What is Operating Profit?

Operating profit is the income earned from the core operations of a business, excluding any financing or tax-related issues. The concept is used to investigate the profit-making potential of a business, excluding all extraneous factors. Operating profit information is particularly valuable when monitored on a trend line, to see how a business is performing over a long period of time. If operating income is negative, a business will likely require additional outside funding to remain in operation.

How to Calculate Operating Profit

Operating profit is derived by subtracting operating expenses, depreciation expense, and amortization expense from the gross margin of a business. The calculation is as follows:

Operating profit = Gross margin - Operating expenses - Depreciation expense - Amortization expense

Presentation of Operating Profit

Operating profit is stated as a subtotal on a company's income statement after all general and administrative expenses, and before the line items for interest income and interest expense, as well as income taxes. If the reporting entity’s income statement contains no subtotals, then no operating profit will appear on the statement. A sample presentation of operating profit appears in the following exhibit, which contains an income statement.

Operating Profit vs. Cash Flows

Operating profit does not necessarily equate to the cash flows generated by a business, since the accounting entries made under the accrual basis of accounting can result in operating profits being reported that are substantially different from cash flows. Over the long term, these two numbers are likely to be roughly equivalent, but there can be substantial differences between them over the short term.

Fraudulent Operating Profits

Operating profit can be falsely modified by aggressive accounting practices, such as by altering accounting reserves, changing revenue recognition policies, and/or delaying or accelerating the recognition of expenses. When these practices are employed, the reporting operating profits of a business may be substantially higher than is really the case. This is especially easy to do under the accrual basis of accounting, where accrual entries can be falsely employed to shift revenues and expenses in and out of a reporting period.

Related AccountingTools Courses

The Income Statement

The Interpretation of Financial Statements

A company may attempt to highlight its operating profits instead of its net profits, usually because its financing or tax costs are unusually high. If so, management is likely attempting to direct attention away from substantial non-operating costs that are a long-term component of the cost structure of the business, and which cause it to have unusually low net profits.

Example of Operating Profit

As an example of operating profit, Dillinger Designs has revenue of $10,000,000, cost of goods sold of $4,000,000, general and administrative expenses of $3,000,000, interest expense of $400,000, and income taxes of $900,000. The operating profit is $3,000,000, which includes the revenue, cost of goods sold, and general and administrative expenses. The interest expense and income taxes are excluded from the calculation.