What is Operating Profit? – Definition, Formula & Example
Operating profit is the amount of money a business generates from sales, minus all operating expenses (cost of sales, marketing, general and administrative etc.).
It excludes other gains or losses from taxes, investments etc.
That might make sense to some of you, but if you didn’t fully understand this at first, don’t worry.
We’re going to break it down and explain exactly:
- What operating profit is
- What operating profit is made up of
- What operating profit means for your business.
So let’s start by breaking down operating profit.
Top tip: In this article, we’re going to be referring to the profit and loss statement a lot, which is where you’ll find the operating profit. The profit and loss statement can also be referred to as the income statement.
What is operating profit?
Here’s a slight extension of the definition we saw earlier – but a little easier to understand.
Operating profit is gross profit minus all operating costs.
In other words – it is the total of all income streams, minus the cost of selling and all other operating expenses.
What operating profit does not take into account is any of the gains and losses further down the profit and loss statement – finance costs, income (for example investments, interest and asset sales) and taxation.
Some other definitions you may see online will overcomplicate it, saying it is gross profit minus depreciation (decreasing value of assets due to wear and tear) and amortization (the process of marking value down over time, for example, the value of a patent will reduce over the course of its life). Whilst this is correct, it requires a depth of knowledge that, unless you’re an accountant, most people won’t have.
You’ll sometimes hear operating profit referred to as EBIT.
Don’t panic though.
EBIT is exactly the same as operating profit, just a different way of saying it.
EBIT is just an acronym for “earnings before interest & tax”, which is actually a very good way to remember operating profit. It will, however, always be referred to as operating profit on the profit and loss (income) statement.
Here’s the formula for Operating Profit:
Here is where it exists on the profit and loss (income) statement.
Operating Profit Example
We’ll do the same here.
Continuing my example of a shoe shop… our profit and loss statement currently looks like this:
We’ve got a gross profit of £5000 (remember this is revenue or total sales minus cost of goods sold).
We can now move further down the profit and loss statement to look at operating profit.
As we stated earlier, operating profit sits after all the operating expenses in the profit and loss (income) statement.
So what this means is that we are going to subtract everything that appears on our profit and loss statement that comes AFTER gross profit but BEFORE operating profit.
If you’ve not been following these articles, I’ll bring you up to date.
Our shoe shop currently has:
- A gross profit of £5000.
- And operating expenses of £2845.
We will now add an asset:
- A computer purchased for £500
Because the value of a computer will decrease over the course of its life, we have to reduce the amount it’s worth each year – this is known as depreciation.
The average computer lasts about 10 years, so we can depreciate it at 10% each year.
So our computer will depreciate by £4.17 per month or £50 over the course of the year.
We enter this into our financial plan and we now have an operating profit of £2,150.83.
And this is now what our profit and loss report looks like:
Bear in mind this is a very simplified example, there are going to be more costs that are involved here – but for the sake of keeping it simple, this example does the trick.
Now, what exactly does operating profit say about your business?
What does operating profit show?
Simply put, operating profit is a good indicator of whether your business model works.
Operating profit shows that your sales can cover your cost of sales and all other operating expenses.
In a larger business, the operating profit is watched by stakeholders like hawks and often affects stock prices. This is because it also indicates how well a business is being managed and also how efficient it is at supplying customers with the product.
“How? Surely, the overall net profit of a business is the best indicator of how well it’s being run and managed?”
This is true to some extent. However, lines on the profit and loss report that come after operating profit and before net profit, interest and taxes, don’t necessarily have anything to do with how well a business’ day-to-day operations are being run.
Because these lines don’t contribute to core business activities, looking at what’s left of your gross profit when you reach the operating profit line in the P&L report is one of the best ways to evaluate the efficiency and productivity of your business.
Let’s just have a quick recap of what we’ve learned:
- Operating profit is gross profit minus operating costs. It is the total of all income streams, minus the cost of selling and all other operating expenses.
- Operating profit can also be known as EBIT (earnings before interest and tax)
- Operating profit is a key indicator of how well a business is being run as it shows that your sales and therefore revenue can cover your cost of sales and all other operating expenses.
Tracking your operating profit and analysing it is key to growing your business.
We can now look at the best ways to improve your operating profit, check out a future article to find out how!