Operating Income

What Is Operating Income?

Operating income is an accounting figure that measures the amount of profit realized from a business's operations after deducting operating expenses such as wages, depreciation, and cost of goods sold (COGS).

Operating income—also called income from operations—takes a company's gross income, which is equivalent to total revenue minus COGS, and subtracts all operating expenses. A business's operating expenses are costs incurred from normal operating activities and include items such as office supplies and utilities.

Understanding Operating Income

Operating income is a measurement that shows how much of a company's revenue will eventually become profits considering its business operations. It's a measurement of what money a company makes only looking at the strictly operational aspect of its company.

Operating income factors in two major types of expenses: cost of goods sold and operating expenses. Cost of goods sold are the expenses directly related to the manufacturing of a good and often include labor, raw materials, and overhead allocated to items sold. Operating expenses include the selling, administrative, and general expenses prior to taxes and interest expenses.

Analyzing operating income is helpful to investors because it doesn't include taxes and other one-off items that might skew profit or net income. A company that's generating an increasing amount of operating income is seen as favorable because it means that the company's management is generating more revenue while controlling expenses, production costs, and overhead.

Operating Income Formulas and Calculations

Operating income can be calculated in three different ways. One approach is top-down, one approach is a bottom-up approach, and one leverages cost accounting classifications.

Operating Income Formula: Top-Down Approach

The formula for operating income using the top-down approach is:

$\begin{aligned}&\text{Operating Income} = \text{GP} - \text{OE} - \text{D} - \text{A} \\&\textbf{where:} \\&\text{GP} = \text{Gross profit} \\&\text{OE} = \text{Operating expenses} \\&\text{D} = \text{Depreciation} \\&\text{A} = \text{Amortization} \\\end{aligned}$​Operating Income=GP−OE−D−Awhere:GP=Gross profitOE=Operating expensesD=DepreciationA=Amortization​

Gross profit is the net profit earned after the cost of goods sold is subtracted from net revenue. Operating expenses are the selling, administrative, and general expenses necessary to operate a business, though this does not include interest or taxes. Because operating expenses do not incorporate allocated costs, depreciation and amortization must also be subtracted.

Operating Income Formula: Bottom-Up Approach

Instead of starting with revenue, you can also calculate operating income if you know net income. Because net income is calculated by subtracting a few items from operating income, you can add them back in to arrive at operating income:

$\begin{aligned}&\text{Operating Income} = \text{NI} + \text{IE} + \text{TE} \\&\textbf{where:} \\&\text{NI} = \text{Net income} \\&\text{IE} = \text{Interest expense} \\&\text{TE} = \text{Tax expense} \\\end{aligned}$​Operating Income=NI+IE+TEwhere:NI=Net incomeIE=Interest expenseTE=Tax expense​

In this formula, you must have a fully calculated income statement as net income is the bottom and last component of the financial statements. In this case, the company may already be reporting operating income towards the bottom of the report.

Operating Income Formula: Cost Accounting Approach

Though direct costs and indirect costs are not widely used in financial accounting, a company may classify these types of expenses for internal use. If a company does so, it can find operating income by simply subtracting all of these costs from net revenue (as taxes and interest are often not classified as either):

$\begin{aligned}&\text{Operating Income} = \text{NR} - \text{DC} - \text{IC} \\&\textbf{where:} \\&\text{NR} = \text{Net revenue} \\&\text{DC} = \text{Direct costs} \\&\text{IC} = \text{Indirect costs} \\\end{aligned}$​Operating Income=NR−DC−ICwhere:NR=Net revenueDC=Direct costsIC=Indirect costs​

In this formula, net revenue is used in case there have been product returns or other deductions to make to gross revenue.

Operating Income vs. Other Financial Calculations

Operating Income vs. Revenue

When looking at a company's financial statements, revenue is often the highest level of financial reporting. Gross revenue is the total amount of revenue earned by a company for a given period, while net revenue is the total amount of revenue less any discounts, returns, or deductions to make from the total that was sold.

While revenue does not incorporate any expenses, operating income does. In fact, it incorporates almost every expense of a company. Revenue may demonstrate how successful a product is selling, but operating income is more useful in demonstrating how successful a company is at being efficient with how it spends money to incur that revenue.

Operating Income vs. Net Income

It's important to note that operating income is different than net income. Operating income includes expenses such as costs of goods sold and operating expenses. However, operating income does not include items such as other income, non-operating income, and non-operating expenses. Instead, those figures are included in the net income calculation.

In almost all cases, operating income will be higher than net income because net income often deducts more expenses than operating income. For this reason, net income is often the last line reported on an income statement, while operating income is usually found a few lines above it.

Operating Income vs. EBIT and EBITDA

Operating income is similar to a company's earnings before interest and taxes (EBIT); it is also referred to as the operating profit or recurring profit. Both measurements calculate the amount of money a company earned less a few noncontrollable costs. Technically, EBIT may include other operating expenses outside of interest and taxes but for most companies, these two calculations will be the same.

EBITDA, on the other hand, will differ from operating income as operating income deducts depreciation and amortization expense. EBITDA is calculated without incorporating either.

Example of Operating Income

The image below represents Apple Inc's income statement for the three months ending June 25, 2022. It also represents the nine month period for the company through the end of Q3.

On its income statement, Apple reported $82.959 billion of product and service revenue, up very slightly from the prior year. However, looking further down its income statement, the company's operating income for the three-month period was $23.076 billion, less than the $24.126 billion from the year before.

The reason for this is the increase in expenses. First, the company's cost of goods sold increased from last year to this year. Second, the company's operating expenses also increased. Both "Research and Development" as well as "Selling, General, and Administrative" expenses increased. The company spent $11.129 billion on operating expenses the year prior; now, it had reported operating expenses of almost $13 billion.

Last, the company is reporting a very material increase in provision for income taxes as Apple, Inc. estimated an additional $1 billion of expenses from what had been incurred one year ago. Because this expense is not directly tied to operational functions of the company, this increase has no bearing on operational income (though it does factor into net income).

The Bottom Line

Companies may be more interested in knowing their operating income instead of their net income as operating income only incorporates the costs of directly operating the company. Operating income can be calculated several different ways, but it is always found towards the bottom of a company's income statement. Operating income is generally defined as the amount of money left over to pay for financial costs such as interest or taxes.