Operating Profit Definition

Operating Profit is the type of profits that record in the entity’s financial statements for the period of time after the deduction of operating expenses from Gross Profit.

This profit is before charging of interest expenses and tax expenses of the period. Operating Profit is reported in Income Statements rather than Balance Sheet.

All other non-operating profit 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.

Related: Gross Profit

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 helping users of financial information to assess how is the entity’s operation in terms of generating profit compare 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:

Operating Profits Formula

Now, in order 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)

Equal Gross Profit $XXX

Less Operating Expenses ($XXX)

Equal Operating Profit $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.

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The most important thing that 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 to assess how is the company’s operating expenses and operation profitability margin compare to others.

If the margin is low, that means the operating cost is high and it probably faces the 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 gap of profit 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.

For obvious reason, if the margin is high, compare to the gross profit margin, that means the operating expense low or it means the company 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 the internal purpose, management control this because they need to make sure that the company’s cash flow could support the current operating expenses or not.

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Another reason is that they do the Operating Ratio Analysis to making identify and track certain expenses that increase uncertainty.

One 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 as the result of the creditors, banks, customers and suppliers’ requirements and assessment.

All of these stakeholders require to want 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 long term the company could run and abilities to pay back all of the debt, and stable suppliers.

Example

Let move to the example together so that you could 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 USD 1,000,000
  • Cost of Good Sold during the period USD 500,000 and,
  • Operating Expenses for the period is USD 200,000

Now, we will calculate the operating income, margin, ratio and last but not least, we will perform an analysis of ABC.

Answer

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%

Analysis

As 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.

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This ratio is quite good for ABC but, for better analysis, we should have a previous period figure, industry figure, and competitor or the expectation from management.

Compare 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.

Written by Sinra