What It Is:
How It Works/Example:
The formula is for calculating operating profit is:
Operating Profit = Revenue - cost of goods sold, labor, and other day-to-day expenses incurred in the normal course of business
It is important to understand what expenses are included and excluded when calculating operating profit. It typically excludes interest expense, nonrecurring items (such as accounting adjustments, legal judgments, or one-time transactions), and other income statement items not directly related to a company's core business operations.
To see how operating profit works, consider Company XYZ's income statement:
Using this information and the formula above, we can calculate that Company XYZ's operating profit is:
Operating Profit = $1,000,000 - $500,000 - $300,000 - $50,000 = $150,000
Why It Matters:
Operating profit is important because it is an indirect measure of efficiency. The higher the operating profit, the more profitable a company's core business is.
Several things can affect operating profit, such as pricing strategy, prices for raw materials, or labor costs, but because these items directly relate to the day-to-day decisions managers make, operating profit is also a measure of managerial flexibility and competency, particularly during rough economic times.
It is also important to note that some industries have higher labor or materials costs than others. This is why comparing operating profits or operating margins is generally most meaningful among companies within the same industry, and the definition of a "high" or "low" profit should be made within this context.