What is operating profit? Explain the difference between gross profit and ordinary profit and how to calculate it

Do you have an accurate picture of your operating income? Operating profit is the profit remaining after deducting expenses from a company’s revenue.

If you are a company representative, officer, or person in charge of accounting, you should know this, but other employees should also know it. Especially if you work for a startup or small business, you may want to look at operating profit as well as sales.

Approximately 20% of SMEs are said to go bankrupt within a year of starting a business. It is true that it is not easy to achieve profitability from the first year. On the other hand, if a certain amount of profit is generated, you can think positively that your company is moving in the right direction.

In this article, we will explain the basic knowledge of operating profit, the difference between gross profit and ordinary profit, which are often confused, and how to actually calculate it.

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Creditors and investors take a close look at a company’s operating income. This is because the future of the company is clearly visible there. For example, if the operating profit is positive, the company has room for further growth in the industry, but if it is negative, it is unlikely that it will scale and grow any further.

Now that you understand operating profit, let’s take a closer look at how it’s calculated.

Let’s check the definitions of “sales”, “cost of sales”, “gross profit”, and “operating expenses (selling, general and administrative expenses)” necessary to derive operating profit.

amount of sales

Revenue refers to the total amount of sales earned by selling products, goods, and services. At this time, “sales of products” is the amount obtained by selling products manufactured by the company, while sales of products procured from other companies are recorded separately as “sales of products”. will be

Cost of sales

Cost of goods sold is the cost of manufacturing or the cost of goods sold. Without an accurate understanding of these costs, it is not possible to accurately generate gross profit.

The actual cost of goods sold is expressed by the following formula:

Inventory at the beginning of the period + Purchases at the end of the period – Inventory at the end = Cost of sales

The beginning inventory is the inventory value of products and merchandise carried over from the previous year. Suppose you purchase 10 units of a product with a cost of 1,000 yen and sell 8 units. The cost of sales recorded at this time is 8,000 yen. The remaining 2 items x 1,000 yen will be carried forward and become the “starting inventory amount” of the next term.

Current purchases include production costs and purchase costs for products in the current period. At the end of each fiscal year, the unsold goods (ending inventory) are subtracted from the sum of the beginning inventory and current purchases.

for the manufacturing industry

Inventory of products at the beginning of the period + Cost of manufacturing products for the current period – Inventory of products at the end of the period = Cost of sales

can be obtained as

gross profit

Gross profit is the amount obtained by deducting the cost of sales (manufacturing cost and purchase cost) from sales. Also called gross profit. Financial institutions use this amount as a guide when deciding how much to lend to a company. In many cases, businesses cannot borrow more than their gross profit.

Operating expenses (selling, general and administrative expenses)

Operating expenses, referred to as “selling, general and administrative expenses” on the income statement, are the total amount of expenses necessary to run the core business. Operating expenses generally include:

• land rent
• Advertising expense
• transportation cost
• communication cost
• Transportation expenses
• utility bills
• supplies expense
• wage
• Welfare expense
• sales commission
• Insurance fee
• depreciation

Let’s take a closer look at the depreciation expense included in the above selling, general and administrative expenses.

depreciation

Depreciation is the amount of the purchase cost of an asset, such as equipment, distributed over the period of its use. This amount appears in the operating expenses section of the income statement and is reported over the life of the asset.

Depreciation is the method of recording the purchase cost of a tangible asset over its useful life. Tangible assets (fixed assets) refer to tangible assets such as land, buildings, vehicles, equipment, office desks and cabinets. In order to calculate the depreciation cost, it is necessary to grasp the two elements of “acquisition cost” and “useful life”. Acquisition cost is the cost of purchasing an asset plus the costs incidental to the purchase. For example, it refers to the shipping cost when purchasing a manufacturing machine.

Useful life is the number of years an asset can withstand use.

There are several methods of calculating depreciation, but here we will explain how to use the straight-line method.

Company A purchased a machine for 500,000 yen. Assume that the useful life of this machine is 10 years.

500,000 ÷ 10 = 50,000

You will accrue 50,000 yen each year until the end of the machine’s useful life in 10 years.

6. Operating profit

Operating profit can be calculated by the following formula.

(Sales – Cost of sales) – Selling, general and administrative expenses = Operating income

Sarah’s Bakery is a popular wedding cake specialty store in the Boston area, USA. The store is small but growing steadily, and the owner Sarah is currently thinking about purchasing a new large store and relocating the store. To move the store, you must first borrow the necessary funds from the bank.

So Sarah’s Bakery decided to create a segmented income statement to demonstrate that its core business is performing well. Wedding cake sales have posted $80,000 in the past year. The cost of running the store is as follows.

• Rent Rent: $24,000
• Utilities: $5,000
• Premium: $1,000
• Cookware fee: $10,000
• Equipment: $700
• Depreciation: $100

Add all of the above expenses to calculate selling, general and administrative expenses. In this example, $40,800 corresponds to selling, general and administrative expenses.

Operating profit in this case is calculated by the following formula.

$80,000 (gross profit) – $40,800 (selling, general and administrative operating expenses) = $39,200 (operating income)

With an operating profit of $39,200, Sarah’s Bakery can prove to the bank that the business is profitable enough. There is also a high possibility that you will be able to obtain a loan to purchase the store.

In this article, we focused on “operating profit” in the income statement.

In addition to this, the income statement includes “management profit,” which describes non-operating income, and “extraordinary profit,” which describes profit and loss arising from factors unrelated to the company’s normal operating activities, such as profits from the sale of real estate. ” is described.

The profit and loss statement shows the company’s ability to generate profits. Taking a closer look at ‘benefits’, we can see the benefits for each:

• Gross profit: The power of products, goods, and services provided by a company
• Operating profit: Profit made by the company
• Ordinary income: management power of a company
• Net income: An index that shows the final corporate performance

Look at the actual income statement

Let’s look at Google ‘s performance (including operating profit) for the past few years and see what the actual income statement looks like.

There are four types of financial statements that are indispensable for corporate management: the balance sheet, the income statement, the cash flow statement, and the statement of changes in shareholders’ equity.

Using operating income in conjunction with other indicators of a company’s cash flow and financial health provides a more accurate measure of a company’s ability to generate profits. The higher the operating profit, the higher the profitability of the company’s core business.