Operating profit is the amount of gain or loss obtained from the firm's core operations. Net profit, on the other hand, is the bottom line; the amount of money that shareholders have made at the end of an operating period after all parties, such as the taxman and creditors, have been fully paid.
Operating profit is calculated by subtracting all operational expenses from revenue. Operational expenses include: cost of goods sold, overhead, management costs, sales, promotional and advertising costs, money paid to outsiders because of such things as patent purchase fees, consulting fees and temporary employment agreements and research, and development expenses.
The amount of operating profit generated gives a good idea of how well the firm performs its core function. A car manufacturer's operating profit, for instance, will allow you to assess if the company can manufacture and sell good cars cars at a competitive price.
One of reasons for differences between operating profit and net profits is the exclusion of extraordinary items also known as one-time costs and expenses. Such items include all transactions that are not expected to be recurring and are not within the confines of the firm's core activities. The sale of a large building, where an automobile manufacturer's headquarters used to be located, may generate immense income, for instance. Such profit is not included in the operating profit because it will likely not happen again anytime soon and will, therefore, mislead investors, as well as management about the true long-term earnings potential of the company.
The net profit figure is calculated by adding extraordinary gains, subtracting interest expenses and subtracting accrued taxes from the operating income. If extraordinary operations have resulted in a net gain, this figure must be added to the gross profit; if such operations resulted in a net loss, the amount must be subtracted. Interest and tax expenses are always subtracted. It is important, however, to account for accrued interest and tax liabilities, as opposed to actual cash layouts. For example, if a bond's interest payment came due before the end of the year but the actual cash payment will occur in the first days of the upcoming year, the expense belongs to the year that has just ended.
What ultimately matters to shareholders is the net income figure because this is what is left to be distributed to the owners of the firm after all expenses have been taken care of. The operating profit, on the other hand, may provide a better idea about the true long-term potential of the business. Generally, extraordinary items and interest expenses can be managed more easily than a product portfolio that is not competitive. Tax liabilities, too, largely depend on the firm's strategic financial decisions. Therefore, investors often analyze the operating margin to get a better sense of how well the firm performs its core functions and how competitive it is in the marketplace.
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