Let’s get acquainted with your big three; we are not discussing your birth chart.
Business owners can calculate one of three profitability measures:
- Gross profit is a business’s profit after subtracting all the costs of manufacturing and selling its products.
- Net profit shows the amount of $$ your business earns after you deduct all operating, interest, and tax expenses.
- Operating profit, we are slowly dealing with it.
Or operating income is the profit generated from the company’s core business before accounting for interest and taxes.
The operating profit for a business like Domino’s Pizza will be the pre-tax profit from selling pizzas with cheesy borders and other pizzas, also known as the company’s core business.
How to calculate Operating profit:
Operating profit = operating revenue – the cost of goods sold (COGS) – operating expenses – depreciation.
Here operating revenue is the income from the company’s core business operations.
COGS, or the cost of goods sold, is the cost incurred in manufacturing and selling the company’s products.
Operating expenses include sales, marketing, R&D, administration, restructuring, etc.
Depreciation accounts for the decrease in the value of the assets over time.
Consider the income statement of Domino’s Pizza “Domino’s Pizza limited.”
- Revenue – $2 million.
- Interest earned in bank accounts – $80 000.
- Earning from 30% stake in “Yes, beverages limited” – $1 mln.
- COGS – $1 mln.
- Labor – $400 000.
- General and administrative expenses – $50 000.
Before we start “mathing” with numbers, remember that earnings that are not directly related to the core business operations are not included when calculating operating profit.
The earnings that will be left out are earnings from companies’ investments, capital gains on asset sales, rental income, bank account interest, various earnings, like dividends, and so on.
Based on the information, the operating profit for Domino’s will be:
Operating profit ($2 million) – COGS ($1 mln) – Operating expenses ($400,000 + $50,000 of general and administrative expenses) = $550,000.
We do not include the sum of $80,000 and 1 million dollars because it is income from investments, not from selling pizzas.
Operating profit helps to measure the health of a company’s Core Business and is one of the essential factors that investors consider when picking the company stock.
When comparing companies within the same industry, using operating profit for comparison makes sense and gives an investor an objective outlook on your business.
If operating profit declines, it reflects less money for future expansion paying off the debt burden.
Operating profit shows the profits from a company’s Core Business that are not diluted with income from any other source and thus reveals a lot about the vision-generating capacity of the management.
Check out the formulas with different components:
- Operating profit = Gross Profit – Operating Expenses – Depreciation – Amortization
- Operating Profit = Net Profit + Interest Expenses + Taxes
- Operating profit = Revenues – Direct Costs – Indirect Costs
- Operating profit = Revenues – Operating Costs
Non-operational factors may influence the gap between operating profit may and net profit. Stuff like economic disruption, industry upheaval, changes in corporate or managerial structure, or the existence of large debt loads can make a huge difference.
What Is the Difference Between Operating Profit and EBIT?
Reminder: EBIT stands for Earnings Before Interest and Taxes.
Using EBIT as Operating Profit can only apply to a company that doesn’t have revenues outside its core business.
Dividend income, capital gains from investments, profits from foreign exchange, and asset write-downs are examples of non-operational payments and will not be included when calculating the operating profit.
Why Do You Need to Understand Your Operating Profit?
Owning your operating profit knowledge is a green flag suggesting you understand your cash flow for salaries, rent, travel, raw materials, and energy.
It shows you how much money you’re making before paying interest payments and taxes.
What insights does Operating Profit offer?
- Comparisons over the year make trends for pricing strategy, labor costs, and raw material prices.
- Operating profit also gives investors a quick look at the company’s day-to-day management and the choices they make. How flexible and responsive are you? And sort of answers the annoying question like “Where do you see your company in 5 years”. The Operating Profit numbers reflect potential trajectory and prospects.
- Answers the “Are you better than your competitor” question for potential investors.
Operating profit helps generate another critical measure of a company’s profitability: its operating margin.
Let’s deal with depreciation and amortization and how they affect your assets.
Depreciation is the way you extend the cost of fixed assets over time. So, for example, your ice cream machine would be a great example of something that may lose its value over time.
Amortisation relates only to immaterial assets as opposed to physical stuff. Among them, there are trademarks, patents, or franchise agreements, which may decline in value over time.
SAT prep minute:
Company A’s income statement reveals the following:
Revenues: $2.3 billion
- Cost of goods sold: $982.7 million
- Operating expenses: $115.7 million
- Depreciation and amortization: $42 million
Company A’s operating income is calculated thusly:
$2,300,000,000 – $982,700, 000 – $115,700,000 – $42,000,000 = $1,159,600,000
Company A’s operating profit is $1.16 billion. That’s before interest is earned from investments and any taxes are paid to the government.
Here’s another example. Company B’s income statement shows the following:
Total revenue: $1 million
Revenue is the sum of all the business income that you make from the sale of your products or services.
Costs you have to pay to keep your business afloat run, such as premises, utilities, salaries, R&D, and the price of fixed marketing, for example.
Here’s a quick tip, if you want to know whether something is an operating cost, ask yourself if you sold twice as many items would that cost go up?
For instance, when it comes to packaging, you would have to purchase more with the raised amount of materials, which are all included in the cost of goods sold. At the same time, fixed costs like monthly rates count as operating costs.
What else to exclude when calculating operating profit
- Stonks from the sale of assets
- Interest from money market accounts
- Debt burdens
- Investment earnings from stakes in other institutions
- Losses from write-downs or write-offs, as well as uninsured losses
Why keep tabs on operating profit?
To understand how to increase profit, you have to figure out the seasonal patterns of your product. For example, imagine you sell candles and notice that in December, there was a drop in operating profit. This may indicate that the demand for your product fluctuates according to the season.
So if you look at operating profit levels monthly, you will notice when something is off. And it should not frighten you as a founder but rather inspire you to figure out the reason, track it for a while, and understand how to increase profit.
What causes operating profit to change?
A lower operating profit may indicate that business expenses are growing, for example, if you’ve hired new staff members or tried new equipment. By regularly calculating operating profit, you will be able to keep on top of such changes.
Another measure to keep you on your toes with your finances is gross profit, which is the money left from the sale of your goods or services once you deduct the direct expenses used to develop them. It is often used to measure the profitability of a single product via a simple gross profit formula.
Want to get rid of your financial headache?
Thinking like an economist takes time and practice. Finance and economics are not a set of answers and formulas; it’s a way of comprehending how things happen. Sometimes you don’t have time for this. That is why Fuelfinance is here to help you out. We take your numbers and convert them to financial insights. We spend hours automating Google spreadsheets to provide you with dashboards.
Calculating your operating profit is your alert app, keeping you up-to-date on your profitability status and any areas of opportunity.
We will be your alarm clock and good news bearer. Book a free call with our sales team, and we can tell you how to make your life easier. And while the operating profit formula can be pretty straightforward, keeping track of all your expenses is not.