Operating profit: what it is, the formula, and a worked example

Short answer: operating profit is what the business earns from its normal trading: sales minus cost of sales minus operating expenses (wages, rent, vehicles, software, depreciation and the other running costs). It is taken before interest on loans, before tax, and before one-off or non-trading income such as a gain on selling equipment or interest received. That makes it the best single number for “is the business itself getting better or worse?”, because a loan, a tax bill or the sale of an old machine cannot flatter or hide it. Operating profit margin is operating profit ÷ sales × 100. Xero’s standard Profit and Loss has no Operating Profit line, but you can work it out from the report in a minute (shown below).

The operating profit formula

• Operating profit = gross profit − operating expenses
• or, in full: sales − cost of sales − operating expenses
• Operating profit margin % = operating profit ÷ sales × 100
• Working back from the bottom line: operating profit = net profit before tax + interest paid − interest received − one-off gains + one-off losses

On £500,000 of sales, £200,000 of cost of sales and £240,000 of operating expenses (not counting loan interest), operating profit is £60,000 and the operating profit margin is 12%. Operating profit margin has three tests for whether your margin is good enough: its trend, the margin you need to pay interest, tax and the owners, and how far sales could fall before it reaches zero.

Operating expenses include depreciation and everyone’s wages, including a company director’s salary. They do not include loan interest, income tax or company tax, dividends, owner drawings, or loan repayments.

Operating profit vs gross profit vs net profit

	What is taken off sales	Question it answers
Gross profit	Only the direct cost of what was sold	Are prices and product costs right?
Operating profit	Direct costs and all the running costs, including depreciation	Does the business make money from what it does?
Net profit	Everything: also interest, and (after tax) tax, plus any one-off gains or losses	What was left for the owners this year?

For a business with no loans and nothing unusual in the year, operating profit and net profit before tax are the same figure. They split apart when there is loan interest, interest received, a grant, insurance payout, or a gain or loss on selling an asset. Profit before tax takes the next step: from operating profit, less interest, to the company tax bill in the UK, Australia and New Zealand. The gross profit vs net profit guide covers the top and bottom lines in more detail, and the net profit calculator works down from sales to operating profit, net profit before tax and net profit in one go. Types of profit follows one company’s year down every line, from gross profit to profit before tax, net profit after tax and retained profit.

A worked example: net profit up, operating profit down

These are made-up figures for a small joinery company in New Zealand over two years. Every amount excludes GST. In year 2 it sold an old CNC machine for $25,000 more than its value in the books.

	Year 1 ($)	Year 2 ($)
Sales	820,000	860,000
Cost of sales (timber, hardware, subcontract installers)	410,000	447,200
Gross profit	410,000 (50.0%)	412,800 (48.0%)
Wages	210,000	228,000
Rent	48,000	48,000
Vehicles	22,000	24,000
Software and phone	9,000	10,000
Insurance	8,000	9,000
Advertising	12,000	12,000
Other overheads	15,000	16,000
Depreciation	26,000	25,000
Total operating expenses	350,000	372,000
Operating profit (EBIT)	60,000 (7.3%)	40,800 (4.7%)
Gain on sale of CNC machine	–	25,000
Interest received	1,000	1,000
Interest on equipment loan	(14,000)	(12,000)
Net profit before tax	47,000 (5.7%)	54,800 (6.4%)

What the two profit lines say:

• Net profit says year 2 was better: up $7,800, or 17%.
• Operating profit says year 2 was worse: down $19,200, or 32%, from 7.3% of sales to 4.7%.
• The difference is the machine sale. The $25,000 gain happens once. Without it, net profit would have been $29,800, well below year 1’s $47,000. The lower loan interest ($2,000 less as the loan is paid down) helped a little too.
• The cause of the fall is in the trading. Sales grew 4.9%, but the gross margin slipped from 50% to 48%. On $860,000 of sales, those 2 points cost $17,200, so gross profit rose only $2,800. Operating expenses rose $22,000 (6.3%), mostly wages. $2,800 − $22,000 = −$19,200.

An owner reading only net profit would think the year went well and plan next year around $54,800. An owner reading operating profit would look at timber prices and quotes (the margin) and at the extra wages, before the one-off gain runs out. Why did my profit drop? splits a change like this into sales, margin and overheads, and where is my money going finds the cost lines that grew fastest.

EBIT and EBITDA

• EBIT (earnings before interest and tax) is, for most small businesses, the same as operating profit. Strictly, EBIT can also include non-trading income such as the machine gain, so in year 2 above someone might add the $25,000 machine gain to the $40,800. Ask which they mean. EBIT has both formulas, interest cover and how to get it from Xero. In the UK a company’s operating profit is also called its trading profit, which to HMRC means something different for a sole trader; trading profit explains both.
• EBITDA (earnings before interest, tax, depreciation and amortisation) adds depreciation and amortisation back to operating profit: year 1 is 60,000 + 26,000 = $86,000 (10.5% of sales), year 2 is 40,800 + 25,000 = $65,800 (7.7%). The EBITDA calculator works it out from your own Profit and Loss, including adjusted EBITDA.

EBITDA comes up when a business is valued, sold or borrowing, because buyers and lenders often start from a multiple of it. For a smaller business where the owner does the work, buyers often use seller’s discretionary earnings instead, which also adds back one owner’s pay. EBITDA is not cash: it ignores the machines and vans you have to keep replacing, tax, loan repayments, and money tied up in unpaid invoices and stock. For a business that owns a lot of equipment, operating profit is the more honest number, because depreciation is the real cost of wearing that equipment out. The free cash flow calculator starts from profit, takes out the equipment you bought and the cash tied up in invoices and stock, and shows the cash the business actually produced.

How to get operating profit from Xero

Run Accounting › Reports › Profit and Loss. The standard layout goes Trading Income, Less Cost of Sales, Gross Profit, Plus Other Income, Less Operating Expenses, Net Profit. There is no Operating Profit line, and in Xero’s default chart of accounts loan interest is an expense account, so it sits inside Operating Expenses. To get operating profit:

1. Start from Gross Profit.
2. Take off Total Operating Expenses.
3. Add back any interest expense and any one-off costs inside operating expenses (a loss on selling an asset, for example).
4. Leave out Other Income (interest received, grants, gains on sale).

For the joinery’s year 1, Xero would show Gross Profit 410,000, Other Income 1,000 and Total Operating Expenses 364,000 (the 350,000 plus 14,000 of loan interest), so Net Profit is 47,000. Operating profit is 410,000 − 364,000 + 14,000 = 60,000.

If you want the line on the report itself, Xero’s report layout editor can group accounts and add summary rows; search Xero Central for “customise report layout” for the current steps, as menus move between releases and regions. The how to read your Profit and Loss in Xero guide explains every section of the standard layout, and Profit and Loss statement example has a café’s full year, where adding back $3,180 of loan interest gives an operating profit of $57,780 (10.3% of sales).

Reading your operating profit

• Watch the margin, not just the dollars. Operating profit can rise while the margin falls, if sales grew faster than profit. The margin shows whether each $100 of sales is earning more or less than before.
• Compare like with like. Put each month beside the same month last year as well as the month before, because many businesses are seasonal, and compare full years when you can.
• For a sole trader, it is before your pay. Drawings are not an expense, so a sole trader’s operating profit is what the business earns before paying the owner. Take off a fair salary for the hours you work before comparing it with a company that pays its director a wage.
• It is not cash. Unpaid invoices, stock, equipment purchases, loan repayments and GST or VAT all move the bank without moving operating profit. Cash flow from operations is the cash version of the same trading result. Profit in Xero but no cash in the bank explains the gap.
• To lift it, there are three levers: price (the free price increase calculator), direct costs (gross margin), and overheads. The break-even calculator shows how much you need to sell to cover your overheads at your current margin.

Common questions

What is operating profit? Operating profit is the profit from a business’s normal trading: sales minus cost of sales minus operating expenses such as wages, rent, vehicles, software and depreciation. It is calculated before loan interest, tax and one-off items like a gain on selling equipment, so it shows how the business itself is performing.

What is the formula for operating profit? Operating profit equals gross profit minus operating expenses, or sales minus cost of sales minus operating expenses. Working back from the bottom line, it is net profit before tax plus interest paid, minus interest received and one-off gains, plus one-off losses. Operating profit margin is operating profit divided by sales, times 100.

Is operating profit the same as EBIT? For most small businesses, yes. Both are before interest and tax. Strictly, EBIT can also include non-trading income, such as a gain on selling an asset, while operating profit leaves it out, so the two differ in a year with an unusual item.

What is the difference between operating profit and net profit? Net profit is what is left after every cost and every kind of income, including loan interest, interest received, one-off gains and losses and, after tax, tax. Operating profit stops before those, so it shows the trading result. With no loans and nothing unusual in the year, operating profit and net profit before tax are the same.

Does operating profit include depreciation? Yes. Depreciation is an operating expense, so it is taken off before operating profit. EBITDA is the measure that adds depreciation and amortisation back.

Does Xero show operating profit? Not on the standard Profit and Loss layout, which goes from Gross Profit to Net Profit. Take Total Operating Expenses off Gross Profit, add back any loan interest that sits in operating expenses, and leave out Other Income. A custom report layout can show it as its own line.

Your profit lines every Monday

ReportPilot reads your Xero figures and sends a short email every Monday in plain English. It covers sales and profit against last month and the same month last year, and when cost of sales is coded in Xero and gross margin moves by 3 percentage points or more against the month before, the email says so, with what was left from every $100 of sales in each month. It also covers cash, money owed to you that is past due, and bills due soon. It asks Xero for read-only access, and there is a 14-day free trial with no card.