Maximise Your Profits: Evaluate Your Companies Gross, Operating and Net Profits

On financial statements, the words profit and income are often used interchangeably. Gross profit, Operating profit and Net Profits are all closely related but they are distinct financial measurements at three different levels. In a financial statement, first gross profit is calculated and shown at the top, then operating profit is shown by calculation and finally net profit is prepared.

What is Gross Profit?

 In simple word, “Gross Profit” can be defined as the “income from sale less cost of making the sale.” It is a company’s revenue minus its cost of goods sold. Gross profit is the residual profit from selling a product or service after deducting the cost directly associated (like cost of material, production wages, and direct production expenses like electricity, machine expenses, etc)  with such production and sale. Gross profit is calculated by subtracting cost of goods sold from its revenue. It is a measure of efficiency because it indicates how efficiently the management is using its workers and supplies in the production process.

Gross profit is computed to know gross profit margin, also known as gross margin. Gross profit ratio shows a company’s efficiency in which the business turns revenue into gross profit. The formula to compute Gross profit ratio is gross profit divided by revenue for the period.

Thus, Gross Profit = Gross Sales – Cost of goods sold

It is important because gross profit measures the efficiency in use of material, labor and other direct production expenses.

What is Operating Profit?

“Operating Profit” is often described as EBIT or “Earnings Before Interest & Tax.” It is the income from sales minus the cost of sales after gross profit. It is distinct from gross profit because it includes both Cost Of Goods Sold and fixed expenses.  Operating Profit does not include profit earned on any investment. To calculate ‘Operating Profit’ one should properly understand what items of income and expenses are included and excluded in operating profit. It is the income of a company from its core business activity. Operating profit does not include interest expenses or expenses in capital or non recurring nature or one time transaction. It also excludes every type of incomes and expenses which are not directly related to the core business of the company. Operating Profit is calculated after deducting Gross Profit and Selling, General & Administrative Expenses from the operating revenue. ‘Selling, General & Administrative Expenses’ are otherwise known as indirect or overhead expenses because they are not directly related and cannot be directly attributed to any particular production and cannot be charged directly to any units sold or service rendered. The examples of these types of expenses are, rent of the office building, advertisement expenses by the company, director’s salary, etc.

Thus, Operating Profit = Operating Revenue – Cost Of Goods Sold – Operating Expenses – Depreciation & Amortization.

Or, Operating Profit = Gross Profit – Total operating expenses

Operating profit is a good measure of the company’s indirect efficiency. It indicates a company’s efficiency in pricing strategy, control and efficient use of power, labor, material and other direct and indirect expenses

What is Net Profit?

In simple words, “Net Profit” is the actual profit after working expenses not included in the calculation of gross profit but have been incurred or paid. It comes at the bottom of an income statement after gross profit and operating profit. It is often referred as ‘bottom line’ because it is calculated after subtracting a company’s total expenses from its total revenue. It is also known as ‘net income’ or ‘net earnings.’

Net Profit= Operating Profit — Taxes, Depreciation, Interest and any other expense not incurred in connection with sales.

Or, Net Profit= Total Revenue—Total Expenses

Net Profit is one of the most closely watched numbers in finance and plays an important role in every financial analysis. The investors and shareholders always keep close watch on this figure because it is their main source of earning and it serves as a good indicator of health and performance of a company.

On financial statements, the terms profit and income are interchangeable. Gross profit, or income, and operating income, or profit, are very closely related, but distinct financial measurements. A company’s income statement actually shows three levels of profit. Once you show gross income and operating income, the final step on the statement is the calculation of net profit, or income. Essentially, each profit level is a stepping stone to bottom-line net income.

A Sample Income Statement Of ABC & Company For Year Ended 31 December 2013

Sales Revenue

 

 

$ 100,000

Less Cost of Goods Sold

75,000

Gross Profit

$25,000

Less Operating Expenses

Selling Expenses

Advertising Expenses

1,000

Commission Expenses

500

2,500

 

Administrative Expenses

Office Expenses

700

Manager’s Salary

500

1,200

Less Total Operating Expenses

$3,700

Operating Profit

$21,300

Less Non Operating Expenses

Legal Expenses

100

100

 

$21,200

Add Income from Investment

450

Net Profit

 

 

$22,650

About the Author

Sandra
I am working as Editor in Chief for Financeninvestments.com. Writing on Financial Topics is my passion. You can find me on , Seeking Alpha Instablogs or join our Facebook Community, s. FNI is a great Community for financial bloggers and writers. Get everything you wanted to know about your finance and investment related matters such as mutual funds, banking, retirement, economics and much more.

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