Operating Income Defined

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

What Is Operating Income?

Operating income is the profit that remains after subtracting the expenses of day-to-day business operations from the company's net sales revenue. These expenses are typically divided 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 with making the company's products or services. Indirect expenses are costs that are not directly incurred during production, including salaries of administrative staff, office rents, sales commissions and marketing expenses.

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

Key Takeaways

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

Operating Income Explained

Operating income is a key measure of a company's ability to generate cash from its core operations. It measures profit after considering all operational expenses, including manufacturing costs, promotional expenses, R&D and administrative costs. At the same time, it excludes non-operating costs and income that can obscure the performance of the company'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 sales revenue. Operating margin is calculated by dividing operating income by net sales revenue and multiplying by 100%. Because it's expressed as a percentage of sales, rather than in dollars, operating margin is useful for comparing the profits of companies within the same 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 all revenue and expenses. Nonoperating revenue and costs should be excluded from the calculation.

Calculating Operating Income

Once the company has correctly categorized all revenue and expenses, operating income is calculated by subtracting direct expenses (COGS) from net sales to obtain gross income, then subtracting 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 to operations: direct costs (COGS) and indirect costs.

COGS are expenses directly incurred in the creation of the company's products or services. 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 as gross profit.

Operating income is then obtained by subtracting indirect operating expenses from gross income. These are expenses involved in running the business but not directly related to production 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 administrative functions.

Why Is Operating Income Important?

Operating income demonstrates the business's ability to generate profit from its core operations after covering its operating expenses. The company can use those profits to fund business growth or to reward its owners and investors. If a company consistently reports an operating profit, it's more likely to be able to flourish over the long term without requiring outside funding. If a company succeeds in increasing its operating income over time, it typically indicates an ability to increase revenue while holding down operating costs.

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 expenses from net sales revenue, net income takes into account all revenue and expenses. It includes non-operating income from investments and the sale of assets, as well as non-operating costs such as taxes, interest and one-time charges. Net income is also known as “the bottom line,” because it's the last line on a company's income statement.

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

Operating Income vs. EBITDA

Earnings before interest, taxes, depreciation and amortization (EBITDA) is another commonly used profitability metric. To calculate EBITDA, you add interest, taxes, depreciation and amortization to net income. Like EBIT, EBITDA differs from operating income in that it includes income and expenses from non-operating sources. But unlike EBIT, it also excludes depreciation and amortization, which are costs that are included when calculating operating income.

Depreciation and amortization are accounting methods that spread the cost of assets over multiple years, resulting in recurring expenses on the company's income statements. Companies with expensive equipment or other big assets can incur sizable depreciation expenses. Those expenses don't represent real cash outflows, so some investors and managers believe that EBITDA may provide a better picture of the company's day-to-day operating profit and cash flow. However, EBITDA, like EBIT, is not a GAAP-approved metric.

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 and services.

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

The operating profit margin, derived by dividing the operating income by total sales, is a valuable tool for comparing the performance of a business with that of other companies and with industry averages. Companies can also use operating income and operating profit margin to track and compare performance over multiple years. In broad terms, there are only two ways 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 two revenue streams: research reports sold via its website and custom consulting engagements with individual businesses. In 2020, both revenue streams increased, driving a 29% increase in total sales to $461,697. However, the company invested heavily in developing and marketing new services to capture a greater share of the market. Because of this, the company's expenses grew even faster, rising nearly 37% to $451,205. As a result, the company's operating income shrank from $27,374 to $10,492, and its operating profit margin decreased from 7.7% to 2.3% of revenue. To return to higher profitability, the company's managers may consider options such as raising prices and seeking ways to cut costs.

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 materials reduces COGS and thus improves operating income. It's worth negotiating with existing vendors, continuously seeking reliable lower-cost suppliers, and looking for more efficient ways to acquire supplies. Southwest Airlines famously employed a fuel-hedging strategy (opens in a new tab) to protect itself against fluctuations in jet fuel costs. By purchasing long-term contracts when prices were low, the company gained a huge cost advantage over competitors when prices subsequently soared.

2. Optimize inventory management. Especially for inventory-heavy businesses like retail, inventory management is a smart way to cut costs. Inventory management software can help companies gain better visibility into stock levels, forecast demand, and identify bottlenecks and slow-moving items. Focus areas include:

   • Forecasting: Careful analysis of current and historical sales data can help companies forecast demand more accurately. Matching inventory to customer demand can increase sales and reduce warehousing costs.
   • First-in, first-out (FIFO) strategy: Shipping products in the order 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 or obsolete.
   • Identify slow-moving items: When it comes to warehousing, space is money. Identify items that nobody is buying and use the space for high-turnover, higher-value inventory.
3. Automate manual processes. Automating time-consuming manual processes throughout the company can dramatically increase productivity, helping to reduce cost and increase profits. For example, AI-based chatbots operate 24/7 and answer many basic customer questions, enabling customer service representatives to focus on more complex problems. In the banking industry, chatbots are expected to handle nearly 80% of customer interaction and save banks $7.3 billion by 2023. (opens in a new tab)
4. Increase sales to existing customers. Because it generally costs much less to keep an existing customer than to acquire a new one, expanding your relationships with existing customers can help increase operating income. Customer relationship management (CRM) systems can help companies increase revenue by developing better insights into customer needs, identifying cross-selling opportunities, and increasing the effectiveness of sales and marketing efforts.

Calculate and Track Operating Income With Accounting Software

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

Operating income and operating profit margin are critical indicators of a business's financial health. They help managers, investors and lenders gauge the profitability of a company's core business operations. An increase in operating income indicates that the company 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 and expenses, 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 gross margin and net income. Operating income reflects the profit from core operations, after taking direct and indirect operating expenses into account.

Is operating income EBITDA or EBIT?

The term “operating income” is often used interchangeably with earnings before interest and taxes (EBIT), but there are differences between the two profit metrics. Both measure profit from 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.