When evaluating a company's financial statements, there are plenty of metrics to look at when determining how a company is performing. Some of these metrics are very similar but provide a slightly different view of how a company is run, what its earnings look like, and what to expect in the future.
Gross Profit and Operating Income
Both the operating income and gross profit show the income earned by a company. However, the two metrics have different credits and deductions considered during their calculations. Both systems are essential in analyzing a company's financial well being.
Gross profit is the income earned by a company after deducting the direct costs of producing its products. For example, if you sold $100 worth of widgets and it cost $75 for your factory to produce them, then your gross profit would be $25. Gross profit is calculated as:
Gross profit = Revenue - Cost of Goods Sold
Revenue is the total amount of sales generated in a period. You'll often hear analysts refer to revenue as the top line for a company and that's because it sits at the top of the income statement. As you work your way down the income statement, costs are subtracted from revenue to ultimately calculate net income or the bottom line.
The cost of goods sold (COGS) is the direct cost associated with producing goods. COGS includes both direct labor costs, and any costs of materials used in producing or manufacturing a company's products.
Gross profit measures how well a company generates profit from its direct labor and direct materials. Gross profit doesn't include non-production costs such as administrative costs for the corporate office. Only the profit and costs associated with the production facility are included in the calculation. Some of the costs could include:
- Direct materials
- Direct labor
- Equipment costs involved in the production
- Utilities for the production facility
- Shipping costs
Operating income is a company's profit after subtracting operating expenses or the costs of running the daily business. For investors, the operating income helps separate out the earnings for the company's operating performance by excluding interest and taxes, which are deducted later to arrive at net income.
These operating expenses include selling, general and administrative expenses (SG&A), depreciation, and amortization, and other operating expenses. Operating income does not include money earned from investments in other companies or non-operating income, taxes, and interest expenses.
Also, any nonrecurring items are not included, such as cash paid for a lawsuit settlement. Operating income can also be calculated by deducting operating expenses from gross profit.
Example of Gross Profit and Operating Income
To illustrate the difference between operating income and gross profit, we'll analyze the income statement from J.C. Penney for the year ending in 2017, as reported in its 10K annual statement:
- Revenue or Total Net Sales = $12.5 billion. The net sales are its top line.
- Gross Profit = $4.3 billion (Total revenue of $12.5 billion - COGS of $8.2 billion).
- Operating Income = $116 million (highlighted in blue below). The expenses that were deducted beyond the gross profit calculation sit below COGS to arrive at operating income. In calculating operating income, costs and expenses were deducted from net sales, including the cost of goods sold of $8.1 billion and SG&A of $3.4 billion (costs not directly tied to production), for a total of $12.39 billion (highlighted in red below).
- Net income = -$116 million (a loss), which included interest in outstanding debt of $325 million, putting the company in the red.
The Bottom Line
J.C. Penney earned $116 million in operating income and earned $4.3 billion in gross profit. Although operating income was positive, after taking out the cost of debt servicing, the company took a loss for the year.
The difference between the numbers shows why analyzing financial statements is so critical to investors before buying a stock. Each investor might come to a different conclusion about the financial performance of J.C. Penney by evaluating the numbers at different stages in the business cycle. The above example shows the importance of using multiple metrics in analyzing the profitability of a company.