Profitability is the goal of any business owner. While the idea of selling more than you spend may sound simple, the reality of running a business can be more complex.
That’s because sometimes businesses earn income or have expenses unrelated to what they sell. For example, selling a piece of equipment can generate income, and taxes are an expense—but neither of these is a part of your business model.
So, with all these other activities going on, how do you tell if your core business is profitable? You can use operating profit. But what, exactly, is it? And when should you use it? Let’s find out!
What is Operating Profit?
Operating profit tells if you're making money off your sales before taxes and interest are considered. Also known as operating income, you can find it by subtracting all your expenses (except interest and taxes) from your total sales earnings.
This can help you figure out how much money you’re making from your core business operations, like producing and selling your goods or services. This is especially helpful for business owners who had to take out loans to get their business up and running…Looking at operating profit tells you what business profit would look like without your interest payments.
You may also hear it referred to as Earnings Before Interest and Taxes (EBIT)—but that’s technically incorrect. Here’s why:
Operating Profit vs. EBIT
Earnings before interest and taxes is similar to operating profit, but it’s not exactly the same.
While both require you to subtract all business expenses except interest and taxes, they have different starting points.
Operating profit looks strictly at income from sales revenue, whereas EBIT takes a broader approach and includes any income a business generates in addition to net sales—for example, income from investments or the sale of assets.
So operating profit can tell you more about the profitability of your core business activities, while EBIT shows you the total of how much your business earned during an accounting period before you pay your taxes or interest on loans.
How To Calculate Operating Profit?
Operating profit is calculated as your total revenue minus your cost of goods sold (COGS), operating expenses, depreciation, and amortization.
Operating Profit = Revenue - (COGS + Operating Expenses + Depreciation + Amortization)
Let’s take a closer look at what’s included in each part of the operating profit formula:
- Revenue: Income generated by selling goods and services, also known as operating revenue (doesn’t include non-operating income such as interest income, earnings from investments, or money generated by selling assets or real estate).
- Cost of goods sold: Direct costs of the production of goods or services, such as money you spend on raw materials, labor and storage.
- Operating expenses: Costs needed to keep your business running, such as rent, administrative expenses, insurance, and any costs associated with selling your services or products, such as advertising and commissions.
- Amortization: The cost of an intangible asset, which is expensed over a period of time. For example, if you pay for a trademark, you can’t write off the cost immediately. Instead, you amortize it, reporting a portion of the cost as an expense on the income statement over the next 15 years.
- Depreciation: Allocating the cost of a tangible asset, such as a piece of equipment, over its useful life.
Example of Operating Profit
Now that you understand operating profit, let’s look at an example. Say you own a hardware store, and in the previous month, your revenue and expenses were as follows:
Revenue = $100,000
Cost of Goods Sold (COGS) = $60,000
Operating Expenses = $35,000 total, including
- Payroll = $23,000
- Rent = $6,000
- Utilities = $1,500
- Insurance = $2,000
- Advertising = $2,500
Amortization = $2,000
Interest and Taxes = $1,200
When you plug the values into the formula, you get:
Operating Profit = Revenue - (COGS + Operating Expenses + Depreciation + Amortization)
= $100,000 - ($60,000 + $35,000 + $0 + $2,000)
= $100,000 - $97,000
= $3,000
So, in the previous month, your business generated an operating profit of $3,000.
What Your Operating Profit Tells You
Operating income (or profit) tells you whether your core business activities are making you money or not. Removing non-operating factors, such as debt and income taxes, provides a highly accurate look at your business health.
Here’s how:
When starting a business, one of the things you need to know is whether your business idea is profitable.
However, at the beginning of your journey, you may have to take on loans to get started. Even if you don’t take out loans, initial profits often start small and then grow. The problem is that if your interest payments and income tax expenses are higher than your small initial profits, you might think that your business isn’t making any money.
So, operating profit lets you look at the profit associated with your business model and helps you verify your idea. In other words, it can tell you whether or not the profit loss comes from interest and taxes—or if your business operations simply aren’t generating enough money to cover the costs. One way to keep tabs on your costs? Check out Hourly for pay-as-you-go workers’ comp that’s connected directly to your payroll, so you’re never overpaying on premiums.
To see why calculating profit is a must for verifying your business idea, let’s compare it to two other metrics: gross profit and net profit.
Operating Profit vs. Gross Profit
Gross profit is calculated as revenue minus the cost of goods sold. Gross profit tells you how much money your business makes after taking production costs (costs associated with producing your company’s goods or services) into account—but before subtracting overhead expenses.
If we were to calculate the gross profit using the previous hardware store example, it would look like this:
Gross Profit = Revenue - Cost of Goods Sold
= $100,000 - $60,000
= $40,000
In other words, your hardware store generated a gross profit of $40,000 for the last month. Gross profit is a helpful metric for understanding whether or not your profit margin is high enough to keep your business running. If your selling price isn’t enough to cover the cost of goods sold, you’ll have a negative gross profit.
In this example, both operating and gross profits are positive. However, it’s possible to have a positive gross profit but a negative operating income. If your operating costs, amortization, and depreciation are higher than your gross profit, you end up with a net loss.
For instance, let’s say you spent $7,500 on advertising (which is an operating expense) instead of $2,500. You would still have a $40,000 gross profit, but you would now calculate operating profit as:
Operating Profit = Revenue - (COGS + Operating Expenses* + Depreciation + Amortization)
= $100,000 - ($60,000 + $40,000* + $0 + $2,000)
= $100,000 - $102,000*
= –$2,000
The additional $5,000 worth of operating costs would change your operating profit from $3,000 to an operating loss of $2,000. In this situation, you have a profitable set of products—but you’re spending too much running the business, which is preventing you from making money.
Operating Profit vs. Net Profit
Net profit is the amount of money your business earns during an accounting period once you deduct all expenses from the revenue—including interest and taxes.
The formula for net profit is:
Net Profit = Revenue - (COGS + Operating Expenses + Amortization + Depreciation + Interest + Taxes)
If we plug the information from the hardware store into this formula, we will get:
= $100,000 - ($60,000 + $35,000 + $2,000 + $1,200)
= $100,000 - $98,200
= $1,800
So, your hardware store made a net profit of $1,800 in the previous month. This figure is calculated at the bottom of your company’s income statement and is also known as the bottom line. It represents your net income, which is the actual amount of money you earned during the accounting period.
It’s possible to have a positive operating income and a negative net profit—especially if you have high debt.
For instance, let’s say you have $5,000 more in your interest expenses, making your total non-operating expenses $6,200. Here’s what your net profit calculation looks like:
Net profit = Revenue - (COGS + Operating Expenses + Amortization + Depreciation + Interest* + Taxes)
= $100,000 - ($60,000 + $35,000 + $2,000 + $1,200+ $5,000*)
= $100,000 - $103,200*
= –$3,200
In that case, you would still have an operating income of $3,000, but you would report a net loss of $3,200 after making tax and interest payments.
That means you have a profitable business model, but your debts are preventing you from turning a profit.
In this case, you can reduce your monthly interest expenses by refinancing your loan. Or, you can increase your operating income by raising prices or finding opportunities to reduce your production costs and administrative expenses until your loans are paid off.
What is Operating Profit Margin?
Your operating profit margin will tell you how much profit you make for each dollar of revenue you earn. It also tells you how much money you have left over after operating costs are covered.
In other words, it’s the portion of your sales that you have available to pay for interest and taxes. If you have a higher profit margin, your business is in a better position to pay off debt and cover income taxes without losing money.
Once you know how to calculate operating income, finding your operating profit margin is pretty simple; all you have to do is divide your operating profit by your revenue.
As a formula, it looks like this:
Operating Profit Margin = Operating Profit / Revenue
Let’s take a look at calculating the operating profit margin in action:
Calculation
Using the numbers from the hardware store example, you would calculate your operating profit margin like this:
= $3,000 / $100,000
= .03
So, for every dollar of revenue, you earn an operating profit of 3 cents (or .03 of a dollar).
In this instance, you have 3% of your revenue available to pay for interest and taxes.
Analyzing Your Company’s Profitability
Operating profit is an excellent metric to determine whether or not your core business activities are profitable. It’s especially important when you’re starting a new business and want to see if your business model can make money.
Interest payment and income tax expenses often cover up small profits of new business, so it’s important to keep track of your operating profit too. Now that you know how to calculate this important financial metric, all that’s left to do is plug in the numbers and see how well your business is doing.
Ready to transform your business into a profit-pumping machine? Learn how with our monthly newsletter.
.jpg)