The ongoing global economic crisis, with high inflation, shaky economic activity, rising interest rates, and volatile markets, has pushed businesses into uncharted waters, forcing them to operate in an uncertain and chaotic environment.
It’s an entirely new ballgame, and entrepreneurs are quickly realizing they need to tighten their belts and implement the right operational strategies to increase their profits and compete on a strong footing. In these difficult times, it’s easy to lose track of important things like your company’s financial health.
Tracking your operating profit helps you step back, see the big picture, and take suitable measures to reduce your expenses and increase your much-needed profitability in this challenging economic environment. The operating profit gives business owners a clear picture, helping them reduce operational costs and focus on optimizing their business operations.
In this article, we discuss all that you need to know about operating profit, how to calculate it, and what its uses and limitations are. We’ll also share handy tips to help you increase your business’s profits in these challenging times.
What is operating profit?
In the simplest terms, your operating profit is the money left over after you deduct all operating costs from your business’s revenue. It's a critical metric that proves to investors that your business generates more money than it spends. However, the operating profit is not the money you get to keep. Your business's actual profit is the net profit, which is the money you get to keep after paying taxes, debts, and other liabilities from the operating profit.
To summarize, the operating profit is the money your business makes after deducting operating expenses but before paying taxes, debts, and any additional liabilities.
Formula to calculate operating profit
Operating profit = Revenue - Operating costs - Cost of goods sold - Other day-to-day expenses
Let's take a closer look at each element in the formula:
- Revenue: This is the amount of money your business generates by selling products or services.
- Operating costs: These are the expenses required to run your business. They usually include employee salaries, utilities, rent, and other fixed expenditures. The rule of thumb to decide whether something falls under operating costs is to ask yourself, "Will the cost of the item or service increase if this cost were to go up?" For example, let's take utilities. The cost of the product sold will definitely increase if the cost of your utilities rises. Hence, utilities count as an operating cost.
- Cost of goods sold: This is the total amount you spend to manufacture a product or deliver a service.
- Day-to-day expenses: Depreciation and amortization fall under the umbrella of everyday expenses. A company vehicle is an excellent example of something that depreciates over time. Amortization relates primarily to intangible assets like franchise agreements, patents, and trademarks that decrease in value over time.
Here's a quick list of what not to include when calculating your operating profit:
- Debt obligations
- Income from the sale of business assets
- Investment income from stakes in other companies
- Losses due to write-offs or write-downs
- Losses or gains due to changes in accounting strategies
Operating profit calculation example
Let's take a business that has a total revenue of $1 million. Its operating expenses are as follows:
- Overall operating costs: $400,000
- Cost of goods sold: $500,000
- Depreciation and amortization: $10,000
According to the formula we shared above:
Operating profit = $1,000,000 - $400,000 - $500,000 - $10,000 = $90,000
Uses and limitations of operating profit
Your operating profit represents the amount of money you have left to pay taxes, debts, dividends to shareholders, and other liabilities. Hence, it's of particular interest to managers, investors, and creditors.
Operating profit uses
- Indicates how well you manage your company: Since the operating profit is determined based on operating expenses like salaries, equipment leases, and other variable costs, it shows how efficiently you run your business operations. While some expenditures, like raw materials, are beyond your control, you can still negotiate with suppliers to get a better deal, which gives you a chance to reduce your operational expenses.
- Gain accurate insights into your financial standing: Operating profit helps businesses understand their operating expenses, allowing them to take suitable measures to reduce their costs and increase their profitability.
The operating profit is usually seen as a direct reflection of the management team's efficiency, helping the team win the approval of investors and other stakeholders.
Operating profit limitations
- A measure of profit, and not profitability: Profit is a stand-alone metric that doesn't provide the complete picture of the company's financial health. Profitability is a better measure, indicating what the company's finances look like with all expenses, liabilities, and other assets taken into consideration.
- Not a standard metric: Different businesses have varying levels of operating profits. So the operating profit is not a reliable yardstick when it comes to comparing the performance of different organizations.
Differences between net, gross, and operating profit
The profits of a business are broadly classified into three types:
- Gross profit: This is the amount left over from your revenue after you deduct your manufacturing cost. It shows the business’s efficiency in production, pricing, and sales.
- Operating profit: This is the amount left over after you deduct manufacturing and operating expenses from your net sales. It is a good measure of the financial performance and efficiency of the business.
- Net profit: This the ultimate profit the business retains after deducting all expenditures, including taxes and interest. It accurately measures a firm's ability to convert sales into a profit.
Here's a quick overview of the differences:
Differences between operating profit and EBITDA
The operating profit and earnings before interest, taxes, depreciation, and amortization (EBITDA) are key parameters that help measure a business's profitability. Though they might seem similar, they convey different information. Let's have a closer head-to-head look at the key differences:
Best practices for improving operating profit
Here are a few tips to help you improve your operating profit by reducing operating expenses:
- Reduce the cost of goods: Negotiate with raw-materials suppliers to get better discounts. Check to see whether you can find another supplier that offers a lower price without compromising on quality, or whether your supplier provides a volume discount to reduce procurement costs.
- Boost staff productivity: According to the Harvard Business Review, businesses lose more than 20% of their productivity due to organizational drag. Evaluate your operational processes to look for ways to optimize them and increase your productivity. You can also consider automating specific tasks that are time-consuming and burdensome.
- Focus on increasing average order value: This is a great way to increase your overall revenue and, in turn, your profit. Try to provide customers with relevant recommendations and subtly upsell to get them to maximize their spending.
- Identify and reduce waste: Take a closer look at your business operations. Identify areas of waste. Check if any processes or steps are wasteful, expensive, and time-consuming. Work on eliminating these wasteful processes to lower your operating costs and increase your profit margins.
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