How to Calculate Operating Income

Operating income is your business's revenue minus its total operating expenses. It's important because it allows investors to see how your business will become profitable over time, and it can give you an idea of how effective your business is running.

Operating income doesn't take into account changing factors like income taxes or depreciation that might be more or less from year to year. It measures the amount of money your business can make on top of the cost of its business operations. Your company's operating profit is more than just a line on your income statement; it's a core business tool for judging your company's worth.

This guide will give you the rundown on what operating income is and how you can figure it out for your business. If you're not an accountant, you may not enjoy keeping track of your company's finances. Skynova has software that makes processes like managing invoices, calculating taxes, and journaling transactions fast and simple.

What Is Operating Income?

Your net sales are your total revenue after accounting for discounts and returns. Your operating income is the amount of revenue you have left over from your net sales after taking out your direct and indirect operating expenses. It's one of the most important figures that investors use to evaluate the worth of your business.

Direct operating expenses are things like materials, tools for manufacturing, and your workforce. These are anything you use to directly create what you sell. For example, if you own a handmade jewelry business, a worker who puts together the jewelry would be considered a direct expense. Another term for direct operating costs is the cost of goods sold (COGS).

Indirect operating expenses are things like rent, administrative costs, utilities, and office supplies. They are known as selling, general, and administrative expenses (SG&A). These items help you to conduct business but aren't instrumental in creating anything you sell. For example, if you have a supervisor to manage your workers' productivity, the manager's salary would be considered an indirect expense.

Both direct and indirect expenses can be fixed (always the same) or variable (can change month to month). When you deduct your company's total operating expenses (both direct and indirect) from its revenue, you'll have your net operating income and can see how well your business performs at covering its expenses.

Operating Income vs. Earnings Before Interest and Tax (EBIT)

The earnings before interest and tax (EBIT) is your business's net income from operations before accounting for taxes and the capital structure of your business. Operating income and EBIT can often be used interchangeably.

However, they're not always the same. Sometimes, business owners will include nonoperating earnings or nonoperating expenses in the EBIT, as well. Nonoperating income is profit gathered from means not directly related to your company's core business activities (the products you sell). An example of this would be dividend or interest payments from an investment. Nonoperating expenses are costs for things like paying off debt or loans.

It's also important to note that operating income is identified by the United States Securities and Exchange Commission (SEC) as a general acceptable accounting principle (GAAP), while EBIT is not. GAAPs are official standards that businesses and investors can use to measure a company's value.

What Are Examples of Operating Income and Net Income?

Let's say you have a shoe company that makes $3 million in revenue for the year. Your direct and indirect operating costs total $2 million. That means your company has an operating income of $1 million.

However, your business is paying off a loan. During this particular year, it pays $500,000 toward its debt and $200,000 in taxes. Both of these expenses eat into your operating income, making your net income for the year $300,000.

This is an oversimplified example. For a real business, you'd also have nonoperating income to take into account, but it shows how an investor can use operating income figures to gain insight into a business's future profitability.

If an investor only looks at your shoe company's net income, they don't know that the business covered all of its operational costs and made an additional $1 million. As the company pays off its debt, its net income will rise, making the business more valuable.

How to Calculate Operating Income

To determine your company's operating income, you'll have to figure out a few factors first. You'll need to know your company's revenue, gross income, and its operating expenses (both indirect and direct). Here are two equations you can use to figure out your company's operating expenses:

Step 1: Determine Direct Operating Costs

Direct operating costs (also known as the COGS) are expenses directly involved in the making of your products. When tallying up your direct operating costs, be sure to include things like:

• Raw materials
• Direct labor costs (assembly line workers or anyone who builds the product)
• Supplies (factory equipment and other gear)

For example, if your company spends $15,000 on raw materials, $200,000 on direct labor, and $50,000 on supplies, its direct operating expenses will be $265,000.

Step 2: Determine Gross Income

Gross income (also known as gross profit) is your company's net revenue minus its direct operating costs. It shows how much profit your business makes after covering its direct operating costs. On a side note, your company's gross income is also the amount you'll use to determine its taxes.

If your company's revenue is $2 million and its direct operating expenses are $265,000, its gross income is $1,735,000.

Step 3: Determine Indirect Operating Costs

Indirect operating costs (also known as SG&A) expenses are indirectly involved in the making of your products. When you're adding together your indirect operating expenses, take into account things like:

• Rent
• Utilities
• Wages for supervisory and administrative workers (e.g., secretaries, management, quality control, and anyone else who doesn't directly make a product)
• Office supplies (e.g., computers, staplers, and administrative tools)
• Insurance

If your company spends $100,000 on rent and utilities, $50,000 on office supplies, and pays its management and administrative assistants $700,000, its indirect operating costs will total $850,000.

Step 4: Calculate Operating Income

Now that we know all the factors, we can use them to start calculating operating income for a business using either of the two formulas:

Or:

Let Skynova Help You Manage Your Small Business Accounting

Assessing your business's potential is a little more complicated than simply looking at its bottom line. Several other metrics and financial ratios can be just as important, if not more so, in predicting success as a company's profits.

Your financial statements have several figures that can help you evaluate your company's performance. One of the most vital figures for valuing your business is operating income. Operating profit can give investors a clearer view into your company's future profit margin than net income alone.

Being a small business owner is exciting, but doing everything you can to get your company off the ground can be draining. Skynova has accounting software to help streamline your business's accounting so you can focus on doing what you love — running your business.

Notice to the Reader

The content within this article is meant to be used as general guidelines and may not apply to your specific situation. Always consult with a professional accountant for specific advice regarding accounting best practices.