When tracking your business’s financial health, there are many financial reports that your business should review. The numbers you get from those reports indicate how financially healthy your company is, and if your company is seeking money from creditors and investors, they will be asking to look at those numbers too. Operating income is one of those numbers you should be calculating.
What is Operating Income?
The simple definition is that operating income shows your business’s ability to generate earnings from its operational activities. It measures the amount of money a company makes from its core business activities, not including other income that does not relate directly to everyday activities of the business.
On the flip side, a non-operating expense is a one-time or unusual cost. This can include interest, lawsuit expenses, depreciation, obsolete inventory costs, and more.
Popular synonyms for operating income are operating profit and recurring profit. Operating income is also similar to earnings before interest and taxes (EBIT), but the one big difference between them is that EBIT includes any non-operating income the company generates.
How Do We Calculate it?
Operating income is found in the income statement. At the top of the statement cost of goods sold (COGS) is subtracted from revenue to find gross profit. Operating expenses are listed next and are subtracted from the gross profit. The amount remaining after all operating expenses are subtracted is the operating income.
Now that we know where it is, let’s calculate it:
Operating Income = Gross Income – Operating Expenses
Gross income is the amount of money your business has left after subtracting the costs of producing the product— also known as costs of goods sold. To get gross income you subtract COGS from your revenue.
Operating expenses include all of the costs associated with running your core business activities. This includes things like utilities, insurance, rent, employee wages, and insurance.
Now that we know the basics, let’s look at an example:
Amy has a flower delivery business and is looking to expand it. She wants to take out a business loan, but needs to show her operating income to creditors.
Amy reviews her finances and sees that her business made $200,000 in revenue last month.
The rest of her expenses were:
- $3,000 in utilities
- $90,000 in employee wages
- $7,000 in insurance
- $6,000 in vehicle payment
- $8,000 in property and upkeep
- $1,000 in office supplies
- $7,000 in vehicle damages
- $20,000 in COGS
Now that we have the information, the first step in calculating operating income is to calculate gross income.
Revenue – COGS = Gross Income
$200,000 – $20,000 = $180,000
From there we just need to add up operating expenses. Numbers 1-6 of her expenses are operating expenses because they have to do with the everyday function of her business. Note that she didn’t include the $7,000 in damages from line seven because it was an extraordinary loss.
This leaves Amy’s total operating expense as $113,500.
Now, we can calculate operating income.
Gross Income – Operating Expenses = Operating Income
$180,000 – $115,000 = $65,000
Amy can now show her investors or creditors that her business had $65,000 in operating income last year.
What Does Operating Income Tell You?
Operating income is a measurement that shows how profitable a company’s core business operations are. The higher the operating income, the more profitable. Many business owners use the operating income figure to measure the operational successes of their business.
Many things can affect operating income like labor costs, prices of materials, and pricing strategy. And because these items relate directly to a business’ day-to-day operations, operating income can help business owners make strategic decisions about how to grow or where changes are needed.
Why Is It Important?
Your company should be calculating operating income because it separates the operating and non-operating revenues and expenses, giving an outsider a clear picture on how the company makes money.
Investors and creditors can use the number to evaluate the business’s efficiency and profitability without regarding interest expenses or tax rates— two variables that may be unique from one company to another. A higher operating income means your business is more likely to pay back what it owes.
Looking at total revenue or the “bottom line” of your income statement alone isn’t enough for most business owners. It’s important to dig deeper, and examining your operating income on a regular basis helps to shed more light on the overall health of your business.