Also called earnings before interest and taxes (EBIT), operating profit calculates the profits earned from a company’s core business after subtracting the cost of goods sold (COGS), operating costs, and any depreciation expenses.
The balance after deducting these costs and expenses from the company’s operating revenue is the money left in the business that can be used for expansion, investment, and growth.
How Do Investors Use Operating Profit?
Investors compare the operating profits of companies in similar industries in order to assess their financial health and growth potential. The higher the operating profit, the better the company’s financial health – and the better its long-term prospects.
The Operating Profit Formula
The operating profit formula is fairly straightforward:
How to Calculate Operating Profit
To determine a company’s operating profit, refer to the income statement published in the company’s annual report. The numbers needed to plug into the operating profit formula may be found as line items on the income statement.
The formula components are defined as follows:
Operating revenue reflects the company’s core business. Any income not related to the company’s primary business is omitted from the computation.
Cost of Goods Sold (COGS)
The cost of goods sold is the complete cost of whatever a company is selling. For a retail company, COGS is the wholesale cost of the products the company purchases to resell.
Operating expenses include any costs associated with running a business. Companies include salaries and wages in this figure but may also add other business-related expenses.
Depreciation and Amortization
Depreciation and amortization refer to gradually expensing the cost of a fixed asset over time. Some businesses make substantial investments in fixed assets that will be used over several years. Instead of including the entire amount on the income statement, they divide up the cost over the asset’s estimated lifetime. Depreciation applies to a tangible asset, such as equipment, and amortization applies to an intangible asset, such as a patent.
Both depreciation and amortization can be found on the income statement and must be included in the operating profit calculation.
Example of Operating Profit
Imagine two businesses in the same industry. Both companies seek private investment and provide their income statements to potential investors for evaluation.
Pierre’s Bakery offers retail sales of bread, pastries, croissants, and other French treats. Its income statement looks like this:
EXAMPLE 1: Pierre’s French Bakery
EXAMPLE 2: Gino’s Italian Bakery
Gino had a higher gross profit, however, when you take all other costs into account, Pierre’s bakery had a better operating profit. This is a more revealing measure of profit because it includes all the operating expenses (not just the costs of the goods themselves). If an investor were to choose between Pierre’s French Bakery or Gino’s Italian Bakery, Pierre’s offers better potential because its operating profit is greater.
Operating Profit vs. Net Operating Profit
Operating profit and net operating profit differ from each other in that net operating profit takes interest and taxes into account while operating profit does not.
Advantages and Disadvantages of Operating Profit
The advantage of using operating profit as a comparison metric between companies is that it omits certain expenses (such as taxes and interest) from the final figure. If comparing companies in varying tax jurisdiction or debt levels, it’s much easier to assess the profitability of operations.
Operating profit also focuses on the company’s core business and omits any extraneous business revenue from its formula. For example, if a retail company sells a parcel of real estate, the proceeds are not included in operating profit because it would give a distorted view of the profitability related to the company’s business operations.
Operating profit, however, omits expenses that tell the entire story about a company’s financial health (e.g. interest and tax expenses). This is important since these expenses can significantly reduce a firm’s profits.
Consider two businesses in the same industry. Pierre and Gino have equal operating profits, but Pierre’s Bakery is in New York and Gino’s Bakery is in Virginia (where taxes are lower). Gino’s bakery is actually in a better financial position. Merely looking at operating profit misses crucial factors when considering the potential health of the company.
Operating Profit Over Time
Small businesses can react dramatically to both opportunities and challenges. A spike in the cost of ricotta cheese for cannoli filling can make Gino’s operating profit drop as his cost of goods increases. A celebrity might stroll into Pierre’s bakery, take one bite of his famous chocolate eclair, post a picture on Instagram, and Pierre sees sales spike due to the increased exposure. Each of these situations is temporary but can have a dramatic effect on annual operating profit.
Time smooths out the typical jumps and dips in a small business’ income and expenses. Gino may need time to find a new supplier and ultimately reduce his COGS below his original figure. Pierre may invest heavily in eclair production, only to find that interest in eclairs was temporary, driven solely by the celebrity endorsement.
No single metric can provide a complete answer to an investor’s questions, nor should one year’s numbers be used to make any final investment decision. A thoughtful, comprehensive approach that takes the numbers into account – and the story behind them – is one of the best ways to evaluate the prospects of a company.