What is Operating Income?
Operating Income is defined as the difference between Gross Profit and Operating Expenses of the business. It is also known as Operating Profit or Recurring Profit as it 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 popularly denoted with the term Earnings before Interest and Tax (EBIT).
In short, it is the Income/profit earned after all expenses except finance cost is adjusted for.
Methods of Calculating Operating Income
Use different methods to calculate operating income. Some of the popular formulae of Operating Income are mentioned below:
1) Operating Income= Gross Profit- Operating Expenses
- Gross Profit =Net Sales – Cost of goods sold
- Operating Expenses = 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 Tax (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.
Examples of Calculating Operating Income
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 back 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 calculate the Operating Income (discussed above)
First we will find out the Net Sales, Cost of Goods Sold and Operating Expenses
Step 1 – Find the Net Sales
Step 2 – Find the Cost of Goods Sold
Step 3 – Calculate Total Operating Expenses
Step 4 – Find the Operating Income
Now from the above information, we will calculate Operating Income.
Thus ABC Limited made an Operating Income of $400 during the year.
(Remember we have not included Interest and Tax Expenses as they are outside the purview of Operating Income.)
Operating Income Example – Boeing Inc
Let’s understand the same with 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 the 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 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 Margin 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.
Advantages of Operating Income
- This is used to measure the Operating Efficiency of the business and by calculating Operating Income Margin of different business, one can compare the 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 Institution which provides lending to the business. Various important ratios such as Interest Coverage Ratio are derived from Operating Income only (Interest Coverage Ratio= Operating Income/Interest Payment)
Disadvantages of Operating Income
- This excludes Interest Cost and Tax Expenses of the business and 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 includes non-operating items such as gains on Investment and as such, any stakeholder/Analyst must ensure consistency in 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 result in cash outflow.
Conclusion
This 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 Income from its purview.
Furthermore, it helps in measuring the operational success of the business and is unaffected by the financial leverage 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 incurred by the business in fulfilling those sales by taking all operating expenses.
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