Introduction and Meaning of Operating Profit

Operating profit is an accounting term, which describes the profit of a company or organisation from its core business operations. Operating profit is calculated after deducting Operating expenses, cost of goods sold, depreciation and amortisation from the operating revenue.

Formula To Calculate Operating Profit:

Operating Profit = Operating Revenue – (Cost of Goods sold + Operating expenses + Depreciation + Amortisation)

The above terms for calculation are explained as below:

1. Operating Revenue is the revenue generated by selling goods or services from the core activities of a business.
2. Cost of goods sold (COGS) refers to the total cost to produce goods and services which excludes the indirect expenses (expenses which are not directly related to the production of the goods or services). The standard formula for COGS is adding Opening stock and purchases and deducting purchases and direct expenses from the same.
3. Operating expenses refer to the indirect costs incurred in the business. The costs which aren’t directly related to the core business activities. These costs include payroll/salary, sales commissions, administration expenses such as rent, utilities, etc, marketing costs, research and development expenses, etc.
4. Depreciation is the wear and tear of a tangible asset (for example – building, furniture, equipment, vehicle, etc) i.e. the depletion of an asset in terms of its monetary value over a particular period.
5. Amortisation is the depletion of a non-tangible asset i.e. assets that can’t be touched such as goodwill, patents, trademarks, etc.

An Example of Operating Profit, EBIT, and PAT

Suppose a company named ABC Limited is seeking to find the operating profit of its firm. Given below is the profit and loss statement of the company.

Expenses	Amount (in Rs crores)	Revenue	Amount (in Rs crores)
Opening stock	825	Sales (less sales return)	1500
Purchases	500	Closing stock	400
Direct expenses	20
Gross profit	555
TOTAL	1900	TOTAL	1900
		By Gross profit (c/f)	555
Marketing expenses	5	Income from the sale of shares of other companies	10
Selling and administrative expenses	4	Dividend Income	5
Salary and staff expenses	10
Research and development expenses	2.5
Depreciation	10.75
Amortisation	5
EBIT (Earnings before interest and tax but after depreciation and amortisation)	532.75
Interest expenses	5.5
Tax expenses	210.90
Profit after tax (EBIT – Interest – Taxes)	316.35
TOTAL	570	TOTAL	570

1) Calculating Operating Profit from the above given data:

Operating Profit

= Operating Revenue – (Cost of Goods sold + Operating expenses + Depreciation + Amortisation)

= Operating Revenue – (Cost of Goods sold) – (Operating expenses) – Depreciation – Amortisation

= Operating Revenue – (Opening stock + Purchases +Direct expenses – closing stock) – (operating expenses) – Depreciation – Amortisation

= 1500 – (825+500+20-400) – (5+4+10+2.5) – 10.75 – 5

= 1500 – (945) – (21.5)

= 1500 – 966.5

= Rs 533.50 crores

Therefore, here the operating profit is Rs 533.50 crores.

Note: Operating expenses include Marketing expenses, Selling and administrative expenses, Salary and staff expenses, and Research and development expenses)

2) Calculating EBIT (earnings before interest and tax), but after depreciation and amortisation from the above data

EBIT

= Gross Profit + Non-operating income – (Operating expenses except interest and tax) – depreciation – amortisation

= {Sales + Closing stock – (Opening stock + purchases + direct expenses)} + Non-operating income – (Operating expenses except interest and tax) – depreciation – amortisation

= {1500+400 – (825+500+20)} + 15 – (5+4+10+2.5) – 10.75 -5

= {1900 – (1345)} + 15 – (21.5) – 15.75

= 555 +15 – 37.25

= Rs 532.75 crores

Note: EBIT is calculated after adding the non-operating income to the Gross profit minus the operating expenses (excluding interest and depreciation).

Calculating Profit after tax (PAT)

= Gross Profit + Non-operating income – (Operating expenses except interest and tax) – depreciation – amortisation – Interest – Taxes

= EBIT – Interest – Taxes

= 532.75 – 5.5 – 210.9

= Rs 316.35 crores

Profit after tax (PAT) is calculated after deducting interest and taxes from EBIT (Earnings before interest and tax).

Importance of Operating profit

1. Profitability: Operating profit helps to determine the profit derived from operating revenue less the direct expenses and operating expenses, depreciation, and amortisation. It helps to calculate the profit from the operating activities.
2. Efficiency: The operating profit indicates how efficiently a business is working. This excludes non-operating income and expenses.
3. Core business activities: It helps identify and shows how well the business performs from its core business activities.
4. Productivity: Operating profit indirectly measures the overall productivity of a business.
5. Management: The operating profit can show how effective is the management in terms of cost savings, utilising the resources, etc. It shows the strengths and weaknesses of the management.
6. Earnings: The Operating profit is also an indicator of the earnings and shows the ability of a company to generate profit.

What is EBIT?

Earnings before interest and tax (EBIT) is a measure of a company’s or an organisation’s profitability. EBIT is calculated by subtracting all expenses from the operating and non-operating income, except interest and tax expenses. The higher the EBIT is, the better it is.

EBIT is useful to compare companies in the same industry. Although it’s not the ultimate measure of the actual profitability of a company. There are other measures like Profit after tax (PAT), PAT margin, Earnings per share (EPS), etc. which create a greater impact and show a fair picture of the company’s actual profitability.

Difference Between EBIT And Operating Profit:

EBIT (Earnings before interest and Tax) and Operating profit are used together interchangeably, but they are different. EBIT also includes the non-operating income such as income from sale of investments, income received in the form of dividends from other companies, etc.

On the other hand, while calculating Operating profit, we don’t include the non-operating income and non-operating expenses. It only includes operating income subtracted from operating expenses, giving a fair picture of the profitability from the core operations of a business.

This makes Operating profit more reliable than EBIT, in most of the cases.

Difference Between PAT and Operating Profit:

Profit after tax (PAT) is the financial metric used to measure profitability. It is calculated after deducting EBIT (Earnings before interest and tax) less Interest less taxes. On the other hand, Operating profit is the profit derived after subtracting Operating revenue from only operating expenses.

Frequently Asked Questions (FAQs)

What is EBITDA?

EBITDA is Earnings before interest, tax, depreciation and amortisation. It is calculated before arriving to the actual net profit i.e. Profit after tax (PAT).

What is EBT?

EBT is Earnings before tax. It is calculated after deducting interest from EBIT (Earnings before interest and tax).

What is non-operating income?

Non-operating income are income which are not derived from the regular core activities of the business. They are usually from other business or investments.

What are the examples of non-operating incomes?

Examples of non-operating income include income from dividends of other companies, income from investments from other companies, sale of assets, sale of investments, etc.

What is an appreciation of an asset? Give an example.

Appreciation of an asset includes appreciating the value of an asset in monetary terms over a period. For example, the value of land never gets depreciated. Land’s value always gets appreciated from time to time.

What are non-operating expenses?

The non-operating expenses are those expenses that don’t occur in the core business activities. Examples include interest & loan expenses, tax expenses, etc.

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