How do operating income and gross profit differ?

Operating income and gross profit show the income earned by a company. However, the two metrics have different credits and deductions in their calculations, but both 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 by: 

Gross profit = Revenue - Cost of Goods Sold

Revenue is the total amount of income earned from sales in a period. Revenue is also be called net sales because discounts and deductions from returned merchandise may have been deducted. 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.

Cost of goods sold or COGS is the direct costs 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 their 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 is included in the calculation. Some of the costs include:

• Direct materials
• Direct labor
• Equipment costs involved in 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. Operating income helps investors separate out the earnings for the company's operating performance by excluding interest and taxes. 

Operating expenses include selling, general and administrative expense (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 whereby gross profit is total revenue minus cost of goods sold.

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 = $12.50 billion. Since J.C. Penney is a retailer and has returns, its net sales is its top line.
• Gross Profit = $4.33 billion (Total revenue of $12.50B - COGS of $8.17B).
• Operating Income = $116 million (highlighted in blue below). The expenses that were deducted beyond the gross profit calculation sit below COGS. However, in calculating operating income, costs and expenses were deducted from net sales including cost of goods sold of $8.1 billion and SG&A of $3.4 billion, (or 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 on outstanding debt of $325 million putting the company in the red. 

J.C. Penney earned $116 million in operating income and earned $4.33 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 differences between the numbers show 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, but the above example shows the importance of using multiple metrics in analyzing the profitability of a company.

For more on analyzing financial statements, please read "How the Income Statement and Balance Sheet Differ?"