Net Operating Income Definition
Net Operating income is a measure of profitability which represents the amount the company has earned from its core operations and is calculated by deducting operating expenses from operating revenue.
- Net operating income excludes non-operating expenses such as loss on sale of a capital asset, interest, tax expenses etc. Net operating income reflects the effectiveness of the business’s core operating performance.
- Net operating income does not include revenue from the activities which are not directly related to the business such as income from investment, gain on the sale of capital asset etc.
- The concept of net operating income is essential for the creditors and the investors of the business as it gives them a clear picture of the working of the business that how effectively the operations of the organization is performed and how much income is generated from the core business activities of the business.
Below is the formula of Net Operating Income –
- Net Operating Income Formula = Operating Revenue – Operating Expense
- Net Operating Income Formula = Operating Revenue – COGS – SG&A
Operating revenue is the revenue generated from day to day operations of a business. We can take the example of a company involved in the business of selling mobile phones. Now in a financial year, a company has sold mobiles worth $500,000 and equipment at $100,000 earning a profit of $5000. Now in the given case only $500,000 is operating revenue as it is only related to the core activity of the business and profit on the sale of equipment is not a part of operating revenue. Operating revenue doesn’t include income from extraordinary activities.
Operating expenses include all the cost or expenses which are directly related to the business activity. In other words, operating expenses include all type of cost which is required to be incurred in running the day to day operations of the business. Some of the examples of operating expenses are Salary & Wages, Raw material cost, Power & fuel, Rent, utilities, Freight and postage, and advertising. Operating Expenses exclude Income taxes, losses from the sale of assets, interest expense etc. For instance, suppose you paid $300,000 in cost of goods sold, $15,000 in wages, $25,000 in Rent, $4,000 in utilities, $1,500 in interest and $28,000 in income taxes. Your total operating expenses are $344,000, which excludes the interest and income taxes.
Steps to Calculate Net Operating Income
Let us understand the steps to calculate Net Operating Income formula with the help of Colgate Example
Step 1 – Find the Operating Revenue – Identify the core revenue of the business as given in the income statement. Read through the annual report to see what else is included in the Sales / Net Sales figures of the company.
We note that sales of Colgate were $16,034 million in 2015 and $17,277 million in 2014.
Step 2 – Remove Other revenues from these items – If there are revenue sources other than the core operations of the business, then you must exclude those items.
In Colgate, we don’t have any such items.
Step 3 – Find the Operating Expense – Operating Expense can be easily identified from the income statement. It is basically the sum total of Cost of Goods Sold and Selling, General and Admin expenses. Any other expense that is directly related to the business should be included. All other expenses should be excluded from the formula of net operating income calculation.
In Colgate, we note that
- Operating Expense (2015) = COGS + SG&A = $6,635 + $5,464 = $12,099 million
- Operating Expense (2015) = COGS + SG&A = $7,168 + $5,982 = $13,150 million
Step 4 – Remove other expenses not related to the business – Other expenses unrelated to the business should be not included in the calculation of Net Operating Income
In Colgate, we note that there is other expense of $62 million in 2015 and $570 million in 2014, respectively. In addition, do not include the non-recurring charges of Venezuela accounting changes of $1084 million
Step 5 – Use Net operating income formula
- Colgate’s Net Operating Income (2015) = $16,034 million – $12,099 million = $3,935 million
- Colgate’s Net Operating Income (2014) = $17,277 million – $13,150 million = $4,127 million
Net Operating Income Illustration
Let’s take the example of a pizza outlet owned by Mr. X in California that cooks the best pizza in their area. Mr X is working on the refinancing of his current loans with a nearby bank, so needs to calculate NOI.
After analyzing the accounting system Mr. X analysis the following income and expenses incurred in the business.
- Sales: $180,000
- Cost of goods sold: $40,000
- Salary & Wages: $35,000
- Rent: $15,000
- Insurance: $20,000
There has been a fire in the pizza outlet during the financial year. Loss on fire estimated to be $45000. Unfortunately, the insurance company failed to cover all the damages. Mr. X would calculate his operating income like this:
Now Mr. X will deduct all the expenses from the revenue getting $70,000 as a profit from operations. Here the loss on fire of $45,000 is not included because it is an extraordinary business loss, not an operating activity. Therefore, Mr. X will report $70,000 as his net operating income, not $25000 ($70,000- $45000)
Net Operating Income Application
The parties related to the business like creditors, investors and the management itself use this measure to analyze and evaluate not only the profitability but also efficiency of operations, future prospects and overall health of the business. The higher the net operating income of the company higher is the chances of the company surviving in the future and higher chances of paying debts and returns to the lenders and investors respectively.
The increasing trend in this number of operating income indicates that there is more scope for the company to grow in the future and vice versa. Creditors and investors always want to deal with the company having an increasing trend as the possibility of getting a higher return is more in that type of business.
Now in our example, creditors and investors will acknowledge the fact that there had been a loss in the organization but it doesn’t affect them much as it is an extraordinary item and their main business is of selling Pizzas.
This is different from that of net income, as net income is bottom-line profit calculated after taking into consideration all expenses and revenues. Extraordinary gains and losses which are one time, Interest and taxes can distort the net income sometimes which will provide a different picture of the business then it is in reality. In that case, it is used by the parties as there are fewer chances of these figures getting manipulated. It is important for one to review the net income but at the same time reviewing net operating income is also important as it provides a comparison on a consistent basis from one period to another.
This has been a guide to what is Net Operating Income. Here we discuss step by step how to calculate Net Operating Income using its formula along with practical examples and applications. You may learn more about our articles below on accounting –