Operating profit, also called operating income or earnings before interest and taxes (EBIT), is an accounting metric that looks at a company’s profit from core business operations.
All things equal, companies will want a higher operating profit but many factors can influence the metrics. Items like rent, utilities, administrative expenses, payroll, and other fixed costs can all impact the metric. Having a low operating profit may also be part of a low cost pricing strategy.
The operating profit calculation is:
Operating Profit = Operating Revenue - Cost of Goods Sold - Operating Expenses - Depreciation - Amortization
Operating Profit = Gross Profit - Operating Expenses - Depreciation - Amortization
All of these values are found on a company’s income statement. Since there already is a term for revenue less cost of goods sold (COGS), we can also substitute gross profit in the beginning of this equation. Both formulas will get you the same result.
If the value is positive, it is considered an operating profit and if the value is negative, it is considered an operating loss.
We recommend that companies of all sizes track this metric every month, quarter, and year. By tracking the operating profit figure monthly, operators and investors can stay close to how the core business activities are changing and evolving.
Non-operating activities are not included in operating profit.
Examples of unusual income include the gains from the sale of assets, profit from foreign exchange, and profit from selling marketable securities.
Examples of unusual expenses include losses from the sale of assets, losses from foreign exchange, and losses from lawsuit settlements.
These items are not part of operating profit because they are not part of a company’s operations. These gains and losses are captured lower down in net profit.
Now we will walk through two examples of calculating operating profit.
Company A, Fiscal Year 2020
To start, we will use the operating profit formula…
Operating Profit (OP) = Operating Revenue - Cost of Goods Sold - Operating Expenses - Depreciation - Amortization
OP = $500,000 - $280,000 - $200,000 - $56,000 - $31,000
OP = -$67,000
Company A had an operating profit of -$67,000 in 2020. This is also referred to as an operating loss. In order to generate a profit, Company A would need to raise prices, sell more units, or reduce their expenses.
Company B, Fiscal Year 2020
In this example, we need to be careful to only include the values that are in the formula.
OP = $1,500,000 - $680,200 - $513,100 - $89,500 - $34,700
OP = $182,500
Company B has an operating profit of $182,500 in 2020. Notice that we did not include interest expenses, income taxes, non-operating sales, and non-operating expenses. These are below the line and captured in net profit.
The operating profit margin ratio, also called operating profit margin or operating margin, is operating profit divided by operating revenue. This value is expressed as a percentage.
Operating Profit Margin = Operating Profit / Operating Revenue
When looking at similar companies, operating margin is a great way to cut through the noise and understand the overall operations of the business.
In any accounting period, there could be one-time sales, one-time expenses, or reconciliations from prior periods. Operating margin can show us side by side who is profitable, what the trends are, and who is following their plan.
For example, a company that is following a low price strategy will have lower prices and need to carefully manage its operating margin. In another example, a high growth startup might have razor thin margins to begin with and expand their margins over time as their product and market position mature.
There are also non-operating expenses, such as interest expense, foreign exchange, and gains/losses from asset sales. These are not included in either gross profit or operating profit; they are found below the line in net profit.
Business owners, operators, managers, and investors look to operating profit as a single of financial health. For instance, companies with higher operating profit than their competitors will be perceived as having lower financial risk.
A business can earn more profit by increasing its gross revenue, better managing fixed cost expenses, or better managing variable cost expenses.
Any business that does not expect to have or maintain a positive operating margin should communicate that clearly to investors.
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