Operating Profit

In accounting, profit is the difference between the purchase and the component costs of delivered goods and/or services and any operating or other expenses.

Definition

There are several important profit measures in common use. Note that the words earnings, profit and income are used as substitutes in some of these terms (also depending on US or UK usage), thus inflating the number of profit measures.

  • Gross profit equals sales revenue minus cost of goods sold (COGS), thus removing only the part of expenses that can be traced directly to the production or purchase of the goods. Gross profit still includes general (overhead) expenses like R&D, S&M, G&A, also interest expense, taxes and extraordinary items.
  • Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) equals sales revenue minus cost of goods sold and all expenses except for interest, amortization, depreciation and taxes. It measures the cash earnings that can be used to pay interest and repay the principal. Since the interest is paid before income tax is calculated, the debtholder can ignore taxes.
  • Earnings Before Interest and Taxes (EBIT)/ Operating profit equals sales revenue minus cost of goods sold and all expenses except for interest and taxes. This is the surplus generated by operations. It is also known as Operating Profit Before Interest and Taxes (OPBIT) or simply Profit Before Interest and Taxes (PBIT).
  • Earnings Before Taxes (EBT)/ Net Profit Before Tax equals sales revenue minus cost of goods sold and all expenses except for taxes. It is also known as pre-tax book income (PTBI), net operating income before taxes or simply pre-tax Income.
  • Earnings After Tax/ Net Profit After Tax equal sales revenue after deducting all expenses, including taxes (unless some distinction about the treatment of extraordinary expenses is made). In the US, the term Net Income is commonly used. Income before extraordinary expenses represents the same but before adjusting for extraordinary items.
  • Earnings After Tax/ Net Profit After Tax minus payable dividends becomes Retained Earnings.

To accountants, Economic Profit, or EP, is a single-period metric to determine the value created by a company in one period—usually a year. It is Earnings After Tax less the Equity Charge, a risk-weighted cost of capital. This is almost identical to the economists' definition of economic profit.

There are analysts who see the benefit in making adjustments to economic profit such as eliminating the effect of amortized goodwill or capitalizing expenditure on brand advertising to show its value over multiple accounting periods. The underlying concept was first introduced by Schmalenbach, but the commercial application of the concept of adjusted economic profit was by Stern Stewart & Co. which has trade-marked their adjusted economic profit as Economic Value Added (EVA).

Optimum Profit is a theoretical measure and denotes the "right" level of profit a business can achieve. In the business, this figure takes account of marketing strategy, market position, and other methods of increasing returns above the competitive rate.

Accounting profits should include economic profits, which are also called economic rents. For instance, a monopoly can have very high economic profits, and those profits might include a rent on some natural resource that a firm owns, whereby that resource cannot be easily duplicated by other firms.

See also

External links

  • Ludwig von Mises (1951)
  • Measuring the Long-Run Profitability of the Firm, Salmi and Virtanen (1997)
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