How to calculate operating profit?
Operating profit is calculated by measuring how much profit a business generates purely from its core operations, without considering financing costs or taxes. The calculation focuses on operating efficiency and cost control, making it a useful metric for evaluating business performance.
The basic formula for operating profit is:
Operating profit = Revenue – Operating expenses
Revenue refers to the income earned from a company’s primary business activities, such as the sale of goods or services. Operating expenses include all costs directly linked to running the business. These typically cover the cost of goods sold (COGS), employee salaries, rent, utilities, administrative expenses, marketing costs, and depreciation related to operational assets.
To calculate operating profit step by step, you start with total revenue for the period. From this, subtract the cost of goods sold to arrive at gross profit. Next, deduct operating expenses such as wages, rent, advertising, and other overheads. The resulting figure is the operating profit.
For example, suppose a company earns Rs. 10,00,000 in revenue. Its cost of goods sold is Rs. 6,00,000, leaving a gross profit of Rs. 4,00,000. If operating expenses such as salaries, rent, and utilities amount to Rs. 2,50,000, the operating profit would be Rs. 1,50,000.
Operating profit does not include interest expenses, tax payments, or non-recurring items. This exclusion helps you understand whether the company’s core business model is profitable, independent of how it is financed or taxed. By tracking operating profit over time, you can assess operational efficiency, cost management, and the sustainability of earnings, making it a key metric for financial analysis and comparison across companies.
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 is operating profit 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:
1. 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.
2. 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.
3. 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.
4. 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).
Advantages of operating profit
Operating profit is more than just a number—it is a reflection of how well a business is performing in its day-to-day operations. Let’s explore some of the key benefits of tracking and analysing operating profit.
1. Reflects core business efficiency: Operating profit highlights how efficiently a company is managing its core activities, without being affected by external factors like taxes or investments.
2. Helps in comparing businesses: It enables fair comparisons between companies within the same industry by focusing purely on operational performance, excluding interest and tax differences.
3. Useful for internal decision-making: Business leaders rely on operating profit to evaluate product performance, control costs, and make decisions about scaling, hiring, or budgeting.
4. Attracts potential investors: A strong and consistent operating profit indicates financial health, which can attract investors seeking stability and operational excellence.
5. Supports credit assessments: Lenders and financial institutions consider operating profit when determining a business’s creditworthiness and ability to repay debt.
Limitations of operating profit
While operating profit is a helpful indicator, it is not without its flaws. Relying on it alone may not give the full picture of a company’s financial position.
1. Ignores financing and tax costs
Operating profit does not consider interest payments or taxes, which can significantly impact a company’s actual profitability.
2. Excludes one-time expenses or gains
It overlooks extraordinary items like asset sales or legal settlements, which may distort overall financial performance if ignored.
3. Does not reflect cash flow
A company might report healthy operating profit but still struggle with cash flow issues, especially if receivables are high or payments are delayed.
4. Vulnerable to accounting policies
Different depreciation or expense recognition methods can affect operating profit, making cross-company comparisons tricky without deeper analysis.
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:
1. 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.
2. 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.
3. 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.
4. 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.
5. 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.
6. 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:
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Operating profit
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Gross profit
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Net profit
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Meaning
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Refers to the profits derived from primary business operations after subtracting the operating expenses.
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Refers to the income from sales after deducting the cost of the goods sold.
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Refers to profits after deducting all expenses, which can include taxes and interest, from the total revenue.
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Calculation
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Operating revenue - Operating expense
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Revenue - COGS
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Total revenue - (Taxes + Interest + Operating expense)
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Inclusions
(and exclusions)
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Includes administration, production, and selling costs that cover rent, salaries, utilities, and depreciation. Excludes taxes and interest.
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This includes the direct costs of production and delivery. Also, operating expenses (rent, utilities, salaries) are excluded.
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Includes all expenses (taxes, interest, operating expenses)
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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.
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