Operating Earnings Definition
Operating Earnings or Operating Income is the amount of profit a company earns after deducting operational direct and indirect costs from sales revenue. It is also known as EBIT i.e. earnings before interest and taxes. We don’t consider Interest and Taxes and other non-operational income while calculating Operating Income.
Operating Earnings is the number of profits that the company earns from its core operations. It is one of the important concepts which help the investors and creditors to know about the profit that the company is generating from its core business.
In order to calculate the operating profit of the company, we need to understand and distinguish between various types of costs and how they appear in our Income StatementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.. There are three types of financial statementsTypes Of Financial StatementsThere are three types of financial statements, i.e., Balance Sheet, Income Statement and Cash Flow Statements. These written records facilitate the analysis and comparison of an organization's financial position and performance. that a company prepares, Income Statement, Balance Sheet, and Cashflow Statement. Income Statement shows the profitability of the company. Balance sheets SheetsA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company. show the Assets and Liabilities of the company. And the use of the Cash flow statement is to know about cash inflows and outflows of the company. Operating Profit is a part of the Income Statement of the company.
Operating Earnings Formula
There are three formulas to calculate Operating Earnings:
- Total Revenue: This is the total sales revenue earned by the company by selling its goods to the customer. Let’s understand the different terms used in the above formulas.
- Direct Costs: Direct costsDirect CostsDirect costs are costs incurred by an organization while performing its core business activity and can be attributed directly in the production cost, such as raw material costs, wages paid to factory staff, power & fuel expenses in a factory, and so on, but do not include indirect costs such as advertisement costs, administrative costs, etc. are the expenses directly associated with the cost of manufacturing any goods or providing any service. E.g., labor costLabor CostCost of labor is the remuneration paid in the form of wages and salaries to the employees. The allowances are sub-divided broadly into two categories- direct labor involved in the manufacturing process and indirect labor pertaining to all other processes., raw material cost.
- Indirect Costs: These are the cost which cannot be directly linked with the manufacture of a product. These are also called as overhead costsOverhead CostsOverhead cost are those cost that is not related directly on the production activity and are therefore considered as indirect costs that have to be paid even if there is no production. Examples include rent payable, utilities payable, insurance payable, salaries payable to office staff, office supplies, etc.. E.g., Rent and salary costs.
- Gross Profit: We calculate Gross Profit or Gross Income by subtracting the Cost of Goods Sold from Revenue.
- Operating Expense: These are the expenses incurred in running the core business. E.g., Rent, wages, and Insurance cost.
- Depreciation & Amortization: It is the cost of wear and tear of tangible and intangible assetsIntangible AssetsIntangible Assets are the identifiable assets which do not have a physical existence, i.e., you can't touch them, like goodwill, patents, copyrights, & franchise etc. They are considered as long-term or long-living assets as the Company utilizes them for over a year. .
- Non-Operating Income: Income earned from other than the core business activities; E.g., profit from the sale of assets.
- Non-Operating Expense: Expenses not related to the running of the core business. E.g., interest cost and taxes.
How does Operating Earnings Work?
The Operating Profit works as per the below order. We have a Sales revenue figure from which we reduce COGSCOGSThe cost of goods sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company., i.e., the cost of goods sold, which includes Raw material cost, wages cost, etc. to get Gross Profit. Other Operating expenses such as Rent, Insurance cost, depreciation, etc. are reduced from Gross ProfitGross ProfitGross Profit shows the earnings of the business entity from its core business activity i.e. the profit of the company that is arrived after deducting all the direct expenses like raw material cost, labor cost, etc. from the direct income generated from the sale of its goods and services. to get Operating profit figures.
There is another method to calculate Operating profits. We can start from the bottom of the income statement, i.e., take the Net Profit figure and add back Interest expense and Taxes to get the operating profit of the company.
There is a Shoe Manufacturing Company, calculate Operating Profit from below provided information.
Sales Revenue $3,00,00,000 Cost of Goods Sold $1,00,00,000 Marketing & Sales Expense $20,00,000 Office and Admin Cost $10,00,000 Depreciation Cost $20,00,000 Interest Cost $10,00,000 Tax rate 30%.
Calculation of Operating Earnings
The Operating Earnings = Total Revenue – COGS – Indirect Costs
- = 3,00,00,000 – 1,00,00,000 – (20,00,000 + 10,00,000 + 20,00,000)
- = 1,50,00,000
Operating Income = Gross Profit – Operating Expense – Depreciation & Amortization
- = 2,00,00,000 – (20,00,000 + 10,00,000) – 20,00,000
- = 1,50,00,000
Operating Income = EBIT – Non-Operating Income + Non-Operating Expense
- = 1,50,00,000 – 0 + 0
- = 1,50,00,000
- Net Profit = 9800000
It is an important indicator of how business is performing. It is also used in calculating various financial ratiosFinancial RatiosFinancial ratios are indications of a company's financial performance. There are several forms of financial ratios that indicate the company's results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on..
Creditors, Investors, and Management closely monitor the EBIT of the company to track the company’s performance. This is an important aspect to consider while making a decision to invest as investors can compare the different companies at their operating level.
Operating Profit is an indirect measure of the Company’s profitability. Higher the operating income, the more profitable a company is.
Hence, Operating Earnings is an important concept which helps to know about the company’s financial health. Although Net Profit plays an important role in understanding the company’s financial health if we are comparing companies with different tax structures and finance structures, then the Operating profit will give us a more accurate picture.
This has been a guide to Operating Earnings and its definition. Here we discuss the formula to calculate operating earnings along with examples and its importance. You may learn more about financing from the following articles –