In this article, we will explore the definition of operating profit and how it can help you better understand, measure and increase the profitability of your business.
Summary
- What is operating profit?
- The difference between operating, net and gross profit
- What is EBITDA?
- Why is operating profit important?
- What's an operating profit ratio?
- What's a good operating profit ratio?
- Operating profit example
- How to increase operating profit
What is operating profit?
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Operating profit is the total income a company generates from sales after paying off all operating expenses, such as rent, employee payroll, equipment and inventory costs. The operating profit figure excludes gains or losses from interest, taxes and investments.
Operating profit can easily be calculated using the operating profit formula.
Operating Profit = Revenue - Operating Expenses - Cost of Goods Sold - Other Day-to-Day Expenses
What's the difference between operating profit, gross profit and net profit?
When you first start a business, you’d be forgiven for thinking that profit is simply profit, but there are some differentiators between operating profit, gross profit and net profit:
- Gross profit represents revenue minus the cost of goods sold (COGS). It focuses on the basic profitability of the core business operations. Gross profit excludes operating expenses such as selling, general, and administrative costs.
- Operating profit deducts operating expenses from gross profit. It provides a measure of profitability specifically related to the company's core operations. Operating profit excludes non-operating items such as interest and taxes.
- Net profit deducts all expenses, including non-operating items, from operating profit. It represents the final profit after all costs, taxes, and interest have been accounted for. Net profit reflects the overall profitability of the company.
“Being able to analyse all levels of profit allows you to identify the root cause and the ‘so what?’ of your financial situation.” says Growth Strategist and Retail Expert Meg Banjo. “If a company has a strategy to grow profit rather than just increase market share at the cost of profit, their profit will indicate the effectiveness of their pricing strategy and cost management.”
Hardware retailer Plank Hardware has been profitable since its inception. With the company poised for growth, Founder Annie Aveyard is looking to invest more into the business, which is expected to shrink its operating margin temporarily.
“As we scale up, [we are expecting] to fall in line with the industry average,” says Aveyard.
“If operating profits are falling [lower than expected], it either means we are missing our revenue targets, or we’re spending too much. The latter is easier to control, so my first line of defence would be to do a review of expenses. I’d also look carefully at our product margins and the return we are getting on our advertising spend. It’s always a constant balancing act.”
Operating expenses are core to the running of any business but that doesn't mean they can't be rewarding. With your American Express® Business Gold Card, you’ll receive one Membership Rewards® point for every £1 you spend¹, which can be redeemed to reinvest in your business to contribute to improving operating profit margins.
What is EBITDA?
It stands for earnings before interest, tax, depreciation and amortisation (EBITDA). Operating profit generally includes deductions for depreciation (the expensing of a fixed asset over its useful life) and amortisation (the spreading of an intangible asset's cost over its useful life).
Banjo points to challenges with calculating depreciation and amortisation with different methods impacting profit – either by overstating it for valuation gain or understating it for tax reduction. She explains: “EBITDA reduces these challenges by giving a more precise profit figure, allowing estimates of company cash flow to service debt and identifies comparisons across your industry. If EBITDA is increasing year-on-year while operating profit is declining, it indicates high depreciation value or a high cost of borrowing.”
Why is operating profit important?
Operating profit is an important financial metric, below are just some of the key reasons:
- Profitability: Operating profit is a key indicator of a company's core profitability, reflecting its ability to generate profits from day-to-day business activities.
- Business performance: Operating profit reflects a company's operational efficiency and effectiveness. High margins indicate you’re making the right choices.
- Financial health: Investors and creditors often look at operating profit as a measure of a company's financial health.
What is an operating profit ratio?
An operating profit ratio is calculated by dividing operating profit by total revenue. This indicator reflects the percentage of profit a company produces from its operations (before subtracting tax and interest). You can calculate your operating profit margin using the following formula:
Operating profit margin = (operating profit ÷ revenue) x 100
What is a good operating profit margin?
What constitutes a healthy operating profit margin can vary according to your industry. However, as a general rule of thumb, 5% is considered low, 10% is considered average and 20% or above is considered good [1]. However, these are to be considered merely as guidelines. 'Good' operating profit depends on a multitude of factors, including company size, industry and the economy overall.
“An SME should look at the average for their top three to ten competitors [to benchmark themselves],” says Banjo.
Example of operating profit
Branding and marketing company Creative ID has set itself an ambitious target to achieve a 15% operating profit margin in 2021. "This figure is based on previous years’ performance would represent 5% year-on-year growth. As we head towards Q4 we are already on target to exceed this goal," says the company's Creative Director Vaishali Shah.
Shah has undertaken many tactics for increasing profit in the journey towards Creative ID’s current operating profit margin goal with virtual working, increasing prices and recruitment all contributing to a growth in profit figures.
“We’ve taken advantage of technology and automated some of our business processes and functions [while working remotely],” Banjo says.
“We have also raised revenue by increasing fees and adding additional income streams such as introducing a new business and marketing consultancy service [such as power hours and half-day and full-day consultancy]. We have successfully reduced expenses by taking on fewer freelancers and having more permanent staff on the payroll, which also increases commitment to the business and helps build stronger relationships.”
How to increase operating profit
Knowing how to increase profit margins is essential to growing your business and there are several ways to achieve profit maximisation. Some fundamental examples are: raising prices, reducing operating expenses and achieving economies of scale.
“SMEs can use data and business intelligence tools (such as pricing software) to make sure they offer the right product at the right price via the right channel to their target customer,” says Banjo.
Banjo also notes that any pricing strategy should address pricing efficiency and cost management (variable cost in the short term and fixed cost in the long term).
“Cost covers the whole of the supply chain operations and not forgetting the last-mile delivery to the customer,” Banjo comments.
“Care must also be taken in choosing [to reduce operating expenses and achieving economies of scale] to make sure a true economy of scale exists and the right capabilities and resources are available [with lower costs].”
Reducing operating costs means having a great relationship with suppliers. Our American Express Business Gold Card affords you the flexibility to keep suppliers happy by paying them on time and in full while keeping the cash in your account for longer with its payment terms of up to 54 days². A great foundation to start negotiations to improve those all-important operating profit margins.
- Membership Rewards points are earned on every full eligible £1 spent and charged, per transaction. Terms and conditions apply.
- 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.
Sources
[1] CFI, Profit Margin
