Two measures of profitability in a firm are gross profit and operating profit. Each one takes information from a company’s income statement. Gross profit represents a firm’s gross sales for a period of time less the relating costs of goods sold. Companies may use net revenue for this calculation, which is gross sales revenue less any returns, discounts, or allowances. Operating profit is total revenue less cost of goods sold, expenses, and taxes for a specific period.
Gross profit and operating profit provide an analysis for each end of the income statement. Gross profit measures the top-end figures of a company. Total revenues represent the gross sales that result from goods and services sold to consumers. This helps a company track its cost of goods used to produce products. Operating profit measures how much net income a company earns after all expenses, which is the money a company can reinvest into the firm.
Companies often compute both the gross profit and operating profit figures during their financial analyses. For example, a company has $500,000 US Dollars (USD) in total sales and $350,000 USD in cost of goods sold. The company's gross profit is $150,000 USD. An alternative for this formula is to divide the $150,000 USD gross profit by the total revenue. The company has a 30 percent gross profit margin, meaning $.30 USD of every dollar goes to cost of goods sold.
Operating profit has a similar formula. A company with $500,000 USD in sales and $350,000 USD in cost of goods sold also has $100,000 USD in expenses. The firm’s operating profit is $50,000 USD. Dividing the $50,000 USD by total sales shows a 10 percent operating profit from total sales. This provides a relationship between a company’s gross profit and operating profit.
Companies often compute their gross profit and operating profit figures for several periods. This provides a historical trend that companies can use to gauge their profitability. The trend can also provide an indicator of whether the company is experiencing an increase or decrease in profit. The number is also a benchmark for comparison to the industry standard or the leading company in the industry.
Gross profit and operating profit calculations are not without flaws. Both figures use accounting numbers, which can be subject to manipulation by firms. False or incorrect accounting reports result in skewed profit percentages. This can lead owners and managers to make inappropriate decisions based on this information.