Key Takeaways

Financial metrics like gross profit and operating income play a central role in financial analysis, revealing how effectively a company generates earnings at different stages. Gross profit highlights the impact of direct production costs by showing how much revenue remains after covering the cost of goods sold (COGS). Operating income accounts for broader operating expenses, showing the company's operational efficiency.

Understanding 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.

What Is Gross Profit?

Gross profit is the income earned by a company after deducting the direct costs of producing its products.1 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 Sold1

Revenue is the total amount of sales generated in a period.2 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.3

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 costs3

Exploring Operating Income

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.4

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.5

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.

A Real-World 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. 6

The Bottom Line

J.C. Penney reported operating income of $116 million during the period, indicating that its core operations were profitable. Once debt servicing and other non-operating expenses were taken into account, the company recorded a net loss for the year. This highlights why investors must analyze financial statements at multiple levels rather than relying on a single figure. Evaluating metrics at different stages of the business cycle can lead investors to very different conclusions about a company’s performance. This example underscores the importance of using multiple financial metrics to accurately assess profitability.

KEY TAKEAWAYS

Key Differences Between Percentage of Completion and Completed Contract Methods 

Businesses that work on projects lasting months or even years need to understand how long-term accounting works. Industries, such as construction and engineering, rely on these accounting methods to accurately track progress and revenue over time. Choosing the right approach can affect financial reporting, tax obligations, and overall financial health. Each method comes with its own advantages and drawbacks, so the best choice depends on a company’s project structure, cash flow needs, and reporting goals.

Understanding the Percentage of Completion Method

The percentage of completion method allows for the recognition of revenues, expenses, and taxes during the period that a contract is being executed. Through frequent reporting, the percentage of completion method reduces the risk of fluctuations while affording tax deferral benefits.1

A company using this method may arrange milestones throughout the building process or estimate the percentage of the project completed. As long as particular amounts of income and expenses can be attributed to each completed part, whether via percentage calculation or defined milestones, the activities are reportable.2

The percentage of completion method is viewed as a continuous sale. As such, it is considered that both the buyer and the seller have enforceable rights. The buyer carries the right to implement specific performance requirements in the contract while the seller has the right to ask for payments based on fulfilling these requirements.

There are typically two requirements that must be in place to proceed with a percentage of completion method:34

1. A contract that specifies the milestones and payments.
2. Assurance that a buyer can ensure payment and that a seller can ensure completion.

If these requirements cannot be met, it is recommended to proceed with the completed contract method.

Example

Assume that a construction company builds a 10-story office complex that is under contract at a sales price of $4 million. The company estimates its total cost to complete the structure will be $3 million.

At any given point in the construction process, it can report completion by percentage. Therefore, if the project is deemed to be 40% complete, the business would report 40% of the $4 million project revenue ($4 million x 0.4). The firm will also report 40% of the $3 million in expenses ($3 million x 0.4). This calculation will result in a current gross profit of $400,000 ($4 million x 0.4) - ($3 million x 0.4).

Exploring the Completed Contract Method 

The completed contract method (CCM) of accounting considers all income and expenses directly related to a long-term contract as received when work is completed. The date of completion is spelled out in the contract and is often months or even years away from the date work begins.6 The CCM should

Though a construction company may enjoy a break from taxes during the working phase—and sometimes may even qualify for certain tax incentives in the meantime—this method can be a riskier way to account for operations.7

For example, if a contract is set for completion in five years, the business may not incur taxes on that project's income during that time. However, tax laws can and do change from year to year. If tax rates were to increase during that period of five years, the company faces paying higher taxes than it would have if reporting occurred sooner in the process.

Furthermore, if a business seeks outside investors, it can be challenging to prove to them the value of the company during times of little-to-no incoming revenues. Still, even with these risks, the completed contract method is the most conservative accounting method for companies working on long-term contracts.

Example

A company is hired to construct a building for $2 million. The project is expected to take three years to complete and cost the company $1 million.

Under the completed contract method, no income ($2 million) or expenses (estimated to be $1 million) will be recorded and reported to the IRS from this project until it is complete in three years time, assuming everything runs on schedule. Once the building has been constructed and all the payments have been made, the company will declare and record its earnings and costs.

The Bottom Line

The percentage of completion and completed contract methods are used by companies with long-term projects. Each offers distinct trade-offs. The percentage of completion method records revenue as work is completed, with up-to-date reporting. But it requires detailed cost estimates and impacts taxes over time. The completed contract method defers all revenue and expenses until completion, simplifying accounting while delaying financial visibility and tax recognition. The best method depends on a company’s estimating capabilities, tax strategy, and reporting needs.

KEY TAKEAWAYS

It's important for investors to differentiate between realized profits and unrealized or "paper" profits when buying and selling assets. Realized profits refer to financial gains that occur when you sell an investment for more money than you paid for it. Any change of value experienced is unrealized or "on paper" until an investment is disposed of. Only when the investment is sold is a loss or gain realized and only then would you be subject to taxation.1

Understanding the difference between realized and unrealized profits is crucial for investors because it impacts taxation and investment strategy.

Realized Profits in Investments

Simply put, realized profits are gains that have been converted into cash. In other words, for you to realize profits from an investment you've made, you must receive cash and not simply witness the market price of your asset increase without selling. For example, if you owned 1,000 common shares of XYZ Corporation, and the firm issued a cash dividend of $0.50 per share, you would realize a profit of $500 from your investment. This is a realized profit because you have received the actual cash, which cannot be lost due to changes in the marketplace.

Similarly, let's say you purchased your 1,000 XYZ shares at $10 per share, for a total investment of $10,000. If XYZ Corp. were presently trading on the market for $15 per share and you sold all of your 1,000 shares on the open market at $15, you would realize a gain of $5,000 on your investment ($15,000 - $10,000).

Now, suppose that XYZ Corp.'s shares were trading at $15, but you believed they were fairly valued at $20 per share, and therefore, you were not willing to sell at $15. Because you would still be holding on to all of your 1,000 shares, you would have an unrealized, or "paper", profit of $5,000. Of course, if you have not closed out of your position and realized your gain, you could still lose some, or all, of your profits, and your principal as well.

What Are Unrealized or "Paper" Profits?

On the other hand, because you have not realized your profit, you are not required to claim the gain as income; thus, by holding your shares instead of selling, you can potentially defer taxable income for a year (or many). Of course, the reverse is true for losses: realized losses can usually be claimed by investors as capital losses, offsetting other capital gains, while paper losses can not.1

KEY TAKEAWAYS

Secured vs. Unsecured Lines of Credit: An Overview

A line of credit (LOC) is a flexible borrowing arrangement that lets you draw funds as needed up to a set limit and repay them over time, often to manage cash flow, cover emergencies, or pay bills. These accounts can be secured, which require collateral and pose less risk to lenders, and unsecured, which rely on your creditworthiness. Collateral can lead to lower interest rates and higher credit limits, while unsecured options typically cost more to borrow. Choosing between the two can affect your credit score, as usage, repayment behavior, and available credit play key roles in how lenders assess your financial profile.

Understanding Secured Lines of Credit

When any loan is secured, the lender has established a lien against an asset that belongs to the borrower. This asset becomes collateral, and it can be seized or liquidated by the lender in the event of default. A common example is a home mortgage or a car loan. The bank agrees to lend the money while obtaining collateral in the form of the home or the car.

Similarly, a business or individual can obtain a secured line of credit using assets as collateral. If the borrower defaults on the loan, the bank can seize and sell the collateral to recoup the loss. Because the bank is certain of getting its money back, a secured line of credit typically comes with a higher credit limit and a significantly lower interest rate than an unsecured line of credit does.

One common version of a secured LOC is the home equity line of credit (HELOC). With a HELOC, money is borrowed against the equity in the home.1

Exploring Unsecured Lines of Credit

A lender assumes greater risk in granting an unsecured line of credit. None of the borrower's assets are subject to seizure upon default. Unsurprisingly, unsecured lines of credit are tougher to get for both businesses and individuals.2

Credit cards are essentially unsecured lines of credit. That's one reason why the interest rates on them are so high. If the cardholder defaults, there's nothing the credit card issuer can seize for compensation.

A business may want to open a line of credit in order to finance its expansion, for example. The funds are to be repaid out of future business returns. Such loans are only considered if the company is well established and has an excellent reputation. Even then, lenders compensate for the increased risk by limiting the amount that can be borrowed and by charging higher interest rates.

Choosing Between Secured and Unsecured Lines of Credit

Whether you choose a secured or an unsecured line of credit depends in large part on why you are using it.

For everyday purchases, an unsecured line of credit (such as a credit card) may make the most sense.

However, an unsecured line of credit is usually not your best option if you need to borrow a lot of money. As mentioned earlier, unsecured credit is riskier for lenders and typically comes with higher interest rates. Secured credit, on the other hand, is cheaper and easier to get.

The Bottom Line

Secured and unsecured LOCs offer flexibility that many traditional loans don't. Borrowers can draw funds as needed, repay them, and borrow again up to the approved limit, often with relatively low minimum payments compared with installment loans. Secured LOCs typically provide lower interest rates and higher credit limits because they are backed by collateral, while unsecured lines rely on creditworthiness and generally carry higher rates and lower limits. As long as required payments are made on time, neither usually requires full repayment by a fixed date, making them useful for ongoing or unpredictable expenses.