Any business is not worth investing in if it's not generating profits or doesn't aim to do so in the future. To understand a business's profitability, we have multiple metrics like gross profit, operating profit, EBITDA, net profit, and profit after tax.
All these metrics are used to gauge where the business stands and gives insight into the direction it's headed. In this blog, let's take a deeper look at operating profit and understand how it differs from net profit and gross profit.
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Operating profit calculates the profits earned by a company from its core business. It aims to understand how much profit you are earning from your primary business before considering interest and taxes. It is also commonly used by investors to compare the financial performance of companies in the same industry.
Formula to compute operating profit:
Operating profit = Operating Revenue - Cost of Goods Sold - Operating Expenses - Depreciation and Amortisation
â—Ź Operating revenue is the total sales that is generated by a company's primary business.
â—Ź Operating expenses are the total expenses incurred by a company's core business operations like salaries, rent, and other expenses related to production, administration, and selling.
â—Ź Cost of goods sold refers to the total cost incurred to procure/create the goods.
â—Ź Depreciation refers to the wear and tear of fixed assets.
â—Ź Amortisation refers to the decline in the value of an intangible asset.
Why does operating profit matter?
Operating profit is an important metric as it helps you to understand the company's core profitability. Here are several reasons why operating profit is important:
Assesses operational efficiency: A higher operating profit suggests that the company is generating more revenue and can manage operating expenses well leading to efficient resource management.
Performance comparison: Operating profit helps in the comparison of financial performance among companies within the same industry. By comparing the operating profit margin( Operating profit/ total sales) you can get an idea of which company is performing better.
Guided decision-making: Companies use this metric to pinpoint areas for cost reduction and revenue augmentation. A low operating profit might suggest that the company needs to trim operating expenses, boost sales, or adjust pricing strategies.
Strategies to improve operating profits​​​​​​​
Here are strategies businesses can use to boost their operating profit:
- Reducing operating expenses is one method to improve operating profit. It can be done by simplifying production processes, negotiating supplier deals, and eliminating unnecessary expenses.
- Increasing product or service prices can lead to a higher operating profit. Companies can determine the optimal pricing by conducting market research to understand customer price sensitivity and adapting pricing strategies accordingly.
- Improving efficiency in production processes can drive up operating profit. Adopt lean manufacturing principles, reduce waste, and optimise the supply chain.
- Increasing sales revenue will automatically improve operating profit. This can be done by expanding market reach, introducing new products or services, or implementing robust marketing strategies to attract more customers.
- The customer experience means everything to the business. Try to build trust so that you can get repeat business and referrals.
- Technology investments can improve production processes, reduce costs, and improve efficiency. Automation can lower labour expenses contributing to increased operating profit.
How is operating profit different from net profit and gross profit?
Here's a breakdown of what each of these metrics means and how they are different from gross profit and net profit:
Gross Profit
Gross profit is the total revenue generated from goods and services sales minus the cost of goods sold. It includes the direct expenses associated with production and delivery and excludes operational costs like salaries, rent, and utilities.
Net Profit
Net profit shows the overall profit earned by a company after factoring in all the expenses including interest and taxes. It reflects the net earnings remaining once all expenses have been settled.
Conclusion
To summarise, if you are looking to find out the profitability of a company, operating profit would be a good metric to look at as it shows the amount of profit the business can generate from the core business. Each metric has a different significance and it's best to understand all and use the one that best answers your question.
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