A:

As a general rule, an increase in any type of business expense lowers profit. An income statement has three levels of profit, however, and the relationship between operating expenses and profit can be seen most directly when looking at operating profit, also known as profit before income and taxes.

On an income statement, profit calculated by deducting the cost of goods sold (COGS) from total net sales is called gross profit. The COGS includes both fixed costs and variable production costs. Both types of production costs can reduce gross profits. However, fixed production costs, such as buildings and equipment, are unaffected by production levels, whereas variable costs, such as the wages paid to factory workers and the cost of raw materials, increase when production levels rise.

At the second level of profitability, operating profit is calculated by subtracting operating expenses from gross profit. Also known as sales, general and administrative expenses (SG&A), these are overhead expenses not directly related to production. SG&A typically includes the cost of administrative buildings, as opposed to production plants, the salaries of salespeople and executives, and expenditures for office supplies, for example.

Net profit is then calculated by deducting non-operating expenses such as taxes and interest from operating profit. At the bottom line, net profit is equal to revenue minus the cost of goods sold (COGS), operating expenses, and taxes and interest. Cutting back on operating expenses or the COGS can increase net profit, at least in the short term, but a business must be careful not to cut back so much that the sales are adversely impacted by shoddy production quality or a failure to meet customer demand.

On the other hand, some business expenses, such as purchases of new information technology innovations, can lower net income over the short term but raise income potential over the long term. Capital expenses on equipment and other fixed assets can be depreciated over several years, lowering the immediate impact on profits.

RELATED FAQS
  1. Gross profit, operating profit and net income

    Find out how to calculate between gross profit, operating profit, and net income. Learn about the relationships between the ... Read Answer >>
  2. What is the formula for calculating profit margins?

    Learn about gross, operating and net profit margins, how each is calculated and how they are used by businesses and investors ... Read Answer >>
  3. What is the formula for calculating gross profit margin in Excel?

    Understand the basics of the gross profit margin including its interpretation as a measure of profitability and its calculation ... Read Answer >>
  4. What costs are not counted in gross profit margin?

    Explore the various measures of a company's profitability, such as gross, operating and net profit margins, and understand ... Read Answer >>
Related Articles
  1. Investing

    Understanding Profit Metrics: Gross, Operating and Net Profits

    Rather than relying solely on a company's net profit figures, seasoned investors will often look at gross profit and operating profit as well.
  2. Investing

    Understanding the Income Statement

    The best way to analyze a company - and figure out if it's worth investing in - is to know how to dissect its income statement. Here's how to do it.
  3. Investing

    The Difference Between Gross and Net Profit Margin

    To calculate gross profit margin, subtract the cost of goods sold from a company’s revenue; then divide by revenue.
  4. Investing

    A Look At Corporate Profit Margins

    Take a deeper look at a company's profitability with the help of profit margin ratios.
  5. Investing

    Operating Leverage Captures Relationships

    Find out how fixed and variable costs interact to shed new light on old companies.
  6. Investing

    How To Analyze Netflix's Income Statements

    Learn how to read Netflix's income statement, calculate net income and interpret EPS to evaluate the company's current financial condition.
  7. Investing

    4 Tips to Evaluate Growth Companies (KO, AAPL)

    Discover the best metrics for stock investors to utilize when selecting and evaluating the best opportunities in growth investing.
RELATED TERMS
  1. Operating Profit

    Operating profit is the profit earned from a firm's normal core ...
  2. Gross Profit

    Gross profit is the profit a company makes after deducting the ...
  3. Accounting Profit

    A company's total earnings, calculated according to Generally ...
  4. Net Profit Margin

    Net Margin is the ratio of net profits to revenues for a company ...
  5. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and ...
  6. Operating Earnings

    Operating earnings are profit earned after subtracting from revenues ...
Hot Definitions
  1. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  2. Financial Industry Regulatory Authority - FINRA

    A regulatory body created after the merger of the National Association of Securities Dealers and the New York Stock Exchange's ...
  3. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
  4. Cost of Goods Sold - COGS

    Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold in a company.
  5. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and expenses incurred during a specified period of time, usually ...
  6. Monte Carlo Simulation

    Monte Carlo simulations are used to model the probability of different outcomes in a process that cannot easily be predicted ...
Trading Center