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In business, “profit” and “income” are interchangeably used. Depending on the context, each word’s direct meaning changes. For this subject, profit and income hold the exact definition, with “gross” and “operating” being the critical difference. Understanding the distinction between the two measurement units of profit is essential when assessing a company’s income.
In this blog post, we'll take a closer look at the difference between gross profit and operating income and why those numbers are beneficial for founders to know.
Operating Income Vs Gross Profit
These two financial indicators help businesses evaluate their performance. Operating profit stems from gross profit, which is why both metrics are important to calculate. Both numbers are on the company’s income statement.
Gross Profit
Gross profit represents total revenue after subtracting all expenses related to the production of COGS (costs of goods sold). Technically, this is a net measurement; however, it's referred to as “gross” due to COGS being the only expenses deducted. Gross profit is also referred to as net profit, but when calculating total income minus COGS, “gross” is the proper term.
COGS includes:
- Raw materials
- Cost of labor
- Machine expenses (items needed to run machines, for example)
- Direct materials
- Wholesale prices
- Overhead costs
COGS covers all expenses used in the production of products or services.
Gross profit formula = Revenue - COGS
Operating Income
To calculate the operating profit, you need to know the value of your gross income (discussed above). Using that number, you will subtract all other operating and business expenses to find operating profit. An important detail to note is the cost of tax expenses on additional income and expenditure of interest payments will not be deducted in this calculation.
*EBIT is another name for operating income, but with all other expenses deducted. Learn more about it here.
Operating expenses include:
- Payroll
- Office supplies
- Debt payments
- Rent/mortgage
- Travel
Anything unrelated to production can be included.
Operating income formula = Gross profit - operating expenses - depreciation and amortization
Reasons To Monitor Both Metrics
There are a variety of reasons to measure gross and operating income. Each metric provides valuable financial information recorded by accountants or bookkeepers. Once the month closes, founders can access financial statements that list both totals.
1. Measuring Operational Efficiency
When operating expenses are too high, generating excess cash for other goals or higher payments for debt obligations is impossible. Monthly fees tend to stagnate after production becomes consistent, but costs that start small can add up quickly. Pinpointing early on what is hemorrhaging your operational budget helps protect the following month from cash flow problems.
2. Tracking Income Patterns
It’s natural for product or service sales to ebb and flow with the market and consumer needs. With consistent production and operations, most financial experts can assist in operating income projections based on prior months. With this knowledge, you can assess budgets and expenses to assure operating income remains at or above your target goal.
3. Providing Investors With An Overall Picture
Multiple rounds of funding happen in the first few years of a startup’s life. Capital investors want to see a company’s profitability, which significantly depends on how a company operates. When operating expenses consistently balance, the fluctuation of net income doesn’t become a cash flow problem.
Benefits of Consistent Metric Monitoring
Expenses in COGS and operating a business should fluctuate as little as possible. There are situations where this rule of thumb is exempt.
For example, adding more machines to up production will heighten COGS due to the added depreciation. Money made by these machines should balance out the extra depreciation costs. If higher sales don’t counterbalance the added cost of COGS, money problems can start to snowball.
Catching the imbalance early gives founders and their financial team the ability to redirect funds and alter budgets before the problem becomes costly. In traditional bookkeeping, books are delivered after the month is over, eliminating the ability to pivot when the issue starts.
Our software allows founders to make changes immediately due to real-time transaction tracking. Instead of waiting until the month closes out to get your books, you can view every metric on your company’s dashboard.
For example, operating expenses are featured tile on the Zeni Dashboard, showing you monthly, quarterly, or yearly expenses in an easy-to-read color-coded bar graph. Each bar includes broken-down costs that are fully customizable.
Check out the example below to see how simple it is!
At Zeni, we strive to make finances your partner, not a headache. Schedule a free demo with us to see what we can do for you.
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