In the early years of its operations, the difference between net income and operating expenses is probably minimal for a small business. The same is true for most freelancers and independent contractors. However, as you grow and expand your company, you must understand how to calculate and use these two indicators of profitability.
Net income is what's left after deducting the cost of goods sold (COGS), operating and non-operating expenses, depreciation and amortization, and taxes from the total income. This is why net income is also called net earnings or a company's bottom line. On the other hand, operating income is the amount left after you deduct operating expenses from gross income. Add back operating expenses, depreciation and amortization, and you'll get the operating income amount.
Both metrics measure your company's income, except that net income also includes proceeds from additional streams of income and any non-operating expenses. Keep reading as we review operating income and net income and list the differences between the two.
What Is Operating Income?
Operating income is your company's earnings after accounting for expenses incurred during its day-to-day operations. It's a metric that allows you to see your business's profitability if you only account for ordinary operating expenses. This is why operating income is also called operating profit or earnings before interest and taxes (EBIT) because it doesn't account for taxes or interest expenses.
Operating Expense Examples
Operating expenses refer to any fixed or variable expenses that a business incurs through its normal everyday operations. Generally, operating expenses are tax-deductible. But before you go on a shopping spree and attribute the charges to your business, take note of the Internal Revenue Service's (IRS) definition of a business expense.
"A business expense must be both ordinary and necessary." An ordinary expense refers to common and accepted costs in your trade or business. A necessary expense is one that's helpful and appropriate for your business activities.
Examples of business operating expenses include:
- Computers, equipment, and office furniture
- Salaries and wages
- Advertising and marketing expenses
- Insurance costs
- Software subscriptions
- Depreciation and amortization
How to Calculate Operating Income
To calculate your operating income, deduct your company's cost of goods sold (COGS), operating expenses, depreciation and amortization from the gross income or total revenue.
|− Operating Expenses
|− Depreciation & Amortization
|= Operating Income
Your operating income represents your business income based on fixed and variable expenses you incur as you conduct business. It gives you a picture of your business's growth. You can also compare your company's year-to-year operating income to check if something you changed yielded more profit and growth.
Aside from operating expenses, you also have the following to calculate operating income:
- COGS: It accounts for the direct costs of production, such as raw materials, direct labor, equipment and utility expenses for the production site.
- Depreciation and amortization: You'll record depreciation expenses for fixed or capital assets that have a useful life of more than a year, such as computers, equipment or vehicles. Amortization is used to expense costs of intellectual properties, such as patents, trademarks and copyrights.
Use the operating income amount to calculate your operating profit margin, as well. Here's the formula:
|Operating Profit Margin
To illustrate, let's assume an operating income of $55,000 and total revenue of $100,000 for a freelance wedding photographer. Using the formula, you'll get:
|Operating Profit Margin
What does this mean? It means for every dollar of revenue, the business owner in the example retains a profit of 0.55 cents after accounting for operating expenses.
As a business owner, you must understand the breakdown of where your profit comes from. Looking at your operating profit margin, you may decide to go through your expenses and see where you can cut and save. Reducing your operating expenses will allow you to keep more of your income.
For instance, if your office rent is relatively high, you can look for office-sharing opportunities or operate out of your home to reduce expenses. Or you may look at whether your advertising costs are showing any return on investment, for which you may decide to handle your social media marketing on your own.
What Is Net Income?
Net income is the amount left over after you've deducted all expenses from your total revenue for a given period. Net income is commonly referred to as the company's bottom line because it's the last line on the income statement. It's also called net earnings or earnings after tax (EAT).
The computation for net income includes operating income and proceeds from other revenue sources, such as interest income or the sale of assets. It also accounts for taxes, operating expenses, the COGS and other non-operating expenses.
Non-operating expenses or extraordinary expenses are costs you incur that are not considered ordinary or necessary to your core business operations. Examples are borrowing costs, such as interest paid on loans, losses on disposal of assets, or penalties and lawyer's fees in case of lawsuits.
How to Calculate Net Income
Calculate net income by adding up proceeds from all revenue streams and deducting all expenses and taxes within a given period. Only add or deduct amounts earned or spent within the period you want to measure - monthly, quarterly or yearly. Follow the formula below to compute your company's net income:
|+ Investment Income
|− Interest Expense
|+ Extraordinary Income
|− Extraordinary Expenses
|= Net Income
Here's a breakdown of the variables included in the formula:
- Operating income: This represents income from your business's regular operations within a given period. Sales and revenue are other terms used to refer to operating income.
- Investment income: This line accounts for any income your business receives from other sources, such as investment income, dividends or interest income.
- Extraordinary income: This refers to income not earned from operations or other sources of income but may happen from time to time as part of running a business. An example is proceeds from the sale of assets.
- Operating expenses: These are ordinary and necessary expenses you incur in everyday business operations.
- Interest expense: This line item accounts for interests you paid for loans you took out to start or expand your business.
- Extraordinary expenses: These are expenses not considered ordinary but may occur as part of owning a business. Examples are losses you incur from the sale of assets or lawyer's fees from resolving a client dispute.
- Taxes: This line accounts for income taxes and self-employment taxes.
Your net income shows you the total income and expenses of your business over a specified period. It measures your company's profitability and shows you how unexpected expenses affect your bottom line. Tracking your net income will also let you compare your profit over time.
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What's the Difference Between Operating Income and Net Income?
Below is a review of the differences between operating income and net income.
Even though operating income and net income both measure your company's profitability, understanding each figure can help you make decisions for your business in specific aspects. For instance, operating income is useful for business owners to identify and reduce avoidable operating expenses. In contrast, net profit represents your company's overall profitability, which helps you determine what other expenses outside of your operating costs are reducing your bottom line.
The most considerable difference between operating income and net income is their treatment of taxes. By definition, operating income only accounts for the costs associated with the day-to-day operations of doing business and doesn't include taxes paid in its calculation. On the other hand, net income is calculated by deducting all expenses of the business, including taxes (income taxes, self-employment taxes, payroll taxes, etc.).
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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 to ensure you're getting individual advice.