Which one of the following is correct ?

Correct — C, (c) Operating profit = Net profit + Non-operating expenses – Non-operating incomes. All four options print the same three terms and differ only in their two signs, so the item is entirely about the direction in which the adjustment runs.

Start from the definition. OPERATING PROFIT is the profit earned by the business from its main, recurring trading activity — sales less cost of goods sold less operating expenses such as office, administrative, selling and distribution costs. NET PROFIT is what is left after everything, operating and non-operating alike. The two differ by exactly the non-operating items:

Net profit = Operating profit – Non-operating expenses + Non-operating incomes

Non-operating EXPENSES are the losses and charges that have nothing to do with trading — interest on debentures and loans, loss on the sale of a fixed asset or of an investment, loss by fire or theft, writing off preliminary expenses or goodwill, donations. They have been SUBTRACTED in arriving at net profit. Non-operating INCOMES are the gains that have nothing to do with trading — interest received, dividend received, rent from a let property, profit on the sale of a fixed asset or investment. They have been ADDED in arriving at net profit.

To run the relation backwards, from net profit to operating profit, each of those steps must be undone. Add back what was subtracted; subtract what was added. So:

Operating profit = Net profit + Non-operating expenses – Non-operating incomes

A worked check makes the direction impossible to lose. Suppose sales and operating costs give an operating profit of ₹ 1,00,000; the business also pays ₹ 20,000 of interest and receives ₹ 5,000 of dividend. Net profit is 1,00,000 – 20,000 + 5,000 = ₹ 85,000. Now recover the operating profit: 85,000 + 20,000 – 5,000 = ₹ 1,00,000. The signs of option (c) are the ones that return the original figure.

The sanity test to carry into the examination hall is the direction of the effect. Non-operating expenses depress net profit, so removing them must RAISE the figure — hence the plus. Non-operating incomes inflate net profit, so removing them must LOWER it — hence the minus.

Why the others are wrong

• (a)Operating profit = Net profit – Non-operating expenses – Non-operating incomes — Both signs are minus, which subtracts the non-operating expenses a second time. They have already been deducted once in arriving at net profit; deducting them again produces a figure below both the operating and the net profit and corresponds to nothing. The treatment of non-operating incomes in this option happens to be right — they should indeed be removed — but the expenses are handled in the wrong direction. The quickest way to see the error is to ask what should happen to the number: a business burdened with heavy interest has an operating profit HIGHER than its net profit, so an expression that lowers the figure further cannot be the route from one to the other.
• (b)Operating profit = Net profit + Non-operating expenses + Non-operating incomes — Both signs are plus, which adds back the non-operating expenses correctly and then adds the non-operating incomes as well, when they should be taken out. Net profit already includes those incomes; adding them once more counts them twice and inflates the result. This option is what a candidate produces by remembering only that the adjustment involves adding back the items that were left out of the operating calculation, without noticing that non-operating INCOMES were not left out but included. The two categories move in opposite directions, and an expression whose two signs are the same cannot be right for that reason alone.
• (d)Operating profit = Net profit – Non-operating expenses + Non-operating incomes — The two signs are the correct pair but attached to the wrong terms — expenses subtracted and incomes added. This is precisely the formula for going the OTHER way, from operating profit to net profit: Net profit = Operating profit – Non-operating expenses + Non-operating incomes. It is therefore the most instructive of the three wrong options, because it is a true relation stated about the wrong subject. The safeguard is to name the two directions separately when learning them and to test with a single number, as in the worked example above; an expression that gives back the figure you started from is the right one, and this one will not.

Operating profit isolates the performance of the business's own trade, and its usefulness lies in stripping out everything that would make one year, or one company, look better or worse for reasons unconnected with trading. The chain runs downwards from sales: Sales less cost of goods sold gives GROSS PROFIT; gross profit less operating expenses — office and administrative, selling and distribution — gives OPERATING PROFIT, also called EBIT where interest and tax are the items still to come; operating profit less non-operating expenses plus non-operating incomes gives NET PROFIT. Reversing any step means reversing every sign in it. Two ratios that rest on these figures are worth carrying with the formula: the operating ratio, which is cost of goods sold plus operating expenses expressed as a percentage of net sales, and the operating profit ratio, which is operating profit as a percentage of net sales — the two together summing to a hundred per cent. Classification matters as much as arithmetic. Interest on borrowings, loss on the sale of a fixed asset or investment, loss by fire, and the writing off of preliminary expenses or goodwill are non-operating expenses; interest received, dividend received, rent received and profit on the sale of an asset or investment are non-operating incomes. Abnormal items are excluded from operating profit for the same reason that interest is: they say nothing about how well the business trades.

Key facts

• Operating profit = Net profit + Non-operating expenses – Non-operating incomes.
• Net profit = Operating profit – Non-operating expenses + Non-operating incomes.
• Gross profit = Net sales – Cost of goods sold; Operating profit = Gross profit – Operating expenses.
• Operating expenses are the office and administrative and the selling and distribution expenses of the business.
• Non-operating expenses include interest on loans and debentures, loss on sale of a fixed asset or investment, loss by fire, and the writing off of preliminary expenses or goodwill.
• Non-operating incomes include interest received, dividend received, rent received, and profit on the sale of a fixed asset or investment.
• Operating profit is also described as earnings before interest and tax.
• Operating ratio = (Cost of goods sold + Operating expenses) ÷ Net sales × 100; the operating profit ratio is its complement to a hundred per cent.

Common traps

• Giving both terms the same sign. The two categories always move in opposite directions.
• Using the forward formula when the question asks for the reverse. Option (d) is the correct expression for the other direction.
• Misclassifying interest received or paid. Both are non-operating in this computation.
• Confusing operating profit with gross profit. Gross profit is before operating expenses, not after.

• practice — not a real PYQ

  A firm's net profit for the year is ₹ 85,000. It has paid interest on a loan of ₹ 20,000 and received a dividend of ₹ 5,000. Its operating profit is :

  • (a)₹ 60,000
  • (b)₹ 70,000
  • (c)₹ 1,00,000
  • (d)₹ 1,10,000

  Answer(c) ₹ 1,00,000

• practice — not a real PYQ

  Which one of the following is a non-operating income for the purpose of computing operating profit ?

  • (a)Sales of goods dealt in by the business
  • (b)Commission earned on the firm's own sales
  • (c)Dividend received on investments
  • (d)Discount received from suppliers of goods

  Answer(c) Dividend received on investments