Operating profit can be described as the net income a company generates from its primary business operations. In simpler terms, it is the leftover revenue after covering operating expenses but before accounting for taxes.
If the main business has any share in another company then the interest income from that ancillary investment shouldn’t be included in the operating profit formula. A business incurs an operating loss or negative operating profit when the income from the core business becomes lower than the expenses.
When you run a company, one of the most important things to keep track of is the revenue it is generating. However, it is equally important to keep track of the margin to measure the financial health of your company. Operating profit margin is an important financial KPI that you should keep track of for estimating margin.
Operating profit formula
The operating profit formula can be written as:
Operating Profit of a Business = (Gross profit from the core business) - (Operating Expenses) - (Depreciation) - (Amortisation)
You can calculate gross profit as the deduction of the cost of goods sold from revenue earned by a company from its core business.
Why operating profit is important?
Operating profit is a crucial financial indicator, as it reveals a company's capability to derive income from its primary business activities. Let us take a look at some of the reasons that make operating profit an important metric:
Assesses profitability
Operating profit is a direct measure of a business’s profitability. It shows the amount of profit that a company is able to derive from its core business operations. This, however, is before accounting for taxes and interest. The operating profit measure helps analysts and investors assess a company’s financial health and make strategic decisions.
Measures operational efficiency
The operating profit metric is a reliable measure of a company’s operational efficiency. If a company's operating profit is high, it is an indicator that the business has successfully kept operating expenses in check while deriving higher income from its primary business activities. This, in turn, is a sign that the company is managing its resources optimally and functioning efficiently.
Analyse performance
This metric is also useful if you want to understand a company’s performance compared to its competitors in the same sector. Operating profit aids analysts and investors in identifying businesses that are deriving high profits from their core operations, functioning at a high level of efficiency, and managing their resources well.
Informed decision-making
Taking into account the insights from operating profit is an important facet of strategic business decision-making. Companies can use this metric to narrow down potential areas of improvement, where income can be increased while costs are reduced. This can include tweaks in policies surrounding the pricing strategy, sales revenues, or operating expenses, among other things.
Components to exclude while calculating operating profit
All non-operating income or expenses are excluded from the calculation of operating profit. Some of the most important components that you should exclude from the operating profit formula are:
- Profit earned from investments in ancillary ventures
- Dividend earned from investments in ancillary ventures
- Sales of assets
- Any kind of interest payment made on debt servicing
- Any gain made from transactions of foreign exchange
- Inventory that has already been written off
- Any kind of lawsuit settlement
- All kinds of costs related to the restructuring of the company or Mergers & Acquisitions (M&Gs)
As profitability from only core business is taken into account, operating profit is considered a better indicator than other KPIs such as EBIT (Earnings Before Interest And Taxes).
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How to calculate operating profit?
If you want to gauge the health of your business, measuring operating profit can give you an accurate idea. This is mainly because all extraneous factors are done away with from the calculation. Operating profit calculation only includes those expense components that are essential for running a business. The two most important operational aspects of a firm such as amortisation and depreciation are taken into account at the time of calculation.
Let’s try to understand how to calculate operating profit with the help of an example.
US Example:
The company that we will discuss is one of the biggest retail giants in the US, Walmart Inc. In the 2021 fiscal year, the company’s reported operating profit was US$ 22.6 billion. Now, let’s try to understand how this calculation was done.
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First of all, let’s check the total revenue of Walmart Inc. in 2021, which was $559.2 billion. It included all kinds of income from the core operations of the retail business. The total revenue of Walmart includes
- Net sales of the company
- Income from memberships
- Sales from physical stores across the world
- Income from the e-commerce businesses of Walmart
- Other income from the core business
The expenses or cost of running Walmart Inc. was 536.6 billion. While the above five points denote the revenue part, the cost part includes:
COGS (The cost of sales)
All kinds of expenses including:
- Operation cost
- Selling cost
- General cost
- Administrative cost
While the total COGS is $420.3 billion, the total expenses in terms of administrative, general, selling, and operating costs are US$ 116.3 billion. The total expenses are 536.6 billion. When you subtract US$ 536.6 billion from the total revenue of $559.2 billion, you get an operating profit of US$ 22.6 billion. That’s how the calculation is done.
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India Example
Suppose there is an Indian company, named ABC, which has the following financials:
- Operating revenue = Rs. 1,00,000
- Operating expenses = Rs. 60,000
The formula of Operating Profit = (Operating Revenue) - (Operating Expenses)
Therefore, in this case, the operating profit is equal to Rs. 1,00,000 - Rs. 60,000. This means the ABC company’s operating profit is equal to Rs. 40,000.
How to increase your operating profit
With a clear understanding of the critical importance of operational profit, let us take a look at some strategies that companies employ to enhance their operating profits:
Curbing operating expense
Simple yet effective, reducing your operating expense is the most direct way of increasing your operating profit. This can be achieved by implementing policies to reduce costs, optimising the production process, curbing non-essential expenses, and negotiating more profitable arrangements with suppliers.
Raise prices
The quickest way to increase your operating income and profit is to increase the prices of the goods or services you sell. However, the price sensitivity of the audience is a major factor in sales and marketing. Thus, any changes to prices must be backed by extensive and robust research.
Enhance efficiency
With the expenses and prices optimised, another way to raise operating profit is to enhance the efficiency of the production cycle. This can be achieved by implementing streamlining measures at various levels of operations like adopting lean manufacturing guidelines, improving supply chain management, and reducing waste.
Improving sales
Sell more to earn more is another seemingly simple principle to improve operating profit. This can be attained by introducing new goods or services in the market, expanding the operations to target new demographics, or enhancing the marketing to bring in more customers and clients.
Elevate customer experience
Building trust among customers by implementing robust customer experience guidelines can improve a company’s operating profit. These measures aim to enhance customer loyalty,, resulting in increased referrals and repeat business. As these directly increase sales and income, they also raise operating profits.
Adoption of technology
Technology is an excellent investment for a business to increase its operational efficiency, reduce costs, and enhance the production process. Companies can also leverage automation to increase productivity and reduce labour expenses.
Differences between operating profit, net profit, and gross profit
While the terms operating profit, gross profit, and net profit sound similar, there are some key differences between the three. These are highlighted below:
|
Operating profit |
Gross profit |
Net profit |
Meaning |
Refers to the profits derived from primary business operations after subtracting the operating expenses. |
Refers to the income from sales after deducting the cost of the goods sold. |
Refers to profits after deducting all expenses, which can include taxes and interest, from the total revenue. |
Calculation |
Operating revenue - Operating expense |
Revenue - COGS |
Total revenue - (Taxes + Interest + Operating expense) |
Inclusions (and exclusions) |
Includes administration, production, and selling costs that cover rent, salaries, utilities, and depreciation. Excludes taxes and interest. |
This includes the direct costs of production and delivery. Also, operating expenses (rent, utilities, salaries) are excluded. |
Includes all expenses (taxes, interest, operating expenses) |
Final words
The bottom line is that the operating profit of a company calculates the earnings generated by it from its normal business operations only. You can find operating costs in your income statement. You can keep track of this metric as it excludes all types of accounting items including taxes, interest, one-time charges, and others. It is important to note that any accounting item that may skew the profit of a company in a certain financial year is excluded from the calculation of operating profit.
