If you’ve ever looked at an income statement, you’ve probably noticed “operating income” listed as a businesses' main revenue stream.
Operating income is the value that measures the profit that’s left after operating expenses and costs of goods sold have been subtracted.
In this guide, we’ll be explaining why operating income is important, what it includes, how you can calculate it, and everything else you need to know about measuring operating income for your small business accounting.
This guide will cover in-depth:
- What Is Operating Income?
- Why Is Operating Income Important?
- How Do You Calculate Operating Income?
- What Is Included in Operating Income?
- Operating Income Example
- Automate Your Operating Income with Accounting Software
- Operating Income FAQ
What Is Operating Income?
Operating income, commonly referred to as operating profit, is the figure left after deducting a business’ operating expenses and costs of goods sold from the total gross income.
This financial ratio is one of the most common methods of valuing a company, as it measures its ability to cover costs and generate profit. So, if a company starts to increasingly generate more operating income, that means that a business is earning more while being able to keep expenses, production costs, and overheads in line.
Why Is Operating Income Important?
Operating income is an important metric because it shows your company’s ability to generate profits from its operational activities. As a business owner, you can use this data to measure the operational successes of your business and get an insight into what you need to improve.
The figure is also relevant to investors and shareholders who want to put money into your business. They will ask to look at your operating income and accounting reports, as well as to evaluate the efficiency and profitability of the business. It’s important that these financials show that your business is healthy, growing, and can pay off debt.
If you want to learn how to properly keep a daily record of your financial transactions, and generate accurate accounting reports at the end of the year, head over to our complete guide to financial reporting for small businesses.
How Do You Calculate Operating Income?
To calculate operating income you only need the two aforementioned values: gross income and operating expenses.
The formula goes as follows:
Operating Income = Gross Income - Operating Expenses
A more detailed form of displaying this formula would be:
Operating Profit = Gross Revenue – (Operating Expenses + Cost of Goods Sold)
Let’s break down how you can find and calculate each of these elements.
What Is Included in Operating Income?
Gross income is the total revenue that your business earns from sales, before taxes and other business expenses have been deducted. It’s crucial that you measure gross income properly because the value is a starting point for calculating both operating income and taxes.
The formula for gross income is:
Gross Income = Gross Revenue - Cost of Goods Sold (COGS)
Gross revenue is what you earn from selling activities, prior to any sort of subtraction.
Whereas the cost of goods sold is the calculation of the total cost incurred in getting the product ready for market sale. So, COGS will include expenses for raw material, labor costs, packaging material, shipping charges, overhead costs, and so on, depending on your operational activities.
To illustrate how you can calculate gross income, let’s assume that a small business makes $35,000 in sales during the first six months of the year. The cost of goods sold for that half-year amounts to $12,000. Gross Income for this period would be:
$35,000 - $12,000 = $23,000
Operating expenses are expenses that a business makes during its regular, day-to-day activities. There’s not a list of universal operating expenses, as these costs vary depending on the business’s industry, the product it sells, and how many departments the business encompasses.
With that being said, some of the most common types of operating expenses include employee payroll, rent, marketing fees, maintenance fees, supplies, utilities, and so on.
It’s important to keep in mind that capital expenditures and other non-operating expenses are not part of this category.
Capital expenditures are the high-value investments that a business makes, that provide benefits for over a year. Examples include the purchase of fixed assets such as equipment, buildings, machinery, or intangible ones such as patents and trademarks.
Whereas non-operating expenses are the types of expenses you don’t deal with during your everyday office hours, such as interest expenses on borrowed cash, lawsuit fees, costs of relocating the business, and so on.
Operating Income Example
Assume that in the current year, company ABC earned sales revenue worth $350,000. For the time period, the cost of goods sold was $50,000, rent was $15,000, maintenance fees were $3,000, insurance $5,000, and employee net pay $50,000.
First, we calculate operating expenses as follows:
Operating Expenses = Rent + Maintenance + Insurance + Salaries
Operating Expenses = $15,000 + $3,000 + 5,000 + $50,000 = $73,000
Operating income would be:
Operating Income = Sales Revenue - (Operating Expenses + COGS)
Operating Income = $350,000 - ($50,000 + $73,000) = $227,000
The operating income of the business is $227,000.
Automate Your Operating Income with Accounting Software
Tired of manually calculating your operating income? Don’t want to spend hours preparing financial statements on Excel spreadsheets?
Use accounting software like Deskera to completely automate your small business accounting.
With Deskera you can manage your sales from start to finish, automatically receive and record online payments, easily generate and send invoices, track bills and purchases, automate tax calculations, and so much more - all in one single platform.
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Operating Income FAQ
#1. How Do You Calculate Operating Margin?
A business's operating margin, also known as return on sales (ROS), represents the ratio of profit available to cover non-operating expenses, such as interest or bad debt expenses.
The formula for calculating it goes as follows:
Operating Margin = Revenue / Operating Earnings
#2. Is Operating Income the Same Thing as EBIT?
Operating income and Earnings Before Interest and Taxes (EBIT) are both important metrics in analyzing the financial performance of a company, but the terms are not synonymous.
EBIT is a business’s net income before interest and income tax expenses have been deducted. On the other hand, operating income is a business’s gross income after operating expenses and the other costs of goods sold have been deducted.
The key difference between EBIT and operating income is that EBIT includes non-operating income and non-operating expenses, whereas operating income doesn’t.
And that’s a wrap!
Here are some of the key points we’ve covered:
- Operating income is the profit left after deducting operating expenses and the cost of goods sold.
- The figure is important as it shows the ability of a business to generate profit, meet obligations, and pay off debt.
- You can calculate operating income by subtracting gross income from operating expenses.
- Use accounting software like Deskera to automate your operating income calculation, along with your entire accounting processes.