What is the operating profit formula?

Revolut Contributor

 · July 20, 2020  · 07/20/2020

The operating profit formula sometimes creates more confusion than rival profit metrics, such as net profit. This is primarily due to uncertainty over which specific cost categories to include in the operating profit equation. Another reason is because there are two methods to work out this metric.

This post will clarify these ambiguities. In other words: what is operating profit and how is it calculated?

There is no statutory obligation for a business to cite operating profit on its annual income statements. But should the business choose to do so, this metric must conform to the UK's Generally Accepted Accounting Practice (GAAP) guidelines. Either way, the operating profit is a straightforward number to calculate, based on other figures that a business routinely provides in its financial statements.

What is included in operating profit?

Operating profit is the total revenue of a business over a period once it deducts the direct costs of achieving this revenue along with the day-to-day operating costs. These operating expenses include rent and salaries, as well as several less obvious costs, such as the depreciation of long-term assets. The operating profit formula does not take into account the tax due nor interest owed on bank loans.

There are various types of profit, each of which you calculate by subtracting specific categories of costs from the total revenue. This figure is the top-line on a business income statement.

If you think of the income statement as a map, revenue is at the top, and net profit is at the bottom. That's because, generally speaking, you create the net profit metric by removing all costs. The various other profit metrics are destinations en route, and the operating profit lurks in the middle, right next to the EBIT (i.e. earnings before interest & tax). We’ll explain how these two differ in a moment.

To move from revenue down to net profit, you must exclude the cost categories shown in column one. Conversely, to move from the bottom-line upwards, you merely add-back each specific type of cost.

Table one: The profit metric map

Column One

Profit metric 

Revenue

 

– Direct costs (i.e. costs directly related to sales)

= Gross profit

– Operating expenses (inc Depreciation & Amortisation)

= Operating profit

– Non-operational expenses (see Table Two)

= EBIT 

– Interest & Tax

= Net Profit

How do you calculate operating profit?

If you think about how to calculate operating profit, there are two plausible routes (see Table One). The best approach is to take the sales revenue of the business for a period and subtract the direct costs and operating expenses. The formula is below, and we cover operating profit in detail here.

Operating profit = Revenue – Direct costs – Operating expenses

The second method is to take the net profit (also known as net earnings) for the same period and add-back the interest and tax the business owes. This alternative version of the operating profit formula, shown below, is more complex and also typically less accurate than the first approach.

Operating Profit = Net profit + Interest + Tax

To understand why the last point is valid requires a grasp of how the operating profit differs from EBIT. The crucial distinction between these two similar metrics is that the operating profit formula excludes the value of any expenses or income that are considered to be 'non-operational' from the final answer. By contrast, the EBIT calculation leaves these cost categories within the resulting figure.

To illustrate this, let's look at a few specific examples of non-operational expenses/income and show whether to include each one within the figure for the operating profit or the EBIT for a given period.

Table Two:  When is a cost operational?

Category of cost or income

Operating Profit

EBIT

FX gains or losses (i.e. paying for goods/services in a currency different
to the account if the business holds foreign currency in a traditional account) 

NO

YES

Dividend payments received or profits on investments in another business 

NO

YES

Rental income or sales profit made on property (i.e. assuming this is not a
core activity of the business)

NO

YES

Sale of fixed assets at a gain or a loss (e.g. obsolete equipment)

NO

YES

Impairment adjustments to long-term assets (i.e. while checking the allowances
for depreciation or amortisation to reflect true market value)

NO

YES

For many businesses – in particular, SMEs – these items are negligible. Yet if a business routinely holds a decent reserve of foreign currency (and doesn't have Revolut for Business); or it discovers that the value of its machinery has dropped, the operating profit and the EBIT metrics will not match.

This idea explains why it’s sensible to calculate the operating profit formula by removing costs from revenue. To derive the answer properly from net profit (i.e. method two), you must know the correct value of all non-operational items. That task is tricky for non-finance professionals.

Operating profit is a vital metric for investors. The reason is because it focuses the attention on core business operations, without the distraction of costs less under the control of managers, such as interest and tax. There is subjectivity with regards to a few moving parts. Still, now that you know how the operating profit formula works, you can ask the right questions. That's a giant leap forward.

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