Operating Profit: Definition, Example and How to Calculate

By Indeed Editorial Team

Published 27 April 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Managing a successful enterprise requires oversight of the income statement, which is a financial record of an organisation's profits, expenses, total revenue and net income. Proper analysis can also help you understand how to maximise sales and earn more revenue. Learning how to calculate a company's profit helps you determine the efficiency of its daily operations. In this article, we define what operating profit is, explain how to calculate it, highlight what to exclude and describe why the calculation is crucial for a business.

Related: Explanation, Benefits and Examples of Variable Cost

What is operating profit?

Operating profit constitutes a business's total revenue after disbursement of the operating expenses from its core functions within a specified timeframe. It's the amount of money an enterprise pays in taxes, liabilities and shareholder dividends. The profit is a concern for a business's managers and its third-party entities, including investors and creditors because it measures the business's sustainability and growth rate.

Accountants can calculate an enterprise's profit by deducting the operating expenses, such as rent and payroll, from the gross profit, while considering tax exclusions. These exclusions allow you to gauge the company's profitability accurately. It also helps in the decision-making process like departmental budget approval.

Related: How to Become a Financial Manager: Qualifications and Skills

Accountant responsibilities

An accountant handles various roles in a business enterprise. They can develop a corporate strategy, offer financial advice, improve gross sales and mitigate financial risks. Other important duties include the following:

  • Governing the enterprise by approving annual budgets: Accountants analyse annual profits and prepare an appropriate budget. Annual budgets project a business's income and expenses in a financial year and determine whether the business can finance its expansion in the next financial year.

  • Evaluating financial operations: An accountant evaluates the enterprise's financial operations by monitoring expenses and making recommendations for the best strategies to increase profitability. For example, they can analyse the direct costs and suggest changing suppliers to make the cost of goods sold (COGS) more affordable to increase the operating profit.

  • Preparing financial reports: An accountant prepares financial reports that are distributed among stakeholders and taxation authorities. The profit details that appear in the income statement denote a company's performance and can attract potential investors and business partners.

Related: What Does a Sales Representative Do? (And How to Become One)

How to calculate organisational profit

Here's the formula and steps you can use to calculate an organisation's operating profit:

Operating profit = operating revenue – cost of goods sold (COGS) – operating expenses – depreciation – amortisation

1. Determine the cost of goods sold (COGS)

COGS measure all direct costs related to making a product or providing a service in an enterprise. It includes the cost of materials and the necessary expertise to create a product or service. Indirect costs such as distribution aren't part of the COGS because they occur after the existence of a product. For example, if a bakery earned $22,000 in a month but paid a driving company $5700 for retail distribution, the COGS is $16300.

When managing a business, ensure you maintain a low COGS without compromising the quality of products or services. The COGS directly influences a business's net income, therefore it's important to source affordable production materials. This way, you can increase profits and dedicate more money to other activities, such as business expansion.

2. Calculate general and administrative expenses

General expenses are expenses an enterprise incurs in its operations irrespective of whether it manufactures products, such as insurance premiums, rent, utilities and salaries. Administrative expenses can also include company parties and gift incentives because they motivate employees and boost productivity. They don't directly contribute to revenue but are essential in business operations.

Some expenses, like insurance covers, are mandatory for most business operations such as an employee compensation insurance cover. Optional insurance covers include a business interruption insurance cover. It protects businesses from financial loss due to operational disruptions.

3. Monitor asset depreciation and amortisation

Asset depreciation represents how much value an asset loses throughout its period of usefulness. For example, if a company owns a commercial rental enterprise, their buildings may depreciate throughout their life as they generate revenue. Amortisation refers to the process of noting the value of a loan or an intangible asset. It involves the presentation of a loan repayment schedule dependent on a specific maturity date.

When you own or rent equipment for business operations, you can rate the assets' depreciation and amortisation. Assets like vehicles, machinery and buildings depreciate over time, so accountants distribute the asset cost over a specific timeframe. Amortisation involves intangible assets but still has a measurable effect on patents, long-term loans and copyrights. For example, if a business receives a loan, the amortisation process extends the loan over a certain period to offer a more consistent account of income and expenses.

4. Calculate revenue

Revenue refers to the sum of all business income from the sale of products or services. Revenue signifies a business's performance and entails sales, rental and dividend revenue. It consists of two crucial parts, namely the cost of products or services and the number of units sold for each product or service.

5. Calculate the operating profit

To calculate a company's profit in a specific period, you can plug each component into the operating profit formula. Here's an example showing you how to calculate the profit:

Delicious Eatery reported operating revenue of $700,000 in 2021. The COGS was $210,000, operating expenses were $100,000, interest expenses were $50,000 and taxes were $120,000. The company calculates their profit using the following formula:

Profit = $700,000 – $210,000 - $100,000

Profit = $390,000

Details to exclude from your calculation

An organisation may venture into investments, such as stocks or money market funds, which accumulate interest throughout the year. Finance professionals can use profits from these investments to increase the organisation's inventory or expand its operations. When calculating an organisation's profit, accountants exclude the interest that accumulates because they aren't linked to the business's core functions.

Other exclusions include:

  • Real estate sales: Any profits you earn from property rentals don't directly impact business operations, therefore you can exclude them from profit calculations.

  • Accounting adjustments: Profits exclude accounting adjustments since an enterprise earns gross income and expenses after conducting business transactions.

  • Production equipment sales: Production equipment includes tools, moulds and jigs. If you sell equipment because it's old, malfunctioning or you're seeking an upgrade, the money you earn from these sales doesn't relate to your core business function.

  • Tax income: You incur tax charges after the sale, provision or distribution of organisational goods and services, which means that you can exclude them during your profit calculation.

  • One-time transactions: Only recurrent transactions are part of ongoing operations and appear on the income statement.

Related: What Is Business Operations? (With Components and Tips)

Why profit calculation is crucial for enterprises

Calculating profits in a company is crucial since it helps you acquire a financial analysis of the operations. It focuses on the expenses that aid in operational management. Profit calculation is beneficial because it:

Reflects the enterprise's management state

Financial institutions, investors and stakeholders can rate the effectiveness of management by assessing the company's income statement. For example, declining annual profits may indicate an enterprise's high operational costs. It denotes a long-term issue since fixed costs, like rent, are resistant to change, unless the management negotiates lower rates or relocates the business to a more affordable area. Declining profits can also indicate a high COGS, which businesses can amend by hiring different suppliers or negotiating price reductions.

Helps track the sales and turnover

Profit calculations help you understand a company's turnover. To workout business turnover, multiply the product sales volume by the product's price. For example, if you sell 2000 beauty products for $30 each, then your turnover is $60,000. This statistic reveals a company's gross profit margin and what products require a sale increase to maximise profits.

Indicates an enterprise's sustainability level

Sustainability is the enterprise's ability to maintain itself over time. Effective cost management helps sustain an organisation. An increase in the sale of goods and services results in a high COGS, which supports an organisation's long-term sustainability.

Determines the enterprise's breakeven point

The breakeven point is essential to business decision making. This calculation can help professionals determine product prices, prepare sales budgets and create business plans. Breakeven refers to the point where the turnover or sales balances with the total costs, which signifies that you incur no profit or loss. You can make changes like increasing or decreasing prices to cover fixed costs and maximise profits.

Provides clarity on cost control

Analysing a company's profit within a specific timeframe can help senior management understand and control costs. Following this analysis, they can take any corrective measures to maximise profits. For example, if the operating profits are low, you can determine the cause of declining revenue, such as a loss of customers. To increase the company's profit, clear the existing inventory by reducing product prices to boost sales, then focus on customer retention through product giveaways and other incentives.

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