The formula for operating profit

Operating profit is the heartbeat of your business, letting you know just how well your core operations are actually performing.

Whether you’re an experienced accountant or a small business owner eager to understand your financials better, mastering the formula for operating profit is essential. This guide will take you step-by-step through what operating profit is, how to calculate it, and why it matters. It will give you everything you need to not only understand the formula for operating profit, but also be equipped with practical tips to improve this vital financial metric, helping your business to thrive.

What is operating profit?

Before we dive into the formula, let’s properly define operating profit. Operating profit, often referred to as operating income or operating earnings, represents the profit a company makes from its core business activities.

It excludes any revenue or expenses that aren’t directly tied to these operations, such as interest income, taxes, or investment gains.

In simple terms, operating profit tells you how much money your business makes from its primary activities—what you do day in, day out—before you take into account any financial or non-operational costs.

This makes it an essential metric for evaluating the true profitability of your business.

Why is operating profit important?

Operating profit represents a lot more than just a line item on your income statement. It’s a measurement of your company’s operational efficiency and financial health. Here’s why it matters:

1. Focus on core operations: by isolating the profit generated from your main business activities, operating profit provides a clear view of how well your business is doing at what it was created to do. This can help you identify strengths and areas for improvement within your core operations.
   
2. Investor insight: investors often look at operating profit as a key indicator of a company’s ability to generate profit from its main activities. It’s a metric that reflects the business’s true earning power, something which isn’t affected by financial manoeuvres or one-off events.
   
3. Performance comparison: operating profit is an excellent tool for comparing performance over time or against competitors. Since it focuses solely on core operations, it provides a more accurate comparison than net profit, which can be influenced by various external factors.
   
4. Internal decision-making: for business owners and managers, understanding operating profit is crucial for making informed decisions about where to cut costs, where to invest more resources, and how to price products or services.

The formula for operating profit

The formula for calculating operating profit is straightforward:

Operating Profit = Revenue − Operating Expenses

Let’s break this down:

• Revenue: this is the total income your business generates from selling goods or services. It’s often referred to as the top line because it’s the first figure on an income statement.
  
• Operating expenses: these include all costs directly associated with running your business. Examples include the cost of goods sold (COGS), rent, utilities, salaries, and other administrative expenses. Crucially, operating expenses do not include interest payments, taxes, or income from investments.

How to calculate operating profit: Your step-by-step guide

To better illustrate how to calculate operating profit, let’s walk through a hypothetical example.

Imagine you own a small retail business based in the UK, and you’re trying to calculate your operating profit for the past year. These are the steps you’d need to take:

1. Calculate your revenue

Start by determining your total revenue. Suppose your business generated £500,000 in sales over the last year. This figure represents your total revenue.

2. Determine your operating expenses

Next, list all your operating expenses for the same period. Let’s assume the following:

• Cost of goods sold (COGS): £200,000
  
• Rent: £50,000
  
• Utilities: £10,000
  
• Payroll: £100,000
  
• Other operating expenses (e.g. office supplies, marketing, maintenance): £20,000

Total operating expenses: £380,000

3. Apply the formula

Now, subtract the total operating expenses from your revenue to calculate your operating profit:

Operating Profit = £500,000 − £380,000 = £120,000

In this example, your operating profit is £120,000. This means that after covering all the costs associated with running your business, you have £120,000 left before accounting for taxes, interest, or any other non-operating income or expenses.

Common mistakes to avoid when calculating operating profit

While the formula for operating profit is simple, there are some common mistakes that can lead to inaccuracies:

1. Including non-operating expenses: it’s important to exclude expenses that are not directly related to your core business operations, such as interest payments, taxes, and any income from investments. Including these can distort your operating profit and provide a misleading view of your business’s operational performance.
   
2. Overlooking certain operating expenses: it’s easy to overlook smaller operating expenses like office supplies, minor maintenance costs, or software subscriptions. However, these can add up over time and should be included to ensure your operating profit calculation is accurate.
   
3. Misclassifying expenses: proper classification is key to an accurate operating profit calculation. For instance, salaries for administrative staff should be included in operating expenses, but payments for dividends should not. Misclassification can lead to either overstated or understated operating profit figures.
   

4. Failing to update regularly: your business’s operating environment can change rapidly, affecting both revenue and expenses. Regularly updating your calculations ensures that you have an accurate and up-to-date picture of your operating profit, allowing you to make informed decisions.

Beyond the basics: Understanding operating profit margin

While knowing how to calculate operating profit is important, it’s also helpful to understand how it fits into the bigger financial picture. One way to do this is by calculating the operating profit margin.

This metric shows what percentage of your revenue remains after covering operating expenses and is a key indicator of your business’s profitability.

The formula for operating profit margin is:

Operating Profit Margin = (Operating Profit / Revenue) ×100

Using our earlier example:

Operating Profit Margin = (£120,000 / £500,000) ×100 = 24%

A 24% operating profit margin means that for every £1 of revenue, £0.24 is left as operating profit. This is a strong indicator of your business’s operational efficiency.

What constitutes a “good” margin can vary by industry. Generally, a margin between 15% and 25% is considered healthy and desirable for many businesses.

Practical tips for improving your operating profit

Now that you understand how to calculate operating profit, the next step is to think about how you can improve it. Here are some actionable tips:

1. Review and reduce costs

Regularly reviewing your operating expenses can help you identify areas where you can cut costs without compromising quality or service. For example, you might find opportunities to negotiate better rates with suppliers, switch to more energy-efficient utilities, or streamline your inventory management to reduce the cost of goods sold.

2. Increase revenue

Boosting revenue is another way to improve your operating profit. Consider strategies such as upselling to existing customers, expanding your product line, or entering new markets. Increasing your prices, if the market conditions allow, can also lead to higher revenue.

3. Streamline operations

Efficiency is key to maintaining and improving operating profit. Look for ways to streamline your operations—whether through automating certain tasks, investing in technology that reduces manual work, or improving your supply chain management. Streamlined operations can lead to lower operating expenses and, as a result, higher operating profit.

4. Monitor regularly

Make it a habit to calculate and monitor your operating profit regularly, not just at year-end. Regular monitoring helps you spot trends early, allowing you to make proactive adjustments.

For instance, if you notice a decline in your operating profit, you can investigate the cause—whether it’s rising costs or falling sales—and take corrective action before it impacts your bottom line.

Final thoughts

Understanding the formula for operating profit and knowing how to calculate it is essential for anyone involved in running a business.

It’s a powerful tool that helps you assess the health of your core operations and make informed decisions. By regularly calculating your operating profit and keeping an eye on your operating profit margin, you can ensure your business stays on the right track.

Remember, operating profit is a snapshot of your business’s operational health—keeping it strong will help lead you towards long-term financial well-being.