How to calculate operating profit

Reading down a profit and loss statement, sales come first, then the cost of goods sold, leaving gross profit. The costs of running the business come next, and what remains is operating profit. Below that line sit items that are not part of trading, and after them comes net profit.

business.gov.au describes expenses as what a business spends on its operations in order to earn revenue. Those are the costs that come out before operating profit. Interest is different: business.gov.au's glossary treats it as what it costs to borrow, or what an interest-bearing account earns. It reflects how the business is financed rather than how it trades, so it sits below the line.

Operating profit equals gross profit minus operating expenses. If your statement doesn't show the subtotal, you can also work back from net profit: add back interest paid and any other excluded expenses, and take away interest received and any other excluded income. Both routes should give the same answer.

Operating profit measures how the business trades; net profit is what's left after everything, including interest and any other items from outside trading.

Use operating profit when the question is about trading itself: whether prices, volumes and running costs are moving the right way. Use net profit when the question is what the period left for the owners, because interest has to be paid however well the business trades.

The two are the same when a business has no loans, earns no interest and has nothing else below the line. Net profit comes out lower when interest paid and other non-trading costs outweigh non-trading income, as they do for a business with a loan and little cash on deposit. It can come out higher when the business earns more from outside trading, such as interest on a large cash balance, than it pays in non-trading costs.

In the landscaping example below, operating profit is 62,900.00 and net profit 58,650.00. The 4,250.00 between them is the interest on the equipment loan less the interest earned on the deposit.

No. Gross profit takes off only the direct costs of what was sold; operating profit also takes off the costs of running the business. In the same landscaping example, gross profit is 240,500.00 and operating profit 62,900.00. The 177,600.00 between them is the year's staff, vehicle, rent, insurance, marketing and other running costs.

That also answers whether operating profit includes salaries and fixed costs: it does. Staff pay comes off before operating profit, and so do rent, insurance and the other fixed costs that business.gov.au's glossary calls overheads, along with running costs that vary with activity, such as fuel.

One cost that doesn't usually come off is a sole trader's own pay, because what the owner takes out is generally not an expense; your accountant can confirm how it is recorded. Bear that in mind before comparing your operating profit with a company's, where an owner who works in the business may be paid a salary that sits among the expenses.

Go through the income and expense accounts for the period and decide which side of the line each one belongs on.

• Inside operating profit: sales, cost of goods sold, wages, rent, vehicle costs, insurance, marketing, utilities, software, repairs and bank fees on everyday transactions.
• Outside it: interest paid on loans and overdrafts, interest received on deposits, and other income or costs that come from financing or investing rather than trading.

Unusual is not the same as non-operating. A large repair or a one-off marketing campaign is still a cost of running the business. Note it beside the figure if it makes the period look odd, but leave it in.

The interest on the equipment loan is a real cost the business has to pay, and net profit includes it. Operating profit sets it aside so you can see how the landscaping work itself performed, whichever way the equipment was paid for.

Suppose the business takes out a larger loan next year. Interest goes up and net profit goes down, even if the jobs, prices and running costs stay exactly the same. Operating profit stays put, which tells you trading hasn't changed and the difference is in financing.

The same logic helps when you compare product lines, branches or the years either side of a refinance. It also stops interest earned on spare cash from making trading look better than it was.

Divide operating profit by sales for the same period. If your statement doesn't show operating profit, work it out first by either route in the formula section, then divide. Operating margin, operating profit margin and operating profit ratio all describe this one division, and a percentage on a report is the same decimal multiplied by 100.

Last year, 57,200.00 divided by 520,000.00 gives 0.11. This year, 60,300.00 divided by 548,000.00 also gives 0.11. Each dollar of sales kept about 11 cents of operating profit in both years, so the bakery's trading held steady while it grew.

Net margin tells a different story. It slipped from 0.10 to 0.09, because interest rose from 3,100.00 to 11,900.00 after the bakery borrowed for the oven. Reading the two margins together places the change in the loan, not in the bakery's prices or running costs.

Track operating margin month by month or quarter by quarter, and against the margin your budget assumed. An operating margin that falls while sales grow means direct or running costs are growing faster than sales. If your trade has busy and quiet seasons, compare each month or quarter with the same one last year rather than the one just before it, so a seasonal swing in sales isn't read as a change in how the business trades.

Yes. An operating loss means the costs of running the business were larger than its gross profit for the period, before interest is even counted.

Because it arises above the interest line, an operating loss points at trading rather than at how the business is funded: paying off a loan wouldn't remove it. Work back up the statement. Has gross profit shrunk because sales fell, prices slipped or direct costs rose? Or have running costs grown faster than gross profit? One loss-making month can come from a large one-off cost or a quiet season, so set it beside the same period last year before deciding it is a trend.

Net profit can still be positive alongside an operating loss if other income, such as interest earned on a large deposit, covers the gap, but that doesn't make the trading profitable. business.gov.au lists costs that have increased while profits haven't among the signs of poor profitability, and suggests getting professional help early. A run of operating losses is worth raising with your accountant.

There is no one layout every report follows, and the items placed below operating profit vary between businesses. What matters is consistency: write down which accounts you exclude, use the same list every period, and restate earlier periods if you change it. If you are unsure where a line belongs, ask your accountant.

business.gov.au suggests a financial check-up at least yearly, and lists the profit and loss statement among the documents to go through, describing it as the report that shows how the business has performed and how profitable it has been. A consistent operating profit line makes that check much easier.

A few coding habits move amounts across the operating profit line without anyone noticing. Each has a way to spot it and a fix.

• Interest buried in another expense. Finance charges on a vehicle or equipment agreement are sometimes coded to vehicle or equipment costs, which pulls a financing cost into operating profit. Spot it: the business has a finance agreement but no interest in its accounts. Fix it: give interest its own account and take the amounts from the lender's statements.
• Whole repayments coded as an expense. When each loan repayment goes to one expense account, the part that pays down the loan is counted as a cost along with the interest. Spot it: an expense that equals the repayment to the cent every month. Fix it: split each repayment into interest and principal using the lender's statement, and ask your accountant if you are unsure how.
• Loan fees mixed with everyday bank fees. Merchant and account fees are part of trading; fees for arranging or extending a loan relate to financing. Spot it: one bank fees account that jumps in the month a loan was set up. Fix it: keep separate accounts, and ask your accountant which side of the line loan fees belong on.
• Shared costs left with one part of the business. When you work out operating profit for each branch or product line, rent, insurance and other shared costs have to be split somehow. Leaving them all with one part makes it look weak and the others look strong. Spot it: one branch or line carries every shared cost. Fix it: split shared costs on a basis you can explain, such as floor space or sales, and keep to it every period.
• Personal spending among the running costs. A private purchase paid from the business account and coded as a business expense lowers operating profit. Spot it: an expense with no business purpose, or a supplier the business doesn't use. Fix it: take it out of the expenses and ask your accountant how to record it.
• Receipts from outside trading recorded as sales. Interest received, an insurance payout or the money from selling an old vehicle can end up in sales, which inflates both sales and operating profit. Spot it: sales rise in a month with no matching invoices. Fix it: record each in an account of its own, and ask your accountant how the sale of an asset should be recorded.

If the standard profit and loss report in your accounting software has no operating profit line, check whether it lets you group accounts into a layout of your own. If not, work back from net profit as the formula section describes. In a spreadsheet, add a subtotal row after the last operating expense and keep the excluded accounts beneath it.

• Cash. A profitable year can still leave the bank account short if customers pay late or stock builds up.
• Loan repayments. The part of each repayment that reduces the loan isn't an expense at all, so it appears in neither operating nor net profit.
• Equipment and vehicle purchases, which usually go on the balance sheet rather than among the expenses; your accountant can explain their treatment.

For those, use the cash flow statement, the report business.gov.au describes as showing all the money passing through the business.