“Operating Income” is one of the core formulas of Accounting, which is also referred to as “operating profit” or EBIT (Earnings Before Interest & Taxes). It is the net earnings of a company, deducting all the operating expenses from its sales revenue. Simply put, it counts the amount of money a business organization or a company makes from its activities. Operating income is shown in the “income statement” of a company as a subtotal of its earnings. It also indicates the money made by a certain company, indicating whether the company is performing well or not.
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What You Should Know About Operating Income
Formulas to Calculate Operating Income
There is a total of three formulas to calculate operating income. You can choose either of them for your yearly income statement.
1. Operating income = Total revenue – Direct Costs – Indirect Costs
2. Operating income = Gross profit – Operating Expenses – Depreciation – Amortization
3. Operating income = Net Earnings + Interests Expense + Taxes
For example, “In n Out” is one of the most famous fast-food chains in California. While analyzing sells and expenses, the accountant found out that they sold $300,000 worth food last year and the expenses were:
Cost of goods: $55,000
Apart from all these expenses, a part of this shop burnt down which lead to a total loss of $60,000. Unfortunately, the insurance company didn’t cover the loss. The operating income of “In n Out” for the year 2019 would look like this:
Operating Income = $245,000 – $110,000 – $0 = $135,000
It is necessary to mention that, $60,000 from the loss of fire is not included in this list as the loss is not an operating expense.
If you’re unfamiliar with terms mentioned above in the formula, worry not as we are about to break them down here!
Direct costs are some “specific” expenses that are attributed to the cost of manufacturing goods or services. The costs tend to vary in nature, depending on the quantity being manufactured. Direct costs include elements such as raw materials, software, manufacturing supplies, equipment, etc. which are known as direct materials.
As labor is related to directly producing a product, it is considered as a direct cost too. For example, the cost spent on operators, factory workers, quality inspectors, drivers, painters, etc. is a direct cost. In addition to all of these, electric or water bills, shipment fees, insurance, consultancy fees are also included as direct costs.
Indirect costs are expenses that are indirectly associated with producing and purchasing products. The costs are much needed to run a business on a daily basis. These include expenses for salaries, rents, utilities, supplies, maintenance and repairs, advertising costs, etc.
It is said that operating expenses are the costs that help the business go smoothly. It is also referred to as “OPEX COST“. Operating expenses are mainly expenditures that are not directly linked with the production of a product or service. It includes tax expenses, insurance costs, rent or repair costs, legal fees and many more.
Depreciation and Amortization:
Depreciation and Amortization are two essential components in an income statement. These two concepts are used to determine the sinking value of assets of a company over time. When the tangible assets (physical) of a company such as a piece of machinery, equipment, vehicles lose its value over time, the process of recording the loss is called “depreciation”.
As for “amortization”, the case is almost the same except it deals with intangible (non-physical) assets. The process of lowering the book value of intangible assets such as trademark and patents is known as amortization.
Difference Between Operating Income And Revenue
Both revenue and operating incomes are two inevitable elements of an income statement, which portray whether a company or business organization is doing well or not. But some people tend to think that these are identical. It is necessary to understand the differences as your misconceptions can lead you to make an irrational decision while making investments.
Revenue is the amount of money a company makes before any expenses are subtracted out. As revenue sits on the top of an income statement, it is familiar as “top line” too. On the contrary, companies determine their operating income by subtracting operating expenses from the operating revenues.
Why Does Operating Income Matter
The importance of calculating operating in a business organization is immense. It is considered as a barometer to measure the efficiency of a business. It is also beneficial to maneuver planning strategies to earn more and expand the business.
Investors who want to invest in a particular company closely inspects the “income statement” to understand the operating income and other vital elements. If the operating income of a company is high, it is more likely that the core business of this company is profitable.
As operating income indicates the competency, durability and financial health of a company, investors make their decision of investing by closely analyzing it. It also gives an overview of how the company deals with its interest and tax rates, and other expenses. To compare companies within the same industry, there is no better way than taking a look into their operating incomes.
To conclude, operating income is like a litmus test, as it proves the potential and sustainability of a company. In this modern era of technology, you are only one google search away from reports with the operating incomes of renowned companies. So, if you are planning to make investments, deeply analyzing operating income beforehand is important.