Profits of a company can stem from various actives – the core Operations of a business or the non-operating revenues generated from a business. Be it a manufacturing or services company, its core revenue generating operations are the main contributor to profits and its recording and calculation is of utmost importance. Let us look at various aspects of operating profit.
Importance of Operating Profit
For various stakeholders such as employees, investors and analysts OPERATING PROFIT is an important measure of efficiency of the company. This measure denotes a number which remains after deducting the operational costs from the Revenues. Thus, if the business has been run efficiently and well-organized, it will result in high operating profits. This measure is void of any tax related issues. No tax has been deducted so far. To detail let us look at the formula –
Operating Profit = Revenue – (Labour+cost of goods sold incl. material, WIP+expenses incurred in the normal course of business)
READ: Short Sale stocks
The general, administrative and cost of material and labour is deducted from the revenues to derive to this number. As of yet, no interest payments on loan or tax liabilities are accounted for.
This should not be mistaken for cash inflow of the company as the accounting is based on the system of accrual – expenses are accounted for earlier and sales accounted for later.
The following example shows the Income Statement for GE Power, India. One can see the different ways it is called as – Profit Before Tax and also as EBIT or Earnings Before Interest and Tax in various places. GE Power doesn’t seem to have any loans to interest payments. One can see the breakdown of Income between “Revenue from operations” and “Other Income”.
This an important breakup to see how much of the total revenue is really coming from operations.
To make these distinctions for analysts and investors, U.S GAAP and IFRS requires companies to breakdown all the line items in financial statements to enable complete transparency.
There are various heads like “Other Expenses” which are explained in Note 34 where the details can be determined.
Analysis of Operating Income
This breakdown of operating income can give you the true picture of the materials, work in progress (WIP), labour/employee costs, marketing costs and various direct and indirect costs. These can be planned effectively on the basis of the dynamic market demands, changes in supply side and to ensure that the input prices paid by the company are profitable.
The Marketing and Operations Department’s Key Performance Indicators and compensation are closely linked and tracked by these parameters. Similarly, any changes / expansion in either departments is determined by studying the changes in competition, consumer requirements and tastes, regulations and economy at large.
Any miscalculation of operating income can create serious decisional issues for the company at various levels. One of the most common ways to see the contribution of operations is by calculating Operating Profit Margin = (Operating Income divided by Revenues). This is a commonly used parameter by analysts.
Thus, one can see how Operating Income is an important story teller in the story of Income Statement.