Operating Profit is the type of profits recorded in the entity’s financial statements for the period after the deduction of operating expenses from Gross Profit.
All other non-operating profits and expenses are records as Other Income and Other Expenses. This profit tells the reader how profitable the entity is after charging the operating expenses and whether the entity could handle the tax and interest expenses or not.
In this article, you will be able to understand the principle of operating profit and formula on how to calculate its. You will also understand and know how to calculate operating profit margin ratio along with example and deep analysis.
Okay, let start with the objective of calculating this profit,
The objective of calculating and presenting this profit in the entity financial statements is because it helps users of financial information assess how the entity’s operation is in terms of generating profit compared to other entities or other investment centers.
It is sometimes used to assess the cash flow of the company.
Check the picture below to see where the operating profit records in the income statement:
Now, to help you get a better understanding, let move to the formula,
Operating Profit Formula
Here is the formula,
|Sales Revenue for the period||$XXX|
|Less Cost of Goods Sold||($XXX)|
|Less Operating Expenses||($XXX)|
As you can see now, the Operating Profits are coming up with Sales Revenue less Cost of Goods Sold, and Operating Expenses for the period of time.
The most important thing that is relevant to it is operating expenses. Most of the accounting framework requires an entity to present this profit in its income statement.
The main reason is that this profit helps the users of financial information assess how the company’s operating expenses and operation profitability margin compare to others.
The operating cost is high if the margin is low, and he probably faces cash flow problems.
Cost of Goods Sold is the direct cost to products or services. This cost, if not directly affects Operation Profitability, but it affects the gross profit.
Operating Profit Margin or Ratio
Now let move to the Operating Profit Margin concept, formula, and how to calculate it.
Operating Profit Margin or operating margin is the profit gap after deduction of operating expenses from gross profit over sales revenue for a specific period of time.
The margin is the next step in assessing the operation of the entity. The Margin mostly uses in helping to set the expected net profit by setting the expenses margin.
Obviously, if the margin is high, compared to the gross profit margin, that means the operating expense is low, or the company is running efficiently in its operational activities.
The high margin, the better sign of operation. The Operating Profit Margin is the same as the Operating Profit Ratio.
The ratio is quite important for both internal and external purposes. For internal purposes, management controls this because they need to ensure that the company’s cash flow can support the current operating expenses.
Another reason is that they do the Operating Ratio Analysis to identify and track certain expenses that increase uncertainty.
Once the ratio is decreased, probably there some kinds of expenses going wrong by the error of recording or fraud.
For the external purpose, management controls the Gross Profit Margin due to the creditors, banks, customers, and suppliers’ requirements and assessment.
All of these stakeholders require to see the company has a better cash flow position and a high operating margin.
The better cash flow position and high margin are the signals of the company’s long-term ability to pay back all of the debt and stable suppliers.
Let move to the example together so that you can get a better understanding.
ABC is the company operating in the retailing of office equipment. During the period of 01 January 2016 to 31 December 2016, the company has the following transactions. Assuming the figure provide is correct.
- Total Sale Revenue for the period USD1,000,000
- Cost of Good Sold during the period USD500,000 and,
- Operating Expenses for the period is USD200,000
Now, we will calculate the operating income, margin, ratio, and last but not least, we will analyze ABC.
Total Sale Revenue USD 1,000,000
Cost of Goods Sold (USD 500,000)
Gross Profit USD 500,000
Operating Expenses (USD 200,000)
The Operating Profit USD 300,000.
Operating Margin or Ratio = 300,000 / 1,000,000 = 0.3 or 30%
We could see how the ABC’s operational profit is USD 300,000, or the ratio is 30%. This figure is before interest and taxes and other income and expenses.
This ratio is quite good for ABC, but we should have a previous period figure, industry figure, and competitor or the expectation from management for better analysis.
Compared to Gross Profit Ratio 50% (USD 500,000), Operating Expenses of ABC is 20% of Total Sales.
In this case, if ABC wants to increase its operating margin, ABC should consider reviewing two main items. First is the Cost of Goods Sold, and the second is the Operating Expenses.