Companies operate a business to earn profits. They carry out specific operations to conduct business and generate such profits. Operating incomes are the income generates from principal revenue-generating activities after deducting the operating expense. This residual income is termed operating income.
It is referred to as the direct source of income for business entities. Operating income could also calculate deducting the cost of goods sold from the net sales of the entity during the specific period.
What is operating income?
It is the residual amount of revenue left after deducting the cost of goods sold (COGS) and operating expenses from the total revenue or sales. It is one of the measures of the profitability of the operations of an organization.
It infers investors and owners about the amount of revenue that would eventually profit for the company. It is one of the primary indirect indicators of the measure of the efficiency of an entity.
Higher the operating income, higher is the operational efficiency and profitability from the core operations.
Operating income can be affected by:
- Pricing strategy
- Competition in the market
- Pricing of the inputs or raw materials and its availability
- Costs of the direct and indirect labor
The major performance metrics of operating income are EBIT margin and EBITDA margin.
How to compute operating income?
Operating income can be calculated by formula,
Operating income = Revenue- Cost of goods sold – Operating expenses- Depreciation and amortization.
The different ways of calculating operating income are given below:
The formula can calculate operating income:
Operating income = Total Revenue – Direct Costs – Indirect Costs
Operating income = Gross Profit – Operating Expenses – Depreciation – Amortization
Operating income = Net Earnings + Interest Expense + Taxes
It is calculated with the help of figures from the income statement. The income statement is prepared below:
Operating expenses include:
- Employee and labor expenses
- Administration overheads
- Selling and distribution overheads
- Research and development expenses
It excludes non-operating expenses and non-operating income.
Non-operating expenses include:
- Interest expenses
- Loss/gain from disposal of assets
- Impairment loss
The various components to compute operating income are given below:
Direct costs: They are the expenses that are incurred and attributed to creating or purchasing a product. They are often in the cost of goods sold. They can be variable as well as fixed.
Examples of direct costs include:
- Direct materials- includes raw materials, supplies
- Direct labor: cost of hiring machine operators, factory workers wages
- Direct overhead: Power and water consumption: Electricity usage in production
Indirect costs: Operating expenses that are not associated with producing a product or service. Such cost is allocated as overhead costs and charged to various operational activities. Examples of indirect costs are:
- Maintenance and depreciation of factory equipment
- Rent of factory unit or go down
- Salary of administration staff etc.
- Office supplies
- Printing and stationary
- Marketing and advertising expenses.
- Revenue is defined as the monetary amount received after selling goods and services. This can be either cash sales or credit sales. As per AS-9, Revenue is the gross inflow of cash, receivables, or other consideration arising in the course of ordinary activities of an enterprise from the sale of goods and rendering of services and various other sources like rent, royalty, dividend, and interest, etc.
- Gross income is defined as the amount obtained after deducting the cost of goods sold and sales returns or allowances from the sales figure.
Operating income is calculated in the income statement in the following way:
This is how the operating income of a company is calculated.
Percentage change in operating income:
The company needs to know the percentage change in operating income when the comparison is made vis-à-vis in previous years. It shows whether operating income is changing proportionately with sales or the cost of sales has been in an increasing trend.
It can be calculated by deducting the previous year’s operating income from the current year and dividing it by the last year’s operating income.
Use of operating income metric:
Investors, creditors, and the company use this metric to gauge the company’s efficiency, profitability, and overall financial soundness. The higher the operating income, the more able a company would be to pay off its debts. This gives investors an idea about the future viability of the company concerning its operations. Operating income can be increased by:
- Reducing fixed costs
- Increasing mark-up
Also known as peripheral or incidental income, this income is derived from sources other than the company’s core operations. It includes dividend income, profit or loss from investment or sale of fixed assets, etc.
The results of non-operating activities are categorized under heads “Other revenue and gains” and “Other expenses and losses.”
Operating vs Non-operating income
The primary difference between operating and non-operating income is that operating income comes from core operations. In contrast, non-operating income comes from sources other than core operations, such as interest from investments or profit from the sale of fixed assets.
The other difference would be operating income are a consistent and regular phenomenon. In contrast, non-operating income occurs once in a while unless there are investments made by the company from which it receives interest.