WHAT IS OPERATING INCOME? Component, Calculations & Formula

what is operating income

We will discuss operating income, the formula and how to calculate it in this article. We’ll also look at what’s included and excluded from the calculation, how it differs from other totals like net operating income, and why it’s essential.

What is an Operating Income?

Operating income, also known as operating profit or Earnings Before Interest and Taxes (EBIT), is the revenue remaining after deducting operational direct and indirect costs from sales revenue. It can also be calculated using gross income less depreciation, amortisation, and non-directly attributable operating expenses. Interest expense, interest income, and other non-operational revenue streams are not taken into account when calculating operating income.

What are the different components of operating income?

Three major components are used to calculate operating income. The first of these is net revenue.

#1. Revenue (or Sales):

Revenue appears near the top of the income statement. It represents the total amount of money earned by the corporation during its primary business processes. This would include any money received from monthly and annual memberships that occurred during the time covered by the income statement, as well as add-ons, usage fees, and so on.

#2. Net Revenue:

There are certain deductions from revenue (also called gross revenue) that are not quite expenses and occur before expenses are recorded on the income statement. These deductions include consumer discounts and refunds for cancelled services or defective products. After these deductions, the remaining value is the net revenue.

The other two elements are expenses deducted from net revenue: COGS and operating expenses.

#3. COGS (Cost of Goods Sold):

COGS appears on the income statement after revenue. Gross margin is defined as net revenue minus COGS. COGS is the overall cost of a company’s products or services, also known as the cost of manufacturing goods or services. The cost of goods sold (COGS) solely includes the direct costs of manufacturing your service.

#4. Operating Expenses:

These are the expenses incurred as a result of a company’s fundamental business activity. Payroll, utilities, rent, pension payments, and sales commission are all examples of operating expenses.

Since we’ll be comparing operating income to a few of other metrics of a company’s profitability below, let’s define a few terms here:

#5. Depreciation:

Depreciation is a means of spreading the cost of a long-term tangible asset over its useful life. Buildings, equipment, office furniture, automobiles, land, and machinery are examples of depreciable assets. It is important to note that whatever assets can be depreciated depends on local tax codes.

#6. Amortization:

Amortization is a method of spreading the cost of an intangible asset over the life of the asset. Patents and trademarks, franchise agreements, unique techniques, and the cost of issuing bonds to raise cash are all examples of amortizable assets.

#7. Taxes

Taxes are determined by deducting all tax-deductible expenses from a company’s revenue.

#8. Interest Expenditure

The amount of money spent to service a loan is referred to as the interest expenditure. In contrast, a firm may receive interest on its bank deposits.

#9. Gains:

Gains are the results of positive financial occurrences that are unrelated to the primary activity of the organisation. They are the sums of money earned by the company as a result of one-time events. They may include the selling of an operating unit. Baremetrics, for example, just sold Intros for $100,000. Gains can also be realised by selling off non-productive assets or assets that have reached the end of their useful life, such as obsolete automobiles, disused land, and so on.

#10. Losses:

Losses are the result of bad financial occurrences that are unrelated to the primary activity of the organisation. These losses represent the amount of money lost by the company as a result of one-time occurrences such as a litigation settlement or a stock trade loss.

With these additional definitions in place, we can now compare operating income to a variety of different totals found on the income statement. However, for a SaaS company, this is just the beginning of your financial analysis.

How to Calculate Operating Income

Operating income formula

To calculate operating income from operations, three formulas are used:

1. Operating income = Total Revenue – Direct Costs – Indirect Costs

OR

2. Operating income = Gross Profit – Operating Expenses – Depreciation – Amortization

OR

3. Operating income = Net Earnings + Interest Expense + Taxes

Selling, general, and administrative expenses (SG&A), depreciation and amortisation, and other operating expenses are examples of operating expenses. Investments in other enterprises (non-operating income), taxes, and interest expenses are all excluded from operating income. Nonrecurring items, such as funds paid for a litigation settlement, are also excluded. The operating margin, which defines a company’s operational efficiency, is calculated using operating income.

Operating income is the amount of income generated by a firm from its core operations, which eliminates any income and expenses that are not directly related to the main business.

What is the significance of this?

The profitability of a company’s main business operations is measured by operating income. In this scenario, the core business is the primary source of revenue for a company.

Most crucially, operating income eliminates “non-operating” income and expenses that are technically not part of the core business operations yet can be substantial.

Taxes and interest payments are the two largest non-operating expenses. However, there is a separate category for “other” non-operating income and expenses.

Other non-operating income and expenses include:

  • Profitable resale of equipment no longer in use by the company.
  • The payment or receipt of money in exchange for the settlement of a lawsuit.
  • Gains and losses resulting from investments in other companies
  • Accounting alterations

Many of these “other” non-operating expenses are outside a company’s control, and some are one-time items unrelated to day-to-day operations.

This is why investors can benefit from excluding them while examining a company’s financials.

In fact, many investors believe that operating income is a more trustworthy indicator of profitability than net income (bottom-line profits).

Warren Buffett, for example, understands the significance of operating income. He advises Berkshire Hathaway investors to consider operating income rather than net income when investing in his company.

This is because Berkshire owns a lot of stock in other firms, and transient price changes in their stock holdings have an impact on their net income.

As a result, Berkshire’s net income fluctuates significantly depending on the performance of the stock market.

Many analysts and investors are interested in operating income and how it evolves over time. If it rises, it indicates that the company’s primary operation is generating more revenue.

Example of Operating Income

Let’s see if we can calculate all of these different measurements of operating income using the information in the table below (negative numbers are in parentheses for clarity):

ItemValueItemValue
Revenue20,000Amortization(300)
Returns, Refunds, and Discounts(1,000)Interest Paid(500)
Costs of Goods Sold(4,000)Taxes(3,000)
Rent(1,000)Sale of Platform10,000
Payroll(2,000)Settlement of Lawsuit(5,000)
Depreciation(1,000)

Let’s begin from the beginning with net revenue. The revenue is $20,000, and the returns, refunds, and discounts total $1,000. This results in net revenue of $19,000.

With a cost of goods sold of $4,000, we should expect a gross profit of $15,000. As a percentage, this gives us a very healthy gross profit margin of around 79 percent.

Next, add up all of the expenses (excluding interest and taxes) to arrive at the total indirect expenses of $4,300. When we subtract this value from the gross profit, we get an operating income of $10,700.

Adding the gains and losses from the sale of a platform and the settlement of a lawsuit, we can achieve an EBIT of $15,700.

When we exclude depreciation and amortisation, we have an EBITDA of $17,000.

Finally, we can add everything together to achieve a net income of $12,200.

These metrics are insufficient in a SaaS firm. There are numerous more parameters that must be tracked.

Net Income vs. Operating Income

When you look at the income statement, you’ll notice that net income is also stated. This amount does not include operating income. While operating income represents all of a company’s income from day-to-day operations, it includes more expense line items than gross profit. Operating income takes into account COGS as well as all operating expenses.

However, net income takes into account all corporate expenses, not simply those related to day-to-day operations. Other types of income are also included, such as non-operating income and non-operating expenses. Interest payments, taxes, lawsuit settlements, and restructuring charges are all examples of non-operating expenses.

What is Net Operating Income?

Operating income and net operating income are phrases that are sometimes used interchangeably, however, there are some distinctions between the two.

Net operating income is a word that is frequently used in the real estate market, but it can also refer to any business or firm that produces income from its property. To calculate net operating income, add all revenue from the property and calculate related operational expenses such as utilities, repairs, and upkeep. Earnings before interest and taxes, or EBIT, is another term for net operating income outside of the real estate industry.

Operating income vs. revenue, gross profit, and net income

The income statement of a corporation begins with revenue, which is the whole amount of money collected before deducting any expenses. Revenue is often known as the “bottom line.”

The income statement concludes with net income, which is often known as profits or the “bottom line.” It is the amount of money that remains after deducting all expenses.

From revenue to net income, there are three processes, each with a distinct expense item eliminated. To appreciate where operating income fits into the overall picture, consider the following three steps:

  1. Revenue – Cost of Revenue = Gross Profit.
  2. Gross Profit – Operating Expenses = Operating Income.
  3. Operating Income – All Other Expenses = Net Income.

When gross profit, operating income, and net income are expressed as a percentage of revenue, the figures are referred to as gross margin, operating margin, and profit margin, respectively.

Is profit the same as operating income?

No, not exactly. Operating income is what remains after a company deducts its cost of goods sold (COGS) and other operating expenses from its sales revenues. It does not, however, account for taxes, interest or financing charges, or depreciation and amortisation.

Can a business have a high operating income but still lose money?

While a high operating income is frequently indicative of profitability, there may be times when a business gains money through operations but must spend more on interest and taxes. This could be the result of a one-time charge, poor financial decisions made by the company, or an escalating interest rate environment affecting outstanding loans. Alternatively, a corporation may earn a significant amount of interest income that does not appear as operating income.

Where Can I Find the Operating Income of a Company?

Operating income is recorded on the income statement as its own line item near the bottom of the statement. It should display alongside non-operating income to assist investors in distinguishing between the two and determining which income came from which sources.

Operating Income FAQs

Is operating income same as revenue?

Before any expenses are removed, revenue is the complete amount of income generated by a corporation from the sale of its goods or services. Operating income is the overall profit of a corporation after deducting its regular, recurring costs and expenses.

What falls under other operating income?

Other operating income includes revenue from all other operating activities that are not related to the company’s primary activity, such as gains/losses on disposals, interest income, dividend income, and so on.

What is the difference between EBITDA and operating income?

EBITDA represents the company’s earnings. EBITDA is a profit that includes interest, taxes, depreciation, and amortisation. However, operating income indicates profit after deducting operating expenses such as depreciation and amortisation.

Read Also: RISK ADJUSTED RETURN: Ratios, Formula and Calculations

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