Operating Profit

What is 'Gross Profit'

Gross profit is a company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company makes after deducting the costs associated with making and selling its products, or the costs associated with providing its services. Gross profit will appear on a company's income statement or can be calculated with this formula:

Gross profit = revenue - cost of goods sold

Also called "gross margin," "sales profit" and "gross income".

BREAKING DOWN 'Gross Profit'

Gross profit assesses a company's efficiency at using labor and supplies. The metric only considers variable costs, that is, costs that fluctuate with the level of output: materials; direct labor, assuming it is hourly or otherwise dependent on output levels; commissions for sales staff; credit card fees on customer purchases; equipment, perhaps including usage-based depreciation; utilities for the production site; shipping; etc. As generally defined, gross profit does not include fixed costs, or costs that must be paid regardless of the level of output: rent, advertising, insurance, salaries for employees not directly involved in production, and office supplies.

However, it should be noted that a portion of the fixed cost is assigned to each unit of production under absorption costing, which is required for external reporting under GAAP​. For example, if a factory produces 10,000 widgets in a given period, and the company pays $30,000 in rent for the building, a cost of $3 would be attributed to each widget under absorption costing. 

Gross profit shouldn't be confused with operating profit, also known as earnings before interest and tax (EBIT). 

Gross profit can be used to calculate the gross profit margin. Expressed as a percentage, this metric is useful for comparing a company's production efficiency over time. Simply comparing gross profits from year to year or quarter to quarter can be misleading, since gross profits can rise while gross margins fall, a worrying trend that could land a company in hot water. The terminology here can cause some confusion: "gross margin" can be used to mean either gross profit and gross profit margin. Gross profit is expressed as a currency value, gross profit margin as a percentage. The formula for gross profit margin is:

Gross profit margin = gross profit / revenue = ( revenue - cost of goods sold ) / revenue

Gross profit margins vary greatly by industry. Food and beverage stores and construction firms have razor-thin gross profit margins, for example, while the healthcare and banking industries enjoy much larger ones. 

Here is an example of how to calculate gross profit and the gross profit margin, using Ford Motor Co.'s (F) 2014 annual income statement (all numbers in millions of USD):

Revenues
Automotive	135,782
Financial services	8,295
Total revenues	144,077
Costs and expenses
Automotive cost of sales	123,516
Selling, administrative and other expenses	14,117
Financial Services interest expense	2,699
Financial Services provision for credit and insurance loss	305
Total costs and expenses	140,637

To calculate the gross profit, we first add up the cost of goods sold:

Automotive cost of sales ($123,516 m) + FS interest expenses ($2,699 m) + FS provision for credit and insurance loss ($305 m) = $126,520 m

We do not include "Selling, administrative and other expenses," since these are mostly fixed costs. We then subtract the cost of goods sold ($126,520 m) from total revenues ($144,077 m) to obtain a gross profit of $17,577 m.

To obtain the gross profit margin, we divide the gross profit ($17,577 m) by total revenues ($144,077) for a margin of 12.20%. This compares unfavorably to an automotive industry average of around 20%, suggesting that Ford does not operate as efficiently as its peers.

Standardized income statements prepared by financial data services may give slightly different gross profits. These statements conveniently display gross profits as a separate line item, but they are only available for public companies. Investors reviewing private companies' income should familiarize themselves with the cost and expense items on a non-standardized balance sheet that do and don't factor into gross profit calculations.

For more on gross profit, see Understanding Profit Metrics: Gross, Operating and Net Profits.

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Operating Profit

What is 'Operating Profit'

Operating profit is the profit earned from a firm's normal core business operations. This value does not include any profit earned from the firm's investments, such as earnings from firms in which the company has partial interest, and the before the deductions of applicable interest and taxes owed. Operating profit is calculated using the following formula:

Operating Profit = Operating Revenue - COGS - Operating Expenses - Depreciation and Amortization

BREAKING DOWN 'Operating Profit'

Also referred to as earnings before interest and tax (EBIT), operating profit represents the earning power of the company with regard to revenues generated from ongoing operations. Operating profit serves as an indicator to the business’s potential profitability with all extraneous factors removed from the calculation.

Examples of Exclusions from the Operating Profit Calculation

Income created through the sale of assets, outside of those assets created for the purpose of being sold as part of the core business, are not included in the operating profit figure. Additionally, interest earned through mechanisms such as checking or money market accounts are not included.

While the removal of production costs from overall operating revenue, along with any costs associated with depreciation and amortization, are permitted when determining the operating profit, the calculation does not account for any debt obligations that must be met even if those obligations are directly tied to the company’s ability to maintain normal business operations.

Operating income does not include investment income generated through a partial stake in another company even if the investment income in question is tied directly to the core business operations of the second company. Additionally, the sale of assets such as real estate and production equipment are not included as these sales are not a part of the core operations of the business.

Benefits of Referring to the Operating Profit Figure

Companies may choose to present their operating profit figures, in lieu of their net profit figures, as the net profit of a company contains the effects of interest payments and taxes. In cases where a company has a particularly high debt load, the operating profit may present the company’s financial situation more positively than their net profit reflects.

For investors, examining the operating profit may allow for an easier comparison of businesses that operate within industries with differing tax rates or financial structures as this allows for a more equitable comparison.

Operating Profit and Investment Decisions

While positive operating profit may express the overall profit potential of a business, it does not guarantee the business is not experiencing losses. A company with a high debt load may show a positive operating profit while also having a negative net profit. Additionally, large but extraneous costs are not represented, which can again show a company with a negative net profit as having a positive operating profit.

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