, as it shows the revenue and expenses that you can directly control, manage and make predictions on. Online accounting can help you to find out what your company’s operating profit is and track it.
Earnings that are not directly related to the main activity of your company are not included in the operating profit calculation. These earnings can be:
- Income from your company’s investments.
- Capital gains on asset sales.
- Rental income.
- Bank account interest.
- Miscellaneous earnings (like dividends).
The term “operating profit” can be used as a synonym for “Earnings Before Interest and Taxes (EBIT)”, but only if the firm has no expenses unrelated to the principal activity, e.g. costs from currency exchange. These are called non-operating expenses, by the way.
What is the operating profit for?
Operating profit works as an indicator of the business’ profit-making potential. It is highly accurate in this regard because it doesn’t include any external variable factors in the counting.
It is one of the key factors that investors look at considering choosing your company among you and your competitors in the sphere. For them, if your company has been seeing a decline in its operating profit, that will mean that there is less money for its future expansion.
Operating profit formula
Operating Profit = Operating Revenue − Cost of Goods Sold − Operating Expenses − Depreciation − Amortization
Operating Revenue is the income from the company’s main business activity.
Cost of Goods Sold (or COGS, cost of sales) is the money spent on producing the goods the company sells, such as costs of the materials and labour. It doesn’t include other expenses like distribution or sales costs.
Operating Expenses is the money spent on rent, marketing, administration, payroll, etc.
Depreciation is the decrease in the value of the assets over time.
Operating profit calculation
Martin has a company McLarens’ Burgers Ltd. Let’s examine one of the company’s income statements:
- Revenue: £2,000,000
- Interest earned: £50,000
- Earnings from 30% stake in GetDrunk Ltd: £800,000
- Cost of Goods Sold: £1,000,000
- Labour: £400,000
- Administrative & marketing expenses: £50,000
Points 2 and 3 are not taken into account when calculating McLarens’ Burgers Ltd’s operating profit because 2 is earnings from an interest bank account and 3 is the return on investing in another company — both have no connection to the company’s operations.
Let’s apply the formula:
£2,000,000 (Operating Revenue) − £1,000,000 − £400,000 (COGS) − £50,000 (Operating expenses) = £550,000.
Thus, the operating profit of McLarens’ Burgers Ltd in this case is £550,000.
Operating profit margin
Operating profit usually goes together in calculations with operating profit margin — that helps to compare your business model to your competitors’. The operating profit margin is one of the profitability ratios known as margin ratio. Important to note that having the same margin ratio, you can have a different place among the competitors.
For example, let’s say your company’s margin ratio is 8%. If your competitors’ average margin ratio is 10% or more — you are in more financial risk than if the figure for the competitors was 7%.
|8%||10% or more||You are in more financial risk|
|8%||7%||Your competitors’ risk is bigger|
A company with a high operating profit margin ratio is more able to pay for their fixed costs/interest on the debt, survive economic downturns and is more competitive, because it can offer lower prices.
Here is the formula to calculate an operating profit margin:
Operating Profit Margin = Operating Income / Sales Revenue.
Once you know your operating income (described above), you take the net sales revenue (that requires no calculation, because it is already on your income return) and divide the first by the second.
For McLarens’ Burgers Ltd., the operating profit margin is £550,000/£2,000,000= 27,5%.