How to calculate operating profit
Operating profit is calculated by deducting three categories of business costs from revenue: operating expenses (OpEx), cost of goods sold (COGS) and other day-to-day expenses including depreciation and amortisation. The operating profit formula is shown below:
 |
Revenue
This is the sum of all business income generated from the sale of your products or services. It shows how much money you’re bringing in from your sales before any deductions have been taken into account.
Operating expenses (OpEx)
OpEx refers to overhead costs. Catherine Erdly, Founder of The Resilient Retail Club, says OpEx relates to everything you have to pay to run your business such as premises, utilities, salaries and the price of fixed marketing, for instance.
“A good test to see if something is an operating cost or [falls under] COGS is to ask yourself if you sold twice as many items would that cost go up?” she says. “For example, when it comes to packaging, you would have to purchase more with increased handling fees and materials, which are all included in COGS whereas fixed costs – like monthly rates – count as operating costs.”
You can make your operating expenses work harder for you and your business when using your American Express® Business Gold Card. For every £1 you spend, you’ll earn 1 Membership Rewards® point, which can be spent on essential business purchases with hundreds of retailers¹. And it gives you greater flexibility in your cash flow thanks to its 54-day payment period on purchases².
The cost of goods sold (COGS)
Where OpEx refers to costs involved with day-to-day business running operations, COGS refers to costs directly associated with delivering a specific product. A business will incur OpEx whether they deliver products and services or not. Examples of COGS can include things like the cost of raw materials, labour and shipping.
Day-to-day expenses
A business' day-to-day expenses essentially refer to ‘depreciation’ and ‘amortisation'. Depreciation is how you spread out the cost of fixed assets over time – so, for example, [owned] property or a company car would be great examples of something that may depreciate over time, so you are effectively devaluing the asset each year, based on an idea of wear and tear,” says Erdly.
Amortisation, she adds, relates only to intangible assets as opposed to physical ones – such as trademarks, patents or franchise agreements, which may decrease in value over time.
Sometimes a company will choose to report operating profit (EBIT) on its financial statement before depreciation and amortisation. This is referred to as earnings before interest, taxes, depreciation and amortisation (EBITDA).
What to exclude when calculating operating profit
The following should always be disregarded when calculating operating profit:
- Income from the sale of assets
- Interest from money market accounts or similar sources
- Debt obligations
- Investment income from stakes in other organisations
- Losses from write-downs or write-offs, as well as uninsured losses
- Gains or losses due to changes in accounting strategies
- Taxable deductions
Operating profit formula example
Here's an example of a business, ABC Tech, that last year recorded a total revenue of £1 million. This is the sum of the fictional technology manufacturer's income before any deductions.
- Its COGS was £500,000. These deductions include things like the cost of raw materials and factory labour.
- Its OpEx were £300,000. These deductions include things like factory rental and administrative supplies.
- Its day-to-day expenses, depreciation and amortisation, costs were £50,000. These deductions include things like automated assembly-line technology forgoing its useful life.
To calculate its operating profit, ABC Tech must subtract its COGS, OpEx and day-to-day expenses, depreciation and amortisation, from its overall revenue. Therefore, the business’ operating profit is:
(Revenue) £1,000,000 - (COGS) £500,000 - (OpEx) £300,000 - (Day-to-Day Expenses) £50,000 = (Operating Profit) £150,000
Why keep tabs on operating profit?
Lynn Hood, COO at Focus Hotels, who steered the company towards record levels of operating profit during recent uncertain market conditions, says: “We have a full understanding of every cost line in our business, helping us to continually search for our break-even point. It helps us answer questions such as when did we start to burn cash and when did we break even? That point has moved considerably recently as we've been able to reduce costs of operating.”
There are many reasons why operating profits may drop – for instance, demand may fluctuate seasonally, so it’s useful to look at operating profit levels monthly, advises Erdly. A low operating profit during a particular month need not cause concern; it's more about understanding what the seasonal patterns are, tracking these over time and understanding how to increase profit.
“Retail businesses often have a situation where they may have some months in the summer where their sales are relatively low so their revenue is lower but the cost of their goods sold is higher because they are purchasing in their holiday stock, whereas during the holiday time, they are going to have high sales and lower COGS sold because they already have those goods in hand,” says Erdly.
Hood produces a profit and loss statement every calendar month. She says: “It's all segmented into the divisions within the business such as rooms, leisure, food and beverages. The quick approach [to keeping tabs on profit margins] is to review payroll and keep your controls tight as that is your biggest single cost to the business.”
As well as staffing, Hood scrutinises product costs, the cost of servicing rooms, providing meals, pricing and distribution to ensure maximum operating profit.
What causes operating profit to change?
A low operating profit may be an indicator that business expenses are increasing, for example, if you've introduced new staff members, premises or equipment. By regularly calculating operating profit, you will be able to keep on top of such fluctuations.
Operating profit vs gross profit vs net profit
Operating profit is just one of three main types of profit.
Gross profit is the largest profit figure on a company's financial statement as it only deducts COGS. But it's still an important metric for businesses to understand. This is because it helps them evaluate how effectively they are utilising things like raw materials and labour.
Next comes operating profit with COGS, OpEx and day-to-day expenses (depreciation and amortisation) subtracted.
And finally net profit makes the further deductions of the interest the business is paying on its debts and all taxes. This is the profit that can be re-invested into the business or distributed among shareholders.
1. Membership Rewards points are earned on every full and eligible £1 spent and charged, per transaction. Terms and conditions apply.
2. The maximum payment period on purchases is 54 calendar days and is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date. If you'd prefer a Card with no annual fee, rewards or other features, an alternative option is available – the Business Basic Card.
