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Unlock This CourseOperating profit is one of the most important figures on a company's profit and loss statement. It shows how much money a business makes from its day-to-day operations, before considering things like interest payments or taxes. Think of it as the "real" profit from actually running the business - selling products or services and managing everyday costs.
For IGCSE Business Studies, understanding operating profit helps you evaluate how well a company is performing and whether its core business activities are profitable. It's like checking if a shop is making money from selling goods, not just from lucky one-off events.
Key Definitions:
Operating profit tells investors and managers whether the core business is healthy. A company might have high revenue but low operating profit if it's spending too much on running costs. It's the best measure of operational efficiency and management effectiveness.
The basic formula for operating profit is straightforward, but understanding each component is crucial for business analysis. Let's break down the calculation step by step.
Operating Profit = Gross Profit - Operating Expenses
Or alternatively: Operating Profit = Revenue - Cost of Goods Sold - Operating Expenses
Total money received from sales. This includes all income from the main business activities, such as selling products or providing services.
Direct costs of making products or buying stock for resale. This includes raw materials, manufacturing costs and wholesale purchase prices.
Indirect costs of running the business. This includes rent, salaries, marketing, utilities, insurance and administrative costs.
Revenue: £500,000
Cost of Goods Sold: £200,000
Gross Profit: £300,000
Operating Expenses: £180,000 (including £60,000 salaries, £36,000 rent, £24,000 marketing, £60,000 other costs)
Operating Profit: £300,000 - £180,000 = £120,000
Understanding what counts as an operating expense is essential for accurate profit calculations. These are the costs that keep the business running day-to-day, regardless of how much the company sells.
Rent and Utilities: Office or shop rent, electricity, gas, water, internet and phone bills.
Salaries: Regular wages for employees, including management and administrative staff.
Insurance: Business insurance premiums for property, liability and other coverage.
Depreciation: The decrease in value of business assets like machinery, vehicles and equipment over time.
Marketing and Advertising: Costs for promoting products, including digital ads, print materials and promotional events.
Professional Services: Fees for accountants, lawyers, consultants and other professional advice.
Office Supplies: Stationery, computer software, maintenance and other administrative materials.
Travel and Entertainment: Business travel costs, client entertainment and conference attendance.
Different profit figures tell different stories about a business. Operating profit sits between gross profit and net profit, giving a clearer picture of operational performance than either extreme.
Understanding how different profit measures relate to each other helps in financial analysis and decision-making.
Revenue minus direct costs. Shows profit before considering operating expenses. High gross profit suggests good pricing or efficient production.
Gross profit minus operating expenses. Shows profit from core business operations. Best measure of management efficiency and operational health.
Operating profit minus interest and taxes. Final profit after all costs. Important for shareholders but can be affected by financing decisions.
ShopSmart Ltd: Revenue £1m, Gross Profit £400k (40%), Operating Profit £100k (10%)
BargainBuy Ltd: Revenue £800k, Gross Profit £240k (30%), Operating Profit £120k (15%)
Despite lower revenue and gross profit margin, BargainBuy has higher operating profit and margin because it controls operating expenses better. This shows more efficient management and potentially better long-term prospects.
Operating profit isn't just a number - it's a powerful tool for understanding business performance, comparing companies and making strategic decisions.
Formula: (Operating Profit ÷ Revenue) × 100
This percentage shows how much of each pound of sales becomes operating profit. Higher margins indicate better cost control and pricing power. Industry averages vary significantly.
Formula: (Operating Expenses ÷ Revenue) × 100
This shows what percentage of sales goes to operating costs. Lower ratios suggest more efficient operations. Useful for tracking improvements over time.
Many internal and external factors can impact a company's operating profit. Understanding these helps explain changes in financial performance and guides business strategy.
These are factors that management can control through business decisions and operational improvements.
Improving processes, reducing waste and increasing productivity can lower operating expenses and boost profit margins.
Effective hiring, training and retention strategies can improve productivity while controlling salary costs.
Automation and digital systems can reduce long-term operating costs, though they require initial investment.
These factors are largely outside management control but must be considered in planning and analysis.
Recession can reduce sales volume, while inflation increases operating costs like rent, utilities and salaries. Interest rate changes affect borrowing costs for expansion.
Increased competition may force price reductions or higher marketing spending. New competitors can reduce market share and pressure profit margins.
FastBite Restaurants saw operating profit fall from £2.1m to £1.4m despite revenue growing from £15m to £16m. Analysis showed:
• Food costs rose due to inflation (external factor)
• New restaurant openings increased rent and staff costs (internal decision)
• Marketing spend doubled to compete with new rivals (external pressure)
The company responded by renegotiating supplier contracts, improving staff scheduling and focusing marketing on high-profit menu items.
Businesses have two main approaches to improving operating profit: increasing revenue or reducing operating expenses. The best strategy often combines both approaches.
Expanding market reach, improving customer service and developing new products can increase total sales. However, this often requires higher marketing and operational costs.
Premium pricing strategies, value-added services and better customer segmentation can increase revenue per sale without proportionally increasing costs.
Streamlining operations, reducing waste and improving efficiency can cut costs without affecting quality or customer service.
Regular review of all operating expenses, renegotiating contracts and eliminating unnecessary costs can improve margins.
Investing in automation, digital systems and improved equipment can reduce long-term operating costs and improve productivity.