Operating Income Defined (2024)

If you want insights into how a company's business is performing, operating income is akey metric to understand. Operating income measures the profitability of a company'score business operations after deducting all operating expenses. It shows how efficientlythe company can generate cash from its business operations. By excluding the effect oftaxes, interest and one-time events such as acquisitions and write-offs, operating incomehelps managers, investors and lenders focus on the fundamentals at the heart of thecompany's business.

What Is Operating Income?

Operating income is the profit that remains after subtracting the expenses of day-to-daybusiness operations from the company's net sales revenue. These expenses are typicallydivided into two main categories: direct and indirect. Direct expenses, also known as cost of goods sold(COGS) or cost of sales, include raw materials and labor costs associated withmaking the company's products or services. Indirect expenses are costs that are notdirectly incurred during production, including salaries of administrative staff, officerents, sales commissions and marketing expenses.

Operating income excludes nonoperating, recurring expenses like taxes and interest, as wellas extraordinary charges such as litigation costs.

Key Takeaways

• Operating income is a key financial metric that reflects the profitability of acompany's core business.
• Operating income is calculated by subtracting direct and indirect operational expensesfrom net sales revenue.
• Operating income excludes non-operational revenue and expenses that can obscure theperformance of core business operations, such as interest, taxes and one-time events.
• Managers can raise operating income by increasing revenue while controlling operatingcosts.

Operating Income Explained

Operating income is a key measure of a company's ability to generate cash from its coreoperations. It measures profit after considering all operational expenses, includingmanufacturing costs, promotional expenses, R&D and administrative costs. At the sametime,it excludes non-operating costs and income that can obscure the performance of thecompany's core business.

Operating income is also used to calculate another useful metric: operating profit margin,which shows how much operating income the company generates from each dollar of salesrevenue. Operating margin is calculated by dividing operating income by net sales revenueand multiplying by 100%. Because it's expressed as a percentage of sales, rather thanin dollars, operating margin is useful for comparing the profits of companies within thesame sector, and for tracking a company's profitability trend over time.

How to Calculate Operating Income

To accurately calculate operating income, it's important, first, to accurately categorize allrevenue and expenses. Nonoperating revenue and costs should be excluded from thecalculation.

Calculating Operating Income

Once the company has correctly categorized all revenue and expenses, operating income iscalculated by subtracting direct expenses (COGS) from net sales to obtain gross income, thensubtracting indirect operating expenses from gross income to obtain operating income.

Operating Income Formula

The formula for calculating operating income from gross income is:

Operating Income = Gross Income - Operating Expenses

Alternatively, operating income can be calculated from net sales:

Operating Income = Net Sales - Direct Expenses (COGS) - Indirect Operating Expenses (SG&A)

Components of Operating Income

Operating income is calculated from net sales and two main types of expenses related tooperations: direct costs (COGS) and indirect costs.

COGS are expenses directly incurred in the creation of the company's products orservices. Examples include:

• Materials and supplies used to create the company's products or services.
• Wages of employees who work directly on the products or services sold.
• Utilities consumed by manufacturing facilities.
• Depreciation of assets used in production, such as manufacturing equipment.

Subtracting these costs from net sales yields the company's gross income, also known asgross profit.

Operating income is then obtained by subtracting indirect operating expenses from grossincome. These are expenses involved in running the business but not directly related toproduction activities. They are sometimes called selling, general and administrative(SG&A)expenses. Examples include:

• Salaries of management and administrative staff.
• Office supplies.
• Marketing and advertising costs.
• Sales costs, including travel.
• Depreciation of nonproduction assets, such as computers used for administrativefunctions.

Why Is Operating Income Important?

Operating income demonstrates the business's ability to generate profit from its coreoperations after covering its operating expenses. The company can use those profits to fundbusiness growth or to reward its owners and investors. If a company consistently reports anoperating profit, it's more likely to be able to flourish over the long term withoutrequiring outside funding. If a company succeeds in increasing its operating income overtime, it typically indicates an ability to increase revenue while holding down operatingcosts.

Operating Income vs. Net Income

Operating income and net income are both important measures of a company's profitability.While operating income is the profit remaining after deducting COGS and operating expensesfrom net sales revenue,netincometakes into account all revenue and expenses. It includes non-operatingincome from investments and the sale of assets, as well as non-operating costs such astaxes, interest and one-time charges. Net income is also known as “the bottomline,” becauseit's the last line on a company's income statement.

The terms “operating income” and “earnings before interest and taxes”(EBIT) are often usedinterchangeably, but there's a key difference between the two. As its name suggests,EBITisnet income excluding interest payments and taxes. Unlike operating income, EBIT can includerevenue and expenses from non-operational sources. If a company doesn't have revenue orexpenses from those sources, EBIT will be the same as operating income. But EBIT can differfrom operating income if a company has non-operating revenue from investments or the sale ofa subsidiary, or if it incurs non-operating expenses such as a write-off. Another importantdistinction is that operating income is a GAAP-approved accounting metric, while EBIT isnot.

Operating Income vs. EBITDA

Earningsbefore interest, taxes, depreciation and amortization (EBITDA)is anothercommonly used profitability metric. To calculate EBITDA, you add interest, taxes,depreciation and amortization to net income. Like EBIT, EBITDA differs from operating incomein that it includes income and expenses from non-operating sources. But unlike EBIT, it alsoexcludes depreciation and amortization, which are costs that are included when calculatingoperating income.

Depreciation and amortization are accounting methods that spread the cost of assets overmultiple years, resulting in recurring expenses on the company's income statements.Companies with expensive equipment or other big assets can incur sizable depreciationexpenses. Those expenses don't represent real cash outflows, so some investors and managersbelieve that EBITDA may provide a better picture of the company's day-to-day operatingprofit and cash flow. However, EBITDA, like EBIT, is not aGAAP-approvedmetric.

How to Use Operating Income

Managers, investors and lenders all use operating income as a key measure of business health.It's a good measure of how well the company's underlying business is performing,since it covers both the direct and indirect costs of creating and selling products andservices.

Operating income is considered a good indicator of how well the company is managed. Investorsand lenders often examine operating income and operating margin when deciding whether tooffer funds to a business.

The operating profit margin, derived by dividing the operating income by total sales, is avaluable tool for comparing the performance of a business with that of other companies andwith industry averages. Companies can also use operating income and operating profit marginto track and compare performance over multiple years. In broad terms, there are only twoways to improve these metrics: by increasing sales and/or reducing operating expenses.

Operating Income Examples

To illustrate how operating income is derived, imagine a consulting organization that has tworevenue streams: research reports sold via its website and custom consulting engagementswith individual businesses. In 2020, both revenue streams increased, driving a 29% increasein total sales to $461,697. However, the company invested heavily in developing andmarketing new services to capture a greater share of the market. Because of this, thecompany's expenses grew even faster, rising nearly 37% to $451,205. As a result, thecompany's operating income shrank from $27,374 to $10,492, and its operating profitmargin decreased from 7.7% to 2.3% of revenue. To return to higher profitability, thecompany's managers may consider options such as raising prices and seeking ways to cutcosts.

How to Increase Operating Income

There are many ways to increase operating income, but they all boil down to boosting revenue,reducing costs — or both. Here are some examples:

1. Reduce the cost of raw materials. Lowering the cost of raw materialsreduces COGS and thus improves operating income. It's worth negotiating withexisting vendors, continuously seeking reliable lower-cost suppliers, and looking formore efficient ways to acquire supplies. Southwest Airlines famously employed a fuel-hedging strategy (opens in a newtab) to protect itself against fluctuations injet fuel costs. By purchasing long-term contracts when prices were low, the companygained a huge cost advantage over competitors when prices subsequently soared.

2. Optimize inventory management. Especially for inventory-heavybusinesses like retail, inventorymanagement is a smart way to cut costs. Inventory management software canhelp companies gain better visibility into stock levels, forecastdemand, and identify bottlenecks and slow-moving items. Focus areas include:

   • Forecasting: Careful analysis of current and historical salesdata can help companies forecast demand more accurately. Matching inventory tocustomer demand can increase sales and reduce warehousing costs.
   • First-in, first-out (FIFO) strategy: Shipping products in theorder in which they were received is a common way to reduce cost due to wastage.Even nonperishable items can lose value in storage by becoming damaged, lost orobsolete.
   • Identify slow-moving items: When it comes to warehousing, spaceis money. Identify items that nobody is buying and use the space forhigh-turnover, higher-value inventory.
3. Automate manual processes. Automating time-consuming manual processesthroughout the company can dramatically increase productivity, helping to reduce costand increase profits. For example, AI-based chatbots operate 24/7 and answer many basiccustomer questions, enabling customer service representatives to focus on more complexproblems. In the banking industry, chatbots are expected to handle nearly 80% ofcustomer interaction and savebanks $7.3 billion by 2023. (opens in a newtab)
4. Increase sales to existing customers. Because it generally costs muchless to keep an existing customer than to acquire a new one, expanding yourrelationships with existing customers can help increase operating income. Customer relationship management (CRM)systems can help companies increase revenue by developing better insights intocustomer needs, identifying cross-selling opportunities, and increasing theeffectiveness of sales and marketing efforts.

Calculate and Track Operating Income With Accounting Software

Accounting software simplifies and automates everyday accounting tasks, such as recordingtransactions while facilitating timely, accurate reporting and financial close processes. Leading cloud-basedaccounting software helps businesses gain a more complete view of financialperformance with real-time access to a broad range of financial metrics, including operatingincome. Automating repetitive tasks saves time for finance teams and frees them to focus onhigher-value activities, such as investigating anomalies and analyzing trends.

Operating income and operating profit margin are critical indicators of a business'sfinancial health. They help managers, investors and lenders gauge the profitability of acompany's core business operations. An increase in operating income indicates that thecompany has taken strides to improve sales, rein in operating costs or both.

Operating Income FAQs

How do you calculate operating income?

Operating Income is calculated by subtracting cost of goods sold (COGS) and operating (i.e.,indirect) expenses from net sales, or by subtracting operating expenses from gross income.

What is considered operating income?

Operating income is the profit generated by the company's core business operations,after expenses are subtracted. Those expenses include cost of goods sold (COGS) and selling,general and administrative (SG&A) expenses. It excludes non-operating income andexpenses,such as revenue from investments and the cost of inventory write-offs.

Is operating income the same as profit?

No. Operating income is only one of several key business profit metrics, along with grossmargin and net income. Operating income reflects the profit from core operations, aftertaking direct and indirect operating expenses into account.

Is operating income EBITDA or EBIT?

The term “operating income” is often used interchangeably with earnings beforeinterest andtaxes (EBIT), but there are differences between the two profit metrics. Both measure profitfrom net sales after deducting operating expenses, including depreciation and amortization.But EBIT also includes non-operating revenue and expenses, while operating income does not.EBITDA is similar to EBIT but excludes depreciation and amortization expenses.