What is Operating Income?
Operating Income, also known as EBIT or Recurring Profit, is an important yardstick of profit measurement and reflects the operating performance of the business and doesn’t take into consideration non-operating gains or losses suffered by business, the impact of financial leverage and tax factors. It is calculated as the difference between Gross Profit and Operating Expenses of the business.
In short, it is the Income/profit earned after all expenses except finance cost is adjusted for.
How to Find Operating Income
Some of the popular Operating Income formulaeOperating Income FormulaeThe operating income formula (also known as the EBIT formula) is a profitability formula that helps in calculating a company's profits generated from core operations. The formula is a decision tool that allows investors to assess how much gross income will result in profit for a firm. The operating income can be calculated by deducting the cost of goods sold and operating expenses from total revenue. are mentioned below:
1) Operating Income= Gross Profit- Operating Expenses
- Gross Profit =Net Sales – Cost of goods soldCost Of Goods SoldThe 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.
- OpexOpexOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit.= General Administrative Expenses+ Selling and Distribution Expenses+ Depreciation
2) Operating Income= Net Sales – Direct Cost – Indirect Cost
3) Operating Income= Net Sales – Cost of Goods sold – Operating Expenses
4) Operating Income= Profit After TaxProfit After TaxProfit After Tax is the revenue left after deducting the business expenses and tax liabilities. This profit is reflected in the Profit & Loss statement of the business. (PAT) + Tax Expenses + Interest Expenses (Finance Cost)
As we can see, all these formulas can be used to derive the Operating Income, and the user can opt for any of the above to calculate Operating Income for the business.
Operating Income Examples
Let’s understand the concept of Operating Income calculation with the help of a few examples:
ABC limited is in the business of making customized gifts. The company reported total sales of $4200 during the year ended Dec 2018. Out of the total sales, $200 was returned to the company on account of defects. The company incurred the cost of goods sold amounting to $3000 during the year in the manufacturing of customized gifts.
Following are the expenses incurred by the company during the year:
Based on the above information, we can do the calculation.
First, we will find out the Net Sales, Cost of Goods Sold, and Operating Expenses.
- Find the Net SalesNet SalesNet sales is the revenue earned by a company from the sale of its goods or services, and it is calculated by deducting returns, allowances, and other discounts from the company's gross sales.
- Find the Cost of Goods Sold
- Calculate Total Operating Expenses
- Find the Operating Income
Now from the above information, we will calculate the following.
(Remember we have not included Interest and Tax Expenses as they are not included in the calculation.)
Let’s understand the same with the help of another operating income calculation example of a large listed company Boeing Inc.
Following are the P&L Account of Boeing Inc for the last 3 years
source: Boeing Annual Report
From the above screenshot, we can easily see how this Income (Earnings from Operations) of the company has changed over the year 2008 to 2010 and can perform analysis to measure Operational Efficiency.
Points worth noting based on the above analysis:
- From 2008 to 2010, Revenues increased by 5.58% ( $64306 in 2010 versus $60909 in 2008). However, Interest Coverage Ratio decreased from 19.55 times in 2008 to 9.63 times in 2010. It is important to note that a higher Interest Coverage Ratio is a better sign of the financial health of the business.
- From 2008 to 2009 Revenues increased by 12.10% ( $68281 in 2009 versus $60909 in 2008); however, Operating Income decreased by $1854 in absolute terms ($2096 in 2009 versus $3950 in 2008) and Operating Profit MarginOperating Profit MarginOperating Profit Margin is the profitability ratio which is used to determine the percentage of the profit which the company generates from its operations before deducting the taxes and the interest and is calculated by dividing the operating profit of the company by its net sales. Ratio decreased from 6.49% in 2008 to a meager 3.07% in 2009.
It helps in understanding the Revenue growth and Profit growth in better terms and helps in making meaningful insights into the business.
- It is used to measure the Operating Efficiency of the business, and by calculating the Operating Income Margin of different businesses, one can compare operational efficiency.
- Computation is simple and mostly standardized, which leads to an easy comparison between firms as well.
- It is closely linked and monitored by Banks and Financial Institutions, which provides lending to the business. Various important ratios, such as Interest Coverage RatioInterest Coverage RatioThe interest coverage ratio indicates how many times a company's current earnings before interest and taxes can be used to pay interest on its outstanding debt. It can be used to determine a company's liquidity position by evaluating how easily it can pay interest on its outstanding debt., are derived from Operating Income only.
- It excludes Interest Cost and Tax Expenses of the business. It, therefore, is not a correct benchmark for determining the Net value of wealth created by the business for different stakeholders.
- Certain companies, while calculating Operating Income, sometimes include non-operating items such as gains on Investment. As such, any stakeholder/Analyst must ensure consistency in the calculation method before making any comparison and resultant inferences.
- It doesn’t find much usage if one is interested in finding the free cash flows of the business as it doesn’t adjust for Interest expenses, which results in cash outflow.
Operating Income is an important yardstick which highlights the operational efficiency of the business and how good management is at turning their efforts into profits. It helps potential investors and lenders of the business to assess how profitable is the business in which they intend to invest/lend as it shows the company’s core business Income and excludes all Non-Operating IncomeNon-Operating IncomeNon-Operating Income, also called Peripheral Income, is the capital amount that a business earns from non-core revenue-generating activities. The examples include profits/losses from a capital asset sale or Foreign Exchange Transactions, Dividend Income, Lawsuits losses, & Asset Impairment losses, etc. from its purview.
Furthermore, it helps in measuring the operational success of the business and is unaffected by the financial leverageFinancial LeverageFinancial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively. and tax factor. The success of a business is determined by how well a company is managed and it helps in meeting these criteria as it clearly highlights the demand for the business product and services by taking into consideration Sales and also the cost incurredCost IncurredIncurred Cost refers to an expense that a Company needs to pay in exchange for the usage of a service, product, or asset. This might include direct, indirect, production, operating, & distribution charges incurred for business operations. by the business in fulfilling those sales by taking all operating expenses.
This article has been a guide to what is Operating Income and its definition. Here we discuss how to calculate operating income with the help of practical examples. You can learn more about accounting from the following articles –