Operating Income, also known as Operating Profit or Operating Earnings, refers to the amount of profit a company generates from its core business operations before considering non-operating income and expenses such as interest and taxes. It’s a key value that helps us understand how well the company’s main work is going.
Investors, analysts, and management rely on operating income to judge how well a company is doing financially, especially when compared to other companies in the same industry. If a company has a positive operating income, it means that its core operations are making money, which is really important for keeping the business going, covering other expenses, and potentially expanding the business.
What is Operating Income?
Operating Income, also referred to as Operating Profit, Operating Earnings, or Income from Operations, is a financial metric that represents the profit a company generates from its core business operations after deducting all the expenses related to its primary operations.
Operating Income shows a company’s ability to generate profit from its primary revenue-generating activities. It does not consider non-operational items like interest income, interest expenses, gains or losses on investments, and extraordinary items.
Operating Income, Operating Profit, Income from Operations, Operating Earnings – all these terms essentially refer to the same financial metric and are often used interchangeably in financial reporting and analysis.
Operating Income is derived by deducting both the costs directly associated with producing goods or services (Direct Costs) and the ongoing expenses necessary for running the business (Indirect Costs) from the total revenue.
Operating Income = Total Revenue – Direct Costs – Indirect Costs
Total Revenue:This is the actual revenue generated from a company’s primary business operations, such as sales of goods and services. As you know actual revenue means Net Revenue.
Direct Costs: These are the direct costs associated with producing goods or services that a company sells. As you know direct costs mean Cost of Sales, also known as Cost of Goods Sold (COGS) for product-based companies or Cost of Services (COS) for service-based companies.
Indirect Costs: These are the costs associated with running the business on a day-to-day basis but are not directly tied to the production of goods or services. As you know indirect costs mean Operating Expenses.
Operating Income Definition
Operating Income is the amount of profit a company generates from its core business operations after accounting for both direct and indirect costs associated with them, but before accounting for non-operating income and expenses, such as interest income, interest expenses, gains or losses on investments, and extraordinary items.
Operating income is an important metric for assessing a company’s operational efficiency and profitability. A positive operating income indicates that the company’s core operations are generating profits before considering other factors. It reflects how effectively a company manages its costs and generates revenue from its primary activities.
Operating Income Formula
As we discussed above, to arrive at Operating Income, you need to subtract both Direct and Indirect Costs associated with core business operations from the actual revenue generated from them.
Operating Income = Net Revenue – Direct Costs – Indirect Costs
Direct Costs = Cost of Sales or Cost of Revenue, also known as Cost of Goods Sold (COGS) for product-based companies or Cost of Services (COS) for service-based companies
Indirect Costs = Operating Expenses
Hence the formula for calculating operating income is:
Operating Income = Net Revenue – Cost of Sales – Operating expenses
Since, Net Revenue – Cost of Sales = Gross Profit, we can also express the formula as:
Operating Income = Gross Profit – Operating expenses
Operating Income Formula: Bottom-Up Approach
You can also find Operating Income, starting from the bottom side of the Income Statement.
When approaching the Operating Income formula from the bottom side of the Income Statement, you’ll start with the bottom line, which is Net Income (Net Profit), and work your way up by adding back Tax expenses and subtracting Other Income (Expenses) to arrive at Operating Income.
Here’s the formula:
Operating Income = Net Income (Net Profit) + Taxes – Other Income (Expenses)
Operating Income and Earnings Before Interest and Taxes (EBIT)
Though these terms are often used interchangeably in financial reporting and analysis, they are not essentially the same financial metric. Before discussing why they are different, let’s first discuss about Earnings Before Interest and Taxes (EBIT).
Earnings Before Interest and Taxes (EBIT) represents a company’s profit or earnings before deducting interest expenses and income taxes. So to find EBIT, we need to add back interest expenses and income taxes to the Net Income (Net Profit).
Earnings Before Interest and Taxes (EBIT) = Net Income (Net Profit) + Interest Expenses + Taxes
Operating Income (Operating Profit) and Earnings Before Interest and Taxes (EBIT) do not necessarily have the same values for all companies.
Compare the formulas for Operating Income and Earnings Before Interest and Taxes (EBIT).
Operating Income = Net Income (Net Profit) + Taxes – Other Income (Expenses)
Earnings Before Interest and Taxes (EBIT) = Net Income (Net Profit) + Interest Expenses + Taxes
Are they the same? Of course not!
Therefore, Operating Income (Operating Profit) is not equal to Earnings Before Interest and Taxes (EBIT).
Special case
Consider a scenario where the Other Income (Expenses) category of a company has only a single item – Interest Expenses.
For many larger companies, Interest Expenses is just one component of the Other Income (Expenses).
Let’s return to our scenario: Suppose a specific company has only Interest Expenses in the Other Income (Expenses) category.
For such a company,
Other Income (Expenses) = – (Interest Expenses)
Negative sign indicates the net of Other Income (Expenses) is a negative value. We will discuss in detail about Other Income (Expenses) in the next article.
Now substitute this in the formula for Operating Income.
Operating Income = Net Income (Net Profit) + Taxes – Other Income (Expenses)
Operating Income = Net Income (Net Profit) + Taxes – [- (Interest Expenses)]
Operating Income = Net Income (Net Profit) + Taxes + Interest Expenses Now, the formula for Operating Income is the same as EBIT.
So, Operating Income (Operating Profit) is the same as Earnings Before Interest and Taxes (EBIT) only when Interest Expenses are the only item in the Other Income (Expenses) category.
If Interest Expenses are the only item in the Other Income (Expenses) category of a Financial Statement,
Operating Income (Operating Profit) = Earnings Before Interest and Taxes (EBIT)
If Other Income (Expenses) category of a Financial Statement contains items other than Interest Expenses,
Operating Income (Operating Profit) ≠ Earnings Before Interest and Taxes (EBIT)
How to Calculate Operating Income
(a) Top-Down Approach
- Identify Total Revenue (Net Revenue): Start by determining the total revenue generated by the company from its core business activities. Make sure you are considering only the actual revenue generated from the company’s primary business operations such as sales of goods or services.
- Calculate Cost of Sales (COGS or COS): Calculate the Cost of Sales, which is the direct cost associated with producing the goods or services that the company sells. This includes expenses like raw materials, labor, manufacturing costs, and other costs directly related to production or services.
- Calculate Operating Expenses: Calculate the total Operating Expenses, which are the costs directly associated with running the business on a day-to-day basis. They include items such as employee salaries, rent, utilities, marketing, research and development, and other costs necessary for the company’s operations.
- Calculate Operating Income using the above values:Substitute the calculated values of Total Revenue, Cost of Sales, and Operating Expenses into the formula for Operating Income.
Operating Income = Net Revenue – Cost of Sales – Operating expenses
(b) Bottom-Up Approach
From the Income Statement, take the Net Income (Net Profit), Income Taxes and Other Income (Expenses), and just apply in the formula:
Operating Income = Net Income (Net Profit) + Taxes – Other Income (Expenses)
Examples of Operating Income (Operating Profit)
Let’s consider a fictional electronics manufacturing company that produces mobile phones, tablets, personal computers (PCs), and other electronic accessories.
| 31-Dec-22 | |
| Revenue | $1,800,000 |
| Cost of Goods Sold | $1,080,000 |
| Gross Profit | $720,000 |
| Operating Expenses: | |
| – Selling Expenses | $150,000 |
| – General and Administrative Expenses | $180,000 |
| – Research and Development Expenses | $60,000 |
| Total Operating Expenses | $390,000 |
| Operating Income | ????? |
| Other Income (Expenses): | |
| – Interest Income | $4,000 |
| – Interest Expenses | $8,000 |
| – Income from Investments | $6,000 |
| – Other Gains (Losses) | $1,000 |
| Total Other Income (Expenses) | $3,000 |
| Net Income before Taxes | $333,000 |
| Income Taxes | $75,000 |
| Net Income | $258,000 |
Top-Down Approach
To calculate the Operating Profit by Top-Down Approach, we use the formula:
Operating Income = Net Revenue – Cost of Sales – Operating expenses
Net Revenue = Revenue = $1,800,000
Cost of Sales = Cost of Goods Sold = $1,080,000
Operating expenses = $390,000
So, Operating Income = $1,800,000 – $1,080,000 – $390,000
Operating Income = $330,000
In this example, the company’s Operating Profit is $330,000. This represents the profit generated from its core business operations after deducting both direct and indirect costs.
Bottom-Up Approach
To calculate the Operating Profit by Bottom-Up Approach, we use the formula:
Operating Income = Net Income (Net Profit) + Taxes – Other Income (Expenses)
Net Income = $258,000
Taxes = $75,000
Other Income (Expenses) = $3,000
So, Operating Income = $258,000 + $75,000 – $3,000
Operating Income = $330,000
This is the exact amount as derived from the previous Top-Down Approach.
What Does Operating Income Tell You About a Company?
Profitability of Core Operations: Operating Income reflects the profitability of the company’s core business activities before considering non-operating factors such as interest and taxes. It indicates how well the company is able to generate profit from its main products or services.
Operational Efficiency: A positive Operating Income suggests that the company’s core operations are generating more revenue than their associated expenses. It indicates that the company is effectively managing costs and resources to run its business efficiently.
Sustainability of Operations: Positive Operating Income implies that the company can cover its operating expenses and still have profit left over. This shows the company’s ability to sustain its operations over the long term.
Business Viability: A negative Operating Income could be a warning sign that the company’s core operations are not generating sufficient profit to cover expenses. This might lead to questions about the viability of the company’s business model.
Operating Income Related Metrics and Ratios
Operating Margin (Operating Profit Margin)
Operating Margin, also known as Operating Profit Margin or Operating Income Margin, is calculated by dividing Operating Income by Total Revenue and expressing the result as a percentage. It expresses the percentage of each dollar of revenue that remains as operating profit after deducting all relevant operating expenses.
Operating Margin = (Operating Income / Total Revenue) x 100
A higher Operating Margin indicates that a larger portion of revenue is available to cover operating expenses and generate profit, which is a positive sign of operational efficiency.
Let’s consider a fictional company. The following data is taken from its Income Statement.
Total Revenue = $1,500,000
Operating Income (Operating Profit) = $255,000
Now, Operating Margin = (Operating Income / Total Revenue) × 100
Operating Margin = ($255,000 / $1,500,000) × 100 ≈ 17%
In this example, the Operating Margin is approximately 17%. This means that for every dollar of revenue the company generates, around 17 cents remain as operating profit after accounting for all operating expenses. The Operating Margin indicates how efficiently the company’s core operations are generating profit before considering interest expenses, income taxes, and other financial factors.
Operating Income Growth Rate
Operating Income Growth Rate (or Operating Profit Growth Rate), measures the rate of change in Operating Income over a specified period. It is used to assess the company’s ability to increase its profitability from its core operations.
Operating Income Growth Rate = ((Operating Income in Current Period – Operating Income in Previous Period) / Operating Income in Previous Period) x 100
Let’s consider a fictional company.
Operating Income at the end of each year for a period of 5 years is given below
| Year ended | Operating Income |
|---|---|
| 2020 | $2,000,000 |
| 2021 | $2,400,000 |
| 2022 | $2,795,000 |
| 2023 | $3,120,000 |
| 2024 | $3,400,000 |
You can see that the Operating Income of the company is steadily increasing over the five-year period. But is it actually a healthy sign? Or do they divulge any other information?
Let’s calculate Operating Income Growth Rate.
As you know:
Operating Income Growth Rate = ((Operating Income in Current Period – Operating Income in Previous Period) / Operating Income in Previous Period) x 100
Let’s calculate the Growth Rate for years 2020 and 2021.
Operating Income Growth Rate for 2020-2021 = (($2,400,000 – $2,000,000) / $2,000,000) * 100 = 20%
Similarly let’s calculate for the remaining years.
Operating Income Growth Rate for 2021-2022 = (($2,795,000 – $2,400,000) / $2,400,000) * 100 = 16.46%
Operating Income Growth Rate for 2022-2023 = (($3,120,000 – $2,795,000) / $2,795,000) * 100 = 11.63%
Operating Income Growth Rate for 2023-2024 = (($3,400,000 – $3,120,000) / $3,120,000) * 100 = 8.97%
As you can see, despite the increase in operating income, the growth rate of operating income is gradually decreasing. This could be due to multiple factors such as increased operating expenses, changing market conditions, or competitive pressures.
A decreasing operating income growth rate can be a signal for investors to further investigate the company’s financial health and the underlying reasons for the decline.
