Calculating your operating profit is vital for monitoring how your business is performing, keeping you up-to-date on your profitability status and alerting you to any areas of opportunity.
Lynn Hood, COO at Focus Hotels, who steered the company towards record levels of operating profit during recent uncertain market conditions, says: “We have a full understanding of every cost line in our business, helping us to continually search for our break-even point. It helps us answer questions such as when did we start to burn cash and when did we break-even? That point has moved considerably recently as we've been able to reduce costs of operating.”
But what is operating profit? Simply put, operating profit is what’s left when you deduct operating costs, the cost of goods sold and other day-to-day expenses from your revenue. In this article we’ll cover exactly how to calculate operating profit for your business.
How to calculate operating profit
The operating profit formula is:
Revenue - Operating Costs - Cost of Goods Sold (COGS) - Other Day-to-Day Expenses = Operating Profit.
This is the sum of all the business income generated from the sale of your products or services. It shows how much money you’re bringing in from your sales.
These are the cost of your overheads. Catherine Erdly, Founder of The Resilient Retail Club, says operating costs relate to everything you have to pay to run your business such as premises, utilities, salaries and the price of fixed marketing, for instance.
“A good test to see if something is an operating cost or [falls under] cost of goods sold is to ask yourself if you sold twice as many items would that cost go up?” she says. “For example, when it comes to packaging, you would have to purchase more with increased handling fees and materials, which are all included in the cost of goods sold whereas fixed costs – like monthly rates – count as operating costs.”
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The cost of goods sold
This is the sum of all of your operational business costs.
Here is where you focus on ‘depreciation’ and ‘amortisation’, which relate to the company’s day-to-day expenses. “Depreciation is how you spread out the cost of fixed assets over time – so, for example, property or a company car would be great examples of something that may depreciate over time, so you are effectively devaluing the asset each year, based on an idea of wear and tear,” says Erdly.
Amortisation, she adds, relates only to intangible assets as opposed to physical ones – such as trademarks, patents or franchise agreements, which may decrease in value over time.
What to exclude when calculating operating profit
Do not include any of the following when working out your operating profit, as these will skew your figures:
- Income from the sale of assets
- Interest from money market accounts or similar sources
- Debt obligations
- Investment income from stakes in other organisations
- Losses from write-downs or write-offs, as well as uninsured losses
- Gains or losses due to changes in accounting strategies
Operating profit formula example
Here’s an example of a business with a total revenue figure of £1 million, with costs as follows:
- Cost of goods sold: £500,000
- Operating costs: £300,000
- Depreciation and amortisation: £50,000
Therefore, the business’ operating profit is: £1,000,000 - £500,000 - £300,000 - £50,000 = £150,000.
Why keep tabs on operating profit?
There are many reasons why operating profits may drop – for instance, demand may fluctuate seasonally, so it’s useful to look at operating profit levels monthly, advises Erdly. A low operating profit during a particular month need not cause concern; it's more about understanding what the seasonal patterns are, tracking these over time and understanding how to increase profit.
“Retail businesses often have a situation where they may have some months in the summer where their sales are relatively low so their revenue is lower but the cost of their goods sold is higher because they are purchasing in their holiday stock, whereas during the holiday time they are going to have high sales and lower cost of goods sold because they already have those goods in hand,” says Erdly.
Hood produces a profit and loss statement every calendar month. She says: “It's all segmented into the divisions within the business such as rooms, leisure, food and beverages. The quick approach [to keeping tabs on profit margins] is to review payroll and keep your controls tight as that is your biggest single cost to the business.”
As well as staffing, Hood scrutinises product costs, the cost of servicing rooms, providing meals, pricing and distribution to ensure maximum operating profit.
What causes operating profit to change?
A low operating profit may be an indicator that business expenses are increasing, for example, if you've introduced new staff members, premises or equipment. By regularly calculating operating profit, you will be able to keep on top of such fluctuations.
Another measure to help you stay up-to-date of your finances is gross profit, which is the money left from the sale of your goods or services once the direct expenses used to generate them are deducted. It is often used to measure the profitability of a single product via a simple gross profit formula.
Getting to grips with your operating profit will undoubtedly help you to better manage your business finances but as this figure naturally varies, the American Express® Business Gold Card can give you more flexibility in your cash flow, thanks to a payment period of up to 54 days on purchases.²
- Membership Rewards points are earned on every full £1 spent and charged, per transaction. Terms and conditions apply.
- The maximum payment period on purchases is 54 calendar days on Gold & Platinum Business Charge Cards and 42 calendar days on the Basic Business Charge Card, it is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date.
- The Business Gold Card has no annual fee for the first 12 months, and costs £175 a year thereafter.