How to Calculate Operating Income (+ Formula and Examples)
The joy of every establishment is to record substantial progress over long years of operation. Monitoring the financial status of the business is one of the best ways to achieve this.
Business owners need to keep track of the following: gross income, sales, operational and non-operational expenses, interests and tax rates, and more. These records can show the profits or losses that an organization makes within a specific time.
Operating income is another section of calculation that shows a deeper understanding of the company's operational success. In this article, you will learn everything you need to know about operating income. You will learn what it means, how to calculate it, and its overall importance for businesses.
What is Operating Income?
Operating income refers to the revenue a company gets from its central business operations. Another name for operating income is operating profit. It is a popular term in accounting.
Another definition of operating income is that it is the earnings accumulated before the taxes and expenses are deducted (EBIT- Earnings before Taxes and Interests).
A company calculates its operating profits by subtracting its net sales' operational direct and indirect costs from its revenue. You must understand the operations of a company before you can determine the operating income.
Operating income can tell a lot about the performance of a business. Are they recording profits or losses? Is there income progression or regression?
There are different ways to calculate a company's operating income, but let's talk about direct and indirect costs first.
Direct costs refer to charges directly related to the purchase of a product or the offer of services. These costs are either fixed or variable. They include labor, raw materials, utilities, and transportation.
- Labor refers to services offered by humans that aid the manufacturing of a product. They are the operators of a machine, factory laborers, etc.
- Raw materials refer to the unrefined supplies used for the manufacturing of a product.
- Utilities refer to the electrical units and water consumed during the production of goods and services.
- Transportation refers to the cost of moving products. It covers the shipment fees. Transporting finished goods to the wholesaler or end-user attracts some costs.
Indirect costs refer to expenses not directly attributed to the manufacturing of a product. These costs get accumulated over time. You can attribute them to various operations of the company. Some examples of indirect costs include:
- Costs of maintenance of machines
- Salaries and wages of workers
- Indirect utilities, etc.
How to Calculate Operating Income (EBIT Formula)
To effectively achieve progress, a business needs to keep track of whatever comes in and goes out. With this, the company will be aware of the profit and loss rate for a given time frame. When considering the revenues and expenditures of a company, one vital account to note is the operating income.
Using the EBIT (Earnings Before Interests and Taxes) method, you add the net earnings to the deducted interest and taxes. This method is popular among analysts and accounting officials.
There are different ways to calculate using the EBIT formula, although they all come to a common conclusion.
First Method for Calculating Operating Income (EBIT Formula)
Mathematically, EBIT = Net Income + Interest + Taxes.
From the formula, you can tell that it is a simple expression of the acronym EBIT. The operating income of the company is the net sales, combined with the interests and taxes.
Second Method for Calculating Operating Income (EBIT Formula)
We can use the EBIT formula in another way.
EBIT = Revenue – Costs of Goods Sold – Operating Expenses.
We can further break it down into:
Gross Income = Revenue – Costs of Goods Sold.
The gross income is the amount made altogether from sales in the primary operations. Operating income is gotten from the gross income after deducting operating expenses.
Mathematically, Operating Income = Gross Income – Operating Expenses.
These two formulas arrive at the same answer, but they are obtained from different methods. The former uses a bottom-to-top style, i.e., calculating the operating income from the net earnings acquired at the end of the account. The latter uses a top-to-bottom style, i.e., calculating the active income after deducting the expenses from the total (gross) revenue made.
Real-Life Example of the EBIT Formula at Work
For better understanding, let's look at the financial report (fictional) of a company.
Joe Woods Gadgets is an Electronics company that deals in selling new and used gadgets for homes and offices via E-commerce platforms like Shopify and other Shopify alternatives. They have been operating for several years. Also, they have branches across different states. At the end of the antecedent year, the company's account has the following information:
- Sales: $5,000,000
- Costs of goods sold: $3,400,000
- Gross Profits: $1,600,000
- Interests: $200,000
- Taxes: $200,000
- Operating Expenses: $400,000
- Net Income: $800,000
From the breakdown, the company's net earnings are $800,000. Now, let's calculate the Operating income using the EBIT formulas.
Operating Income = Net Income + Interests + Taxes
Operating Income = $800,000 + $200,000 + $200,000 = $1,200,000
From this formula, we calculated the net income first, and then added the interests and taxes expenses back.
Operating Income = Revenue (Sales) – Costs of Goods Sold – Operating Expenses
Operating Income = $5,000,000 – $3,400,000 – $400,000 = $1,200,000.
Obviously, from the two methods, the Operating Income is $1,200,000. What this means is that (after deducting the costs of the sold goods and the operating expenses) the company has $1.2 million to pay for the interests and taxes including payroll taxes, and even the workers' salaries.
As brief as this approach is, it tells us a lot about Joe Woods Gadgets Company. Apart from the knowledge of the profits, you can deduce the risk factor in taking loans to expand the business or take on a big project.
An advantage of the EBIT formula is flexibility. Some financial reports will probably not provide the full details. In that case, you can always apply an approach that suits the information you have. If you have information that does not offer the interest and tax rates, you can use the top-to-bottom approach that has to do with revenue and costs of goods sold. Amazing right?
What is the Importance of Operating Income in Business?
Why is operating income important for businesses? Why should we calculate it? What do we gain from knowing it?
Operating income is an indicator of the progress level of a business. When you monitor a company's operating income, you can deduce the efficiency of the core operations.
In essence, it is a measure of the company's effectiveness in accumulating more profits. Considering what it entails, you can tell that a lot of merits are attached to it.
Here are a few of the many merits of operating income in business:
1. Risk Determination
Operating income can help companies take determined and calculable risks. Proper monitoring of the operating income tells you a little about how much profit you make, either monthly or annually. It is recorded on the income statement.
An example of the significant risks entrepreneurs take is collecting loans. Before financial institutions can offer you a loan, they want to know if you can pay them back.
Knowing your company's operating income enables you to guarantee payback assurance to the financial institutions. If you record a high percentage increase in operating income every year, you will be confident enough to take loans to expand your business.
2. Efficiency of Operations
Operating income can determine the efficiency of operations in the core sector of a business. From the EBIT formula (top-to-bottom approach), you can know the conversion rate of the machines and human labor in the company. A reduction in net income results in a decrease in operating income (bottom-to-top
approach). In essence, if your net income is reducing drastically, then the company's productivity will decline. You can use this information to fast-track the efficiency of the core operations and set financial goals. Also, it can hint you at the expenses on direct and indirect costs (especially costs on maintenance of equipment).
3. Deep Knowledge of the Business Health
A financial report of companies that shows only the income and expenditure is not clear enough. Most business owners want to dig deeper into the financial statements such as the balance sheet and income statement of the company. This approach will ensure critical analysis of the money coming in and going out. It will also highlight the sections that need readjustment and reallocation of funds.
Calculating operating income can also help separate operating expenses from non-operating expenses. Operating expenses refer to the charges attributed to the day-to-day core operations. It is beyond the costs of goods sold and further divided into direct and indirect costs.
Non-operating expenses are the charges outside the regular activities of the company. With this, even an outsider can understand how the company is being run.
4. Better Managerial Decisions
Considering the effect of operating income on a business’s core operations, it can enhance competence in the management. When the operation income generated is higher, it shows the managerial flexibility in the company.
A company will probably not experience rosy moments throughout a year, the operating income can say a lot about how the company handled the downtimes.
Organizations that do not monitor the growth in operating income can suddenly crash when things go south. The competency of the management needs to be accounted for, and the operating income can show this.