Operating Income

What Is Operating Income?

Operating income, or EBIT (Earnings before Interest and Taxes), measures a firm's income before deducting taxes and interest payments. The metric already accounts for expenses like the cost of goods sold, depreciation and amortization, and wage expenses.

To calculate operating income, start with net sales, subtract the cost of goods sold to find gross profit, and then deduct operating expenses from gross profit.

It represents a company's profit from its core operations after deducting operating expenses. Expenses incurred beyond operating income may include both operational and non-operational costs, depending on the nature of the expense.

Understanding Operating Income

EBIT is an important financial metric for financial analysts as it allows an analyst to see how the firm's operations are doing. This can be important when trying to find out how to increase profit. Through EBIT, one can see whether the business’s operational or non-operational side needs work. 

If a company's expenses consistently exceed its gross profit, it may face financial challenges, potentially leading to losses unless supplemented by significant non-operating revenues.

Shareholders (and other stakeholders) should also be very cautious of a company’s EBIT. EBIT is useful because it removes irrelevant information that doesn’t involve the company’s core operations. 

However, looking at line items like profit before tax and net income is still extremely important. Despite a company's high EBIT, it could still incur losses after accounting for interest and taxes, affecting its net income.

After subtracting non-operating expenses from EBIT, you will arrive at EBT or Earnings Before Tax. Then, after subtracting out the tax provision, you will finally arrive at the bottom line – net income. 

Operating income importance

Since EBIT accounts for fewer expenses than net income, EBIT is typically higher than net income due to fewer expenses being deducted, though exceptions may occur, such as when non-operating income exceeds expenses.

For example, net income could only be higher if the company made more income from non-operating activities than expenses, which is unusual. 

The firm will generally look at ratios rather than absolute figures to determine whether a company has a strong EBIT figure compared to other companies in the same industry. 

For example, Company A could have an EBIT of $1 million but have a revenue of $50 million. This means that a substantial amount of its revenues go towards paying expenses. 

On the other hand, Company B could have an EBIT of $500k but a revenue of $2 million. This means the company spends less on expenses than Company A. 

If we relied solely on absolute figures, it might erroneously appear that Company A is in better financial shape due to its larger EBIT. However, financial health should be assessed comprehensively, considering multiple factors beyond just EBIT.

When using ratios, we can see that Company B is substantially healthier because its percentage of EBIT / Revenue is much higher than Company A’s. This is why ratios are important when comparing different companies and their EBITs.

Strategies to Increase Operating Income

Operating income represents the income after the business accounts for all costs directly related to its operations and excludes non-operational expenses.

Any business's goal is to generate the most profit and income possible. Therefore, it’s important to understand how companies can increase their EBIT to achieve this goal. 

While the firm's operations influence EBIT, changes in other factors, such as interest expenses and non-operating income, can also affect operating profit. You can take these two actions to increase your operating income:

1. Increase Revenues

You can increase your revenue by selling more products or increasing the price. When you increase your revenue, intuitively, you will have more money left over if your expenses stay relatively constant.

Before implementing these changes, a firm must consider its market, as increasing prices in a highly competitive market may not necessarily lead to increased profitability.

2. Lower Operating Expenses

Although there is no way to eliminate operating costs, firms can take some measures to reduce them. 

Lowering operating expenses can increase EBIT if done strategically and if revenue remains relatively stable. However, reducing expenses indiscriminately without considering potential revenue impacts can adversely affect profitability.

Since two expense components contribute to EBIT, you can either attempt to lower COGS, Operating Expenses, or both. For example, firms might lower COGS by negotiating better prices with their suppliers and eliminating unnecessary expenses. 

Lowering operating expenses may include cutting wages, laying off workers, and reducing expenses that contribute to sales, such as advertising costs.

Operating Income Formulas and Calculations

Familiarizing yourself with the most common ways it’s calculated is important. The three most common ways to calculate EBIT are:

1. Bottom-Up Approach

The bottom-up approach starts with net income and includes interest and tax expenses along with net sales in the calculation of operating income. The steps follow:

1. First, you’ll start by adding the tax expense to the net income
2. Add the interest (and other non-operating expenses) to net income
3. After these two steps, you’ll arrive at the firm's operating income

The formula looks like this: 

Op. Income = Net Income + Interest Expense + Tax Expense

2. Top-Down Approach

The top-down approach is probably more conventional, starting with net sales. This approach is easier to use when looking at an income statement but can also be useful if you only have net sales, COGS, and operating expenses.

The steps are:

1. First, subtract COGS from net sales. This will give you the firm's gross profit
2. You’ll subtract operating expenses, depreciation, and amortization from the gross profit
3. Then, you’ll be left with the business's operating profit

Starting with gross profit may sometimes streamline the calculation process, but efficiency depends on data availability and contextual factors. The formula looks like this:

Op. income = Net Sales - COGS - Operating Expenses - Depreciation - Amortization

3. Cost-Accounting Approach

The cost-accounting approach involves concepts that may differ from traditional financial accounting methods but are still valid for calculating operating income. For example, you'll use direct and indirect costs instead of costs like COGS and operating expenses.

Direct costs are COGS. They’re expenses related to the direct function of the business to make a product or service. All other costs that aren’t directly related to the manufacturing process are indirect costs. 

The formula looks like this:

Op. Income = Net Sales - Direct Costs - Indirect Costs

Example of Operating Income

Let's take a hypothetical retail firm as an example. Within a specific quarter, this company accumulates $1,000,000 in sales revenue from its product transactions.

The expenses directly associated with the goods sold (COGS) amount to $600,000, covering costs like production, transportation, and raw materials. Moreover, operational costs totaling $200,000, including employee salaries, rental fees, utilities, and promotional efforts.

To determine the operational earnings:

Operational Earnings = Revenue - (COGS + Operational Costs)

Operational Earnings = $1,000,000 - ($600,000 + $200,000)

= $1,000,000 - $800,000 = $200,000

Therefore, the operational earnings for the quarter stand at $200,000. This signifies the profit derived from the company's fundamental business undertakings before factoring in interest and taxes.

Operating Income vs. Other Financial Calculations

To understand the different metrics, take a look at the table below:

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Net Operating Income (NOI)
• Net Operating Loss (NOL)
• Operating Expenses
• Operating Margin
• Revenue vs Income