Operating income is a company’s profits after deducting operating expenses. This type of income is commonly calculated in accounting and investment banking to measure profitability. Operating expenses include costs associated with production and regular business obligations like employee wages. Calculating a company’s operating income involves looking at gross profits and subtracting all costs related to operations.
In this guide, we’ll go over:
- Operating Income Definition
- How to Calculate Operating Income
- Example Calculation
- Showing You Understand Operating Income on Resumes
- FAQ
Operating Income Definition
Operating income, also called operating profit, is the amount of money a company generates from sales after subtracting operating expenses. These expenses are costs related to any normal business function. For example, ordering paper for the printers, paying rent for an office space, or hiring an outside accountant for tax season all count as operating expenses.
Operating expenses also include the cost of goods sold (COGS). COGS is money spent on producing and selling a product. Things like inventory, raw materials, labor, and marketing are all expenses that fall under COGS.
A good way to determine if an expense would or would not fall into this category is to ask: If we did not produce or sell any product right now, would this cost still have been necessary? Employee salaries, mortgages, insurance, and utilities still need to be paid even if no products are sold. But, if a company pauses production for a period of time, it won’t incur the costs associated directly with production — those costs are COGS.
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Who Deals With Operating Income?
Accountants are responsible for tracking and reporting operating income. Accountants typically report this metric on financial statements like the income sheet and the statement of operations, which also gives an overview of COGS, sales numbers, and operating expenses.
Investment bankers and finance professionals in mergers and acquisitions may use a company’s operating income when considering investment options and doing comparable company analyses. Since operating profit doesn’t reflect taxes, analysts can use it to compare companies in states or countries with differing tax systems.
A company’s finance team will also use operating profit when reviewing spending and budgeting. Operating income is a great way to test profitability when compared to sales, and finance teams can use it to determine how well a company manages operating expenses.
>>MORE: See how operating income and financial statements work in real business settings with the Chartered Accountants ANZ Accounting and Business Performance Virtual Experience Program.
How to Calculate Operating Income
There are several ways to calculate operating income. However, each formula is just a different way to express the same idea: Take a company’s sales profit and subtract all costs related to running the business, except for interest and taxes.
Operating Income Formulas
Option one:
Operating Income = Total Revenue – Direct Costs – Indirect Costs
Option two:
Operating Income = Gross Profit – Operating Expenses – Depreciation and Amortization
Option three:
Operating Income = Net Earnings (Profit) + Interest + Taxes
Which formula you choose depends on the information you have on hand. For example, if you have information on net earnings but not on gross profit, the third formula may be the best choice. On the other hand, if you can easily calculate or access direct and indirect cost details, you can use the first formula.
Components of the Formulas
- Total revenue: Revenue from all income sources, also called gross revenue
- Direct costs: Expenses related directly to the production of goods (COGS)
- Indirect costs: Costs a company incurs that are not directly involved in the production process but are still operating expenses (i.e., expenses for the shipping and transportation of products)
- Gross profit: Revenue from sales minus the total cost of goods sold
- Operating expenses: Costs related to normal business functions
- Depreciation and amortization: Cost of assets, expensed over time, representing a gradual loss in value of assets (i.e., total value of a copyright broken down over the lifetime of the license)
- Net profit: Income minus COGS, depreciation, amortization, expenses, taxes, and interest
Example Calculation
For this example, we will use the first formula option that starts with total revenue. Imagine a wireless headphone manufacturer with $2,000,000 in total revenue from 2022.
The company incurred the following direct costs:
- Raw materials (plastic housing, speaker components, battery parts): $200,000
- Labor: $175,000
- Utilities for the manufacturing plant: $75,000
- Supplies for manufacturing: $50,000
So, the company’s total direct costs for the year are: $500,000
The company also incurred indirect costs:
- Rent for office and manufacturing space: $275,000
- Marketing expenses: $65,000
- Employee salaries: $250,000
- Office supplies: $40,000
- Shipping and transportation: $105,000
- Depreciation and amortization: $15,000
The company’s total indirect costs for the year are: $750,000
We can then put these numbers into the formula:
Operating Income = $2,000,000 (revenue) – $500,000 (direct costs) – $750,000 (indirect costs)
The company’s operating income for 2022 equals $750,000.
Without the context of similar companies’ income or information about the company’s historical trends, knowing the company’s operating income alone doesn’t tell an outsider much. However, this information is useful for the business’s finance team to see where they are spending a lot of money and to determine ways to increase operating profit.
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Example of Operating Expenses on Financial Statements
Public companies report financial statements to the U.S. Securities and Exchange Commission (SEC). So, it is easy to source financial details for these businesses. Looking at Apple’s statement of operations from its 2022 10-K report, we can see its operating income for the year:
Notice the increase in Apple’s reported operating income for 2022 compared to 2021. Increases to operating profit are typically due to changes in production costs (finding cheaper ways to produce more products) and lowering the total of indirect expenses by renegotiating property leases, finding less expensive ways to ship and transport goods, and improving overall efficiency.
>>MORE: Explore if finance is the right career path for you.
Showing You Understand Operating Income on Resumes
You can highlight your skills in calculating and using operating income by:
- Mentioning any experience you have creating financial statements
- Discussing an instance where you built a budget for a commercial business
- Showing your familiarity with profitability metrics like profit margins
- Explaining a time you used operating income as a factor in a comparable company analysis
These experiences can come from previous jobs, internships, or intensive projects you completed during school or university. Certain things, like creating a financial statement, can be listed in the skills section of your resume. Other experiences may be better explained in your cover letter, like implementing a budget for a company and the impact it had on the company’s finances.
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FAQ
No, operating income is the income generated by core business activities and doesn’t account for variables like taxes and interest payments. Net income is the “bottom line” for a company’s finances — all income left over after every obligation and expense is paid.
Operating income can be the same as EBIT for companies that don’t generate non-operating income through things like investments and selling assets. Income from non-operating activities is included in EBIT but not in operating profit.
Operating income is also called operating profit. It is sometimes referred to as EBIT, too.
A good operating income depends on the company. In general, a company must have enough operating profit to cover taxes and interest expenses to break even. Negative operating income means the company will require funding to maintain business operations.
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