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 as 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 deduction of 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 turn out to be profits for the company. It is one of the primary indirect indicators of the measure of efficiency of an entity.
Higher the operating income, higher is the operating 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:
Operating income can be calculated by the formula:
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 by 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 which 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.
Example 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 which are not associated with producing a product or service. Such cost is allocated as overhead costs and charged to various operational activities. Example 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 cost of sales has been in an increasing trend.
It can be calculated by deducting the operating income of the previous year from the current year and dividing it by the operating income of the previous year.
Use of operating income metric:
Investors, creditors and company uses this metric to gauge efficiency, profitability and overall financial soundness of the company. The higher the operating income the more able a company would be to pay of its debts. This gives investors 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 core operations of the company. 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 while non-operating income comes from sources other than core operations such as interest from investments or profit from sale of fixed assets.
The other difference would be operating income are consistent and regular phenomena while non-operating income occurs once in a while unless there are investments made by the company from which it receives interest.