What is Operating Income?

Operating Income can be located in the income statement listed as the business’ mainstream revenue. It is the value that calculates the profit left after subtracting operating expenses and the cost of goods sold.

In this blog, let us learn more about operating income and its importance –

Operating Income Meaning

What is operating income? Operating income is another term for operating profit. Operating Income is the profit that is left after deducting the operating expenses and cost of goods sold from the total gross income. The direct expenses include raw materials and labour costs linked to the product or service of the business. Indirect expenses include indirect costs incurred during the production process such as salaries of administrative staff, office rents, sales commissions and marketing expenses.

One of the most common methods to value a company is by adopting the financial ratio method. It has the ability to cover costs and generate profit. If your business is generating more operating income, then it means that the business is earning more, simultaneously controlling expenses, production costs, and overheads.

In simple terms, operating income is a measurement which determines a company’s profit after deducting all the expenses of business operations. Further, there are two types of expenses – the cost of goods sold(COGS) and operating expenses. The cost of goods sold involves the expenses directly related to the manufacturing of a product. It includes labour, raw materials, and overhead allocated to items sold. Whereas, administrative and general expenses prior to taxes and income expenses come under operating expenses.

Significance of Operating Income

A company’s operating income is a vital metric to measure as it reveals the company’s ability to generate profits from its operational activities. This data can be used by the business owner to measure the operational success of your business. Plus, this data will be very helpful to improve the operational capabilities of your business.

Investors and stakeholders find this data to be very useful as they are investing money in your business. You will have to show them the operating income and other accounting reports to inspect the efficiency and profitability of the business. These financial reports reveal the health of your business.

Also Read :?What is Income Statement ? – Definition, Importance and Examples

Operating Income Formula and Calculation

You can calculate operating income in three ways – top-down approach, bottom-up approach and one leverage cost accounting classifications.

Operating Income Formula: Top-Down Approach

Operating Income= GP ? OE? D ? A

where, GP=Gross profit, OE=Operating expenses, D=Depreciation, A=Amortization

When you subtract the cost of the goods sold from the net revenue you will earn net income which is the gross profit. Operating expenses exclude allocated costs, hence, depreciation and amortization should also be subtracted.

Operating Income Formula: Bottom-Up Approach

If you have net income, you can easily calculate the operating income. Net income is calculated by deducting a few items from operating income. Later, you can just add them back to arrive at operating income:

Operating Income = NI + IE + TE

Where, NI=Net income, IE=Interest expense, TE=Tax expense

In this equation, it is essential to have a fully computed income statement since net income represents the final and lowest element in the financial statements. In this scenario, the company might already be disclosing operating income near the conclusion of the report.

Operating Income Formula: Cost Accounting Approach

In the financial accounting of the company, direct and indirect costs are not widely used. However, for internal use, a company will classify these expenses. In that case, the company can find operating expenses by deducting all these expenses from the net revenue(taxes and interests are not classified either):

Operating Income = NR ? DC ? IC

where: NR=Net revenue, DC=Direct costs, IC=Indirect costs

Here, the net revenue is used if there are any product returns or other deductions to make the gross revenue.

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