What is operating income? Income operations are the core blood of your business, and it is the first thing a shareholder will ask their business partner in every meeting (Investopedia). Operating income shows how well your business is doing and helps you understand how to grow it to the next level. In this article, we will explain what net operating income is and how to calculate it for business audits.
What Is Operating Income / Operating Profit
Operating income is the money your business actually makes from running its day-to-day operations. It’s revenue minus the costs it takes to keep the lights on, pay employees, and make the product or service.
It’s the score that tells you if your core business is winning or losing, before taxes, interest, or other distractions.
Operating profit is the core value that a business generates (Investopedia).
The annual average of operating income reveals whether a company grew or shrank over the fiscal year. Analyzing it, at any given time, shows how well (or not) the business is performing.
Why It Matters?
Operational income matters because although it is not the bottom line, it is here to give you a clear picture of the company’s performance. Here are a few reasons that make operational income significant:
- Core Profitability: Operational cost is the final say on the performance of a company (Investopedia). A company always aims to turn a profit, and operational cost sheds light on whether a company succeeded in doing so.
- Efficiency Indicator: The operational cost will tell you whether a company is making a profit, and that will explain whether the company’s efficiency is at an optimal level.
- Strategic Director: The operational cost tells an auditing team which direction the company should take. Where to invest money and where to pull back financing.
- Informs Strategic Decisions: It helps guide management on where to control costs or improve processes for better profitability.
Operational income is one step away from final profit. When you subtract interest and taxes from operational costs, you get the final profit.
Real-World Example: Deriving Operating Income from an Income Statement
Let’s walk through a simplified example to understand operating income as it is calculated from an expense report (True Profit).
Income Statement Example:
| Item | Amount ($) |
| Revenue (Sales) | 10,000,000 |
| Cost of Goods Sold (COGS) | 6,000,000 |
| Gross Profit | 4,000,000 |
| Selling, General & Admin (SG&A) | 1,500,000 |
| Depreciation & Amortization | 400,000 |
| Operating Income | 2,100,000 |
| Interest Expense | 300,000 |
| Income Before Taxes | 1,800,000 |
| Taxes | 450,000 |
| Net Income | 1,350,000 |
Steps to Evaluate Operating Income:
- Revenue/Sales: $10,000,000
- Deduct Cost of Goods Sold (COGS): $10,000,000 – $6,000,000 = $4,000,000 (Gross Profit)
- Deduct Operating Expenses:
- SG&A: $4,000,000 – $1,500,000 = $2,500,000
- Depreciation & Amortization: $2,500,000 – $400,000 = $2,100,000 (Operating Income)
Key Points:
- Operating income comes from deducting COGS and other possible operating expenses from profit.
- Interest expense, taxes, and non-operating income are not included.
How to Increase Operating Income?
Companies can increase operating income by following best practices that reduce unnecessary expenses.
Outsourcing non-core areas of the business is also a great way because outsourcing services such as accounting and bookkeeping can provide up to 60% payroll savings. These companies, like Expertise Accelerated, have industry specialists because they are working with multiple companies in the industry. So, they are very beneficial in improving operating income.
Automation is another way to improve operating income. For example, businesses are increasingly turning to advanced enterprise resource planning (ERP) systems to streamline their accounts receivable processes. These platforms automate key functions such as payment processing, deposits, general ledger posting, and reconciliation, significantly reducing manual effort and error rates.
How to Calculate Operating Income:
How to calculate net operating income? Operating profit or operating income will be calculated by adding all the expenses other than taxes and any interest-related payments (Wall Street Prep). There are two ways to calculate operating income. We will discuss both here:
Easy Formula:
The common and easy formula to calculate net operating income is as follows:
Operating Earnings Gross Profit – Operating Expenses (Cost of Goods Sold (COGS)+ Operating Expense)
Advanced Method:
As most companies have a more advanced accounting setup, there is an advanced version to help calculate operating income.
Operating Income Total Income + Owed Interests + Tax Expenses (Include any other non-operating income or losses).
Glossary:
- Operating Earnings: The profit a company makes in the duration of calculation without deducting interest and taxes.
- Gross Profit/Total Income: The profit a company makes after paying all the dues they are owed.
- Owed Interest: Any interest that the company owes to any other organization.
- Tax Expenses: Any taxes that the company has to pay to the government (Wall Street Prep).
- Cost of Goods Sold (COGS): The financial payments for production, marketing, and delivery of the product.
Top-Down Approach
The top-down approach will anticipate and control the operating costs by getting ahead of them. Rather than calculating the cost after expenses are done. The top-down approach will calculate possible operating costs and define achievable profit targets within the predicted operating costs (Penn State Pressbook). The operating costs will be broken down into smaller components for clarity and better management.
The top-down approach helps leadership review expenses strategically and align spending with business priorities for maximum efficiency. For more practical strategies, explore these tips to operational cost to reduce waste and improve financial control.
Bottom-up / Reconciliation Method
The reconciliation method is a remnant of the old method, where every department dispatches its own operational costs, and they are combined to develop a full-scale assessment of operational costs. It is a comprehensive process that gives rise to a detailed operational cost assessment.
Comparison of the Two Methods:
| Aspect | Top-Down Approach | Bottom-Up / Reconciliation Method |
| Starting Point | High-level goals or targets that are company-wide | Detailed departmental inputs starting at the ground level |
| Decision-Making | Centralized and management-driven | Decentralized and department-driven |
| Level of Detail | Broad, strategic, but speculative | Detailed and operational |
| Time Consumption | Faster, efficient, but presumptive | Slower, detailed, and comprehensive |
| Flexibility | Predictive so less flexible, may overlook department-specific needs (FP&A Trends) | More flexible as it is derived from each department’s needs |
| Risk | Oversimplifying can make one miss operational challenges | Prone to overestimating and can miss out on company goals |
Drivers & Influencers of Operating Income
Operating income depends on cost management, market conditions, operational efficiency, and revenue growth.
Revenue Growth:
An Increase in sales volume, right pricing, and good market demand leads to revenue growth. New target markets and untapped territories are needed for revenue growth.
Cost of Goods Sold (COGS):
Optimal production process, supply chain efficacy, and reduced material costs are essential for a profitable cost of goods sold (COGS).
Currency Fluctuations:
Operating income is greatly affected by currency fluctuations, as most goods are imported and exported (Phoenix Strategy Group).
Management Strategy and Decision:
Strong leadership is essential for an ever-increasing operating income. From revenue growth to hedging to manage currency fluctuations, effective management is vital to delivering solutions.
External Factors:
Seasonality is one of the most common external factors to affect operating income. From retail products to food items to health and medicine, all product utility fluctuates seasonally.
Key Ratios & Operating Margin
How to calculate net operating income? Diving deeper into net operating income, here are a few key formulas that advanced business finance experts always keep in mind when assessing operating income.
Operating Margin:
Operating margin is at the core of operating expenses. It is a financial ratio that shows the revenue percentage that the business should gain after paying operating expenses like rent, raw materials, and production costs. These ratios do not include interest or taxes.
Operating Income Formula:
Operating Margin= (Operating Income\Revenue) ×100
Why: It’s a good way to know if a company is generating profit efficiently. Microsoft has an operating margin of 30-40% because of low variable costs. Walmart has a 3-5% operating margin because of competitive retail prices and higher cost of goods (COGS).
Gross Margin
Gross margin focuses on the cost of goods (COGS) and calculates the percentage of COGS without accounting for other expenses (Corporate Finance Institute).
Operating Income Formula:
Gross Margin={(Revenue−COGS) /Revenue}×100
Why: The production cost of any business shows how much revenue to expect. Tesla has an average gross margin of 20-25% while LVMH will have a gross margin of up to 60-70% as their production cost is far lower than their premium pricing.
Return on Assets (ROA)
Return on Assets (ROA) evaluates how effectively a company uses its assets to generate profit.
Operating Income Formula:
ROA=(Net Income/Total Assets)×100
Why:
ROA shows how your company is using its assets as an industry standard. Apple has a high ROA because hardware and software, or SaaS, require limited assets. Utilities company Duke Energy has low ROA because of its heavy capital investments in infrastructure and assets.
Return on Equity (ROE)
Return on Equity (ROE) shows how much profit was gained through shareholders’ financial investment (Investopedia).
Operating Income Formula:
ROE=(Net Income/ Shareholder’s Equity)×100
Why: Return on equity is a crucial question that stakeholders will ask. Banks have a high ROE of 10-15% while Procter and Gamble, a goods company, can have an even higher ROE of 15-25%.
Limitations, Adjustments & Caveats
There are limitations and caveats to every assessment. Here are a few limitations and needs for adjustment in operating income analysis.
Non-Monetary Expenses: Problems like amortization or depreciation will reduce profit, but they are hard to trace in operating income.
Non-Operating Elements: Taxes, interest, one-time buys, all impact profitability but are hard to predict for planning operating income.
Capital Working & Structure: Operating income can not reflect debt, financing disparities, and changes in working capital. These elements affect liquidity and debt financing.
Industry / Sector Variations
Operating income ballpoint averages vary greatly from one sector to another. Just as an example, Apple will have an operating income of 40% as a standard, while a bank will have the same operating income at 5% (Daloopa).
The changes in seasons also make the buying, selling, production, and utility of products vary greatly. One of the good business examples of operating income is that snow shuffle is rarely used in summer, and lemonades will not sell in winter. Most products and services are specific to different seasons and experience much lower demand in other times of the year.
FAQs
- What is the formula for operating profit?
Add all expenses other than taxes and debt, and subtract the total from net profit. You will get the operating profit.
- How to calculate operating profit from EBIT?
EBIT is the abbreviation for operating profit. They are the same. There is no calculation needed.
- Where do you find operating profit?
Operating profit is usually stated in an income statement generated by the company.
- Why do we calculate operating profit?
We calculate operating profit to understand whether the core operations of the company are generating profits or not.
Conclusion:
Operational income is essential to understanding how well a business is doing.Get it wrong, and every choice that follows is a guess. Get it right, and you gain clarity, control, and confidence. (Do you know, developing a clear and persistent record of operating income also helps in getting an excellent credit score (Salesforce).)
Expertise Accelerated is a top-dollar financial help team out of the USA. We have ACCA, CA, and CFA experts here to help ensure every aspect of your operating income is measured and reported accurately. Our clients achieve up to 60% payroll savings compared to the US counterparts. Ready to see your finances with clarity? Call now, and let’s get started.