As a small-business owner, it's important to get a grip on accounting basics. The terms income, revenue and profits, for example, are often used interchangeably although they mean different things. Make sure you know what your operating income is and how it differs from net income, revenue and profits. This way, you will get a better understanding of your finances and how your business is running.
TL;DR (Too Long; Didn't Read)
A company's operating income is the amount of money left after subtracting operating expenses and the cost of goods sold from its gross income. This number can be used to assess the financial health of a business and reduce its operating costs.
What Does Operating Income Mean?
Operating income is often used to measure a company's financial health. As its name suggests, it indicates how much of your profit comes from business operations before interest and taxes. This number will appear on your income statement.
Also known as earnings before interest and taxes, or EBIT, operating income is calculated by subtracting operating expenses from gross income. To put it simply, it measures the profit resulting from core business operations after deducting the cost of goods sold, rent, office supplies, administrative expenses, labor costs and more. The cost of goods sold is the amount of money required to produce the goods sold by a company.
Say you own a fashion boutique that earned $60,000 in total sales revenue during the first quarter of the year. For that period, you have paid $20,000 in salaries and spent $5,000 on fabric and other raw materials, $3,000 on marketing activities and $6,000 on rent and utilities. Therefore, your operating income before taxes is $26,000. What you have left after paying interest and taxes is your net income.
EBIT vs. Revenue vs. Profits
Operating income is calculated by subtracting a company's operating expenses from its gross income. Profit, on the other hand, is the money it pulls in after subtracting all indirect and direct costs from its total revenue, including interest and income taxes. This number is determined by the cost of stock, the money you earn from sales and all incurring expenses.
Another factor to consider is your revenue, or the income generated by the sale of products and services. Profit is what you have left after deducting all of your expenses from the total revenue. Without revenue, there can be no profit.
Both your revenue and profits are listed on the income statement. If your total expenses exceed total revenues, it needs to be registered as a net loss. This number will appear at the bottom of a company's income statement.
How to Calculate Operating Income
While your profit and revenue are important, the operating income matters too. You may use this number to determine your company's ability to make a profit and cover costs. Then you can take the steps needed to improve its bottom line.
Calculating the operating income is relatively simple as long as you know the cost of goods sold, your operating expenses and your gross income, or gross profit. Subtract your operating expenses and the cost of goods sold from your gross income to determine the operating income. For example, say your company earned $120,000 in total sales revenue last year and had the following operating expenses:
- Wages: $60,000
- Insurance: $7,000
- Rent: $12,000
- Office supplies: $3,000
The cost of goods sold was $25,000. Add this number to the company’s operating expenses ($82,000) and then subtract the total amount from your total revenue ($120,000). The operating income is $13,000.
How Is Operating Income Used?
Creditors and investors may want to check a company's operating income over several years to assess its performance and to make financial forecasts. A high operating income typically indicates good financial health and thus can make your business more appealing to potential investors.
An operating income gives more insight than you might otherwise glean from regular bookkeeping and balance sheet snapshots. For example, in real estate, the seller may advertise an investment property with earnings before interest, taxes, depreciation, and repair costs. But a prudent buyer will want to consider these costs against the rental rates to find the net operating income — reflecting his real profit margin.