What is operating profit?
Operating profit is an estimate for a company of the difference between operating profit and operating expenses for that company. Operating income is often used synonymously with earnings before interest and taxes (EBIT), although strictly speaking EBIT includes both non-operating income and operating income. It is an important concept both for a company to determine its own health and for an investor to assess a company's earning potential before investing in it.
There are two main things calculated to determine a company's operating income: the company's operating income and operating expenses. Operating income is any income that comes in through standard income channels, like widget sales, but excludes things like interest income or dividend income. Operating expenses are expenses incurred in the day-to-day operations of the business, but exclude extraordinary expenses. Generally, one can view operating income as revenue from sources that recur from year to year and operating expenses as expenses within a class that recur from year to year.
Expenses that can be left out of operating expenses, and therefore from the operating income calculation, include things like paying a class action lawsuit. As it is assumed to be a one-time cost, it is not particularly relevant to analyze potential gains in subsequent years. Likewise, income from investments in other companies is not really a reflection of how well the business itself is doing, only how well its investments are doing, and therefore is usually excluded from the operating profit calculation.
For a concept like this, an example might be the best way to show the difference between the different calculations. We will see a fictional manufacturing company, which produces and sells widgets. As an investor looking to buy stock in the company, we are interested in how well they are doing as a business, so we want to know their operating income and their earnings before interest and taxes.
First, we analyze your operating income. This is quite simple as we just need to see how much money they brought in from their widget sales across the world. This includes all of your store locations, your wholesale operations, and your online sales. The total number is $5 billion US Dollars (USD).
Next, we analyze your operating expenses. To make their widgets, they spend $2.2 billion, which represents raw materials, rents from their factories, their distribution network and their employees. They spend an additional $1.1 billion on administrative costs, including executive compensation, legal expenses, and other employees. About $150 million goes into amortization and depreciation. And they spend about $50 million on other miscellaneous expenses that recur year after year. So everyone said their operating expenses are $3.5 billion.
That means your total operating income is $1.5 billion, which we get by subtracting your operating expenses from your operating income. If they also had $150 million in earnings, such as foreign exchange and other non-operating income, we would calculate their total earnings before interest and taxes as $1.65 billion. From there, we can also add your net interest income and expenses and the taxes you paid to calculate your total net income.