How to Calculate Operating Profit for Your Startup

The operating profit formula provides a measure of how well your startup is performing and strips away some components which may obscure the core picture. It also provides a useful benchmark when you’re trying to compare different companies in similar markets or industries.

In this blog, we’ll discuss everything you need to know about operating profit. From what it means, to how this calculation can be useful to businesses in different ways. We also discuss similar metrics and the subtle differences between them.

Contents

• What is operating profit?

• What operating profit is not

• Operating profit formula

• How to calculate operating profit

• Why is it important?

• Operating profit margin

What is operating profit?

In a nutshell, the operating profit for your startup is the total earnings from your core business (over any given time) before any deductions for interest, expenses and tax payments are made.

Excluded from this operating profit formula are any profits made from non core areas of your business, or any investments that your business may have made. This includes other businesses that your startup might part own.

An operating profit would mean that the income from your core business is higher than your expenses.

An operating loss would mean that the income from your core business is lower than your expenses.

When you calculate operating profit it serves as an indication of the health of a business. This is because the operating profit formula removes extraneous factors and only the expenses needed to keep the business running are included.

A company might choose to present operating profit as opposed to net profit if it’s advantageous to their business. For example, if a business has a high debt burden, the operating profit may be a better way to positively present the financial situation of the company.

What operating profit is NOT

Operating profit is often confused with EBIT. Which stands for:

Earnings Before Interest and Tax.

Operating profit can sometimes be used interchangeably with EBIT in some contexts, but please take care. It’s important to understand the subtle difference between the two calculations. EBIT includes non core income (there’s that word again, core), operating profit does not.

If your startup has no non operating income, then Operating Profit = EBIT. However, this isn’t always the case so a distinction needs to be made, especially so when making comparisons between different businesses.

If you get it wrong, your comparison at best lacks nuance, and at worst it isn’t fit for purpose.

Operating profit formula

Here is the operating profit formula that you’ll need to perform the calculation.

Operating Profit = (Total Revenue) – (Cost of Goods Sold) – (Operating Expenses) – (Depreciation) – (Amortisation)

The terms included in operating profit formulas:

1. Total revenue;

2. Operating expenses;

3. Cost of goods sold;

4. Depreciation;

5. Amortisation.

Total revenue: This is the revenue from all core business operations.

Operating expenses: These are all the fixed cost expenses needed to keep the core business operating, plus amortisation and depreciation of assets. These can include such things as rent, utilities, and payroll.

Cost of goods sold: This represents labour costs, raw materials and other expenses directly related to the production of goods. The cost of goods sold does not include any indirect expenses, for example, such as any costs relating to the maintenance of a corporate headquarters.

Depreciation: The allocated cost of a tangible or physical asset over its expected useful lifetime.

Amortisation: The lowering of the value of non tangible assets over time.

What we exclude from operating profit formulas

1. Income from non core business activities;

2. Income from investments;

3. Interest expenses;

4. Tax expenses;

5. Business expenses relating to non core activities.

Any revenues generated by selling assets would not be included in the operating profit formula unless it was related to the core business. For example, assets created for the sole purpose of being sold.

If a real estate asset or piece of machinery were sold, this income would not be included as it is not generated as part of the core business operations.

Interest earned from cash, whether held as currency in money markets or held in other accounts, would not be included either.

Debt expenses are not included in the formula. This is always the case for operating profit calculations, even if the debt is needed to facilitate the business in maintaining its operation.

Total Revenue does not include any revenue generated by non-core activities. This includes investment income from equity stakes in other businesses.

How to calculate operating profit: an example

Now we know what operating profit is, (and discussed what an operating profit isn’t), let’s work through an example.

We want to work out your startup’s operating profit so we can see how you compare to a competitor.

SolarFix has been operating for several years, developing and selling a coating that when added to solar panels increases their efficiency by 25%.

In the last 12 months SolarFix had:

• Revenue: £17m

• Operating expenses: £3.6m

• Cost of goods sold: £6.9m

• Depreciation: £920k

• Amortisation: £500k

Now we can use our operating profit formula.

Operating Profit = (Total Revenue) – (Cost of Goods Sold) – (Operating Expenses) – (Depreciation) – (Amortisation)

Operating Profit = (£17m) – (£3.6m) – (£6.9m) – (£920k) – (£500k)

Operating Profit = £5.08m

Operating profit is important, here’s why…

Operating profit calculations can give people a lot of information about a company. This metric is useful to people both inside and outside of a business. For example, an investor may use this metric to evaluate the core profitability of a company’s operations. Or a founder may want to get an understanding of how their company measures up against competitors operating in the same industry.

Managers can use this metric to gain insight into how they can control costs. The retail price of goods sold, labour costs and the costs of raw materials all have an impact on the cost of goods sold (and therefore operating profit). Management can use this figure to see how changes to these values are impacting the financial performance of the core business and make decisions accordingly. Potential investors may also use this metric to help understand how competent the incumbent management team is.

As explained above, operating profit is not the whole story. A company may choose to present operating profit to showcase strong underlying profitability, however, the net profit of that company may still be negative.

This would be the case, for example, if a company had a high debt burden. This company could show positive operating profit while also incurring a net loss.

As with all business metrics, context is important and an understanding of how metrics complement each other is essential.

Operating profit margin

Speaking of metrics that complement each other….

Operating profit margin measures the profit that a company makes per £1 of sales (after core business expenses, but before interest and tax). It’s calculated by first finding the operating profit and then dividing it by the company’s net sales.

The output of the operating profit formula is a value in £’s. The output of the operating profit margin formula is expressed as a percentage.

The operating profit margin represents how good a business is at generating profit through the core business. A higher margin is generally considered to be better, but care must be taken when comparing companies, especially if they operate in different market conditions.

The operating profit margin formula is:

Operating Profit Margin = (Operating Profit / Net Sales)

Let’s try an example using our SolarFix company which had net sales last year of £32m:

Operating Profit Margin = (£5.08m / £32m)

Operating Profit Margin = 15.8%

The operating profit margin can really only be used to compare companies that use similar business models and operate in the same market. Operating profit margins can be very different across industries and so using them for competitor analysis can be difficult and sometimes meaningless.

However, the operating profit margin can be used to help you understand your fixed costs and manage them effectively. For example, you can finesse the calculation to better understand how making changes to your cost of goods sold impacts your operating profit margin. This could help you to develop sales strategies, or even specifically target discounts from certain suppliers that could positively impact your margin.

In summary

We’ve seen how calculating operating profit can be useful for every business. We’ve looked at the operating profit formula and discussed why it’s important, whilst also acknowledging the limitations it has. Keeping on top of the financial health of your startup is a good habit to get into and metrics such as operating profit are dynamic and user friendly. Its inherent flexibility can give you an insight into how small changes in your business model, or terms of operation, can have an impact on operational profit.

When running a business, the metrics we need can be time consuming to produce, even the straightforward ones! One solution is to integrate your metrics onto a dashboard. A dashboard is a piece of software designed to ensure that all the information that is important to your business is available to you and presented in a simple way. A good dashboard will give an overall picture of the current state of your business while also allowing you to perform a deep dive and get into granular detail when you need to.

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