What is operating income?
Operating income is the amount of profit a company has after paying for all expenses related to its core operations.
Operating income is calculated by taking a company's revenue, then subtracting the cost of goods sold and operating expenses. This is the formula:
Operating Income = Revenue - Cost of Goods Sold - Operating Expenses.
These expenses are the ongoing costs of running the business. They include salaries, inventory, marketing, depreciation, administrative costs, and others.
Operating income is also called income from operations or operating profit.
Why is it important?
Operating income measures the profitability of a company's core business operations. In this case, the core business is the main way that a company produces revenue.
Most importantly, operating income excludes "non-operating" income and expense items that are technically not part of the core business operations but can be significant.
The biggest non-operating expense items are taxes and interest payments. But there is also a category called "other" non-operating income and expenses.
Examples of other non-operating income or expenses include:
- Selling equipment the company no longer uses for profit.
- Paying or receiving money for the settlement of a lawsuit.
- Gains and losses from investments in other companies.
- Accounting adjustments.
Many of these "other" non-operating expenses are outside of a company's control, and some of them are one-off items that have nothing to do with day-to-day operations.
This is why it can be helpful for investors to exclude them when analyzing a company's financials.
In fact, many investors consider operating income to be a more reliable measure of profits than net income (bottom-line profits).
Famously, Warren Buffett recognizes the importance of operating income very well. He encourages investors in his company, Berkshire Hathaway, to look at the company's operating income instead of the net income.
That's because Berkshire holds a lot of stock in other companies, and the net income is affected by temporary price swings in their stock holdings.
This causes Berkshire's net income to swing wildly up or down, mostly depending on what the stock market does.
Many analysts and investors pay close attention to operating income and how it changes over time. If it increases, it means that the company is making more money from the core business.
Operating income formulas
There are several different formulas to calculate operating income:
- Operating Income = Gross Profit - Operating Expenses
- Operating Income = Revenue - Cost of Revenue - Operating Expenses
- Operating Income = Net Income + Interest + Taxes + Other Income/Losses
All of these formulas lead to the same result.
How to calculate operating income
This is the simplest formula to calculate operating income:
Operating Income = Gross Profit - Operating Expenses
Both gross profit and operating expenses are listed on a company's income statement.
Gross profit can also be calculated by taking the revenue and subtracting the cost of goods sold (COGS), also called the cost of revenue or cost of sales.
Operating expenses include all the costs and expenses required to run the core business. These include selling, general, and administrative (SG&A), marketing, fulfillment, depreciation and amortization, monthly salaries, and others.
But they do not include taxes, interest, or other non-operating income or expenses.
The cost of goods sold is also called direct or variable cost because it depends on how much the company produces. Operating expenses are termed fixed or indirect costs because they don't change strictly based on the company's output.
Let's imagine a grocery store called Linda's Groceries. The store had $1 million in sales last year.
However, Linda needed to pay $700,000 for inventory and hourly staff. This was her cost of goods sold, which left her with a gross profit of $300,000.
She also had $200,000 in various operating expenses, such as paying her own salary, buying office supplies, and advertising.
Her operating income was therefore $300,000 - $200,000 = $100,000.
If the store was in debt, some of that money would have gone towards interest payments. A percentage of the rest would have been used to pay taxes. But the rest could have been used for something else, such as paying dividends to the owner.
How to find operating income
Operating income is shown on a company's income statement. It is listed after the gross profit calculation and before the net income calculation.
Here's an example from Apple's annual report for 2019:
Source: Apple, Inc.
All the line items required to calculate operating income are highlighted on this income statement, as well as the operating income itself.
As you can see, Apple's operating income in 2019 was $63.9 billion. This was less than the $70.9 billion in 2018, which makes sense because revenues decreased while operating expenses increased.
You can find the income statements of all publicly traded companies for free online, both on the SEC website and the companies' investor relations pages.
Operating income examples
In 2019, Amazon had $280.5 billion in sales, with cost of sales of $165.5 billion and operating expenses of $100.5 billion.
Their operating income in 2019 was therefore $280.5 - $165.5 - $100.5 = $14.5 billion. This was an increase of 17% year-over-year.
In the fourth quarter of 2019, Starbucks had $7.1 billion in sales, $2.2 billion in cost of sales and operating expenses of $3.7 billion.
Their operating income was $7.1 - $2.2 - $3.7 = $1.2 billion, a YoY increase of about 21%.
Operating income vs. revenue, gross profit, and net income
A company's income statement starts with revenue, which is the total amount of money received without accounting for any expenses. Revenue is also termed the "top-line."
The income statement ends with net income, also termed profits or the "bottom-line." It is the amount of money left after subtracting all expenses.
There are three steps on the way from revenue to net income, with different expense items subtracted in each step. It can be helpful to consider these three steps to see where operating income fits into the big picture:
- Revenue - Cost of Revenue = Gross Profit.
- Gross Profit - Operating Expenses = Operating Income.
- Operating Income - All Other Expenses = Net Income.
When gross profit, operating income, and net income are listed as a percentage of revenue, they are termed gross margin, operating margin, and profit margin.
Understanding operating margin
Operating income is often expressed as a percentage of revenue, termed operating margin. This is the formula to calculate it:
Operating Margin = Revenue / Operating Income
Operating income is a dollar amount while operating margin is a ratio or percentage. To convert from ratio to percentage, multiply by 100%.
In some cases, looking at operating income as a percentage of revenue is easier to understand than just looking at the straight dollar figure.
Is operating income the same as EBIT?
It is a common misunderstanding that operating income is the same as EBIT or Earnings Before Interest and Taxes. They are similar, but not identical.
EBIT is calculated by taking the net income and adding back taxes and interest (EBIT = Net Income + Taxes + Interest).
The big difference between operating income and EBIT is that EBIT includes non-operating items other than interest and taxes. These are often listed as "Other Income / Loss" on the income statement.
Operating income and EBIT are identical for many companies. But for those that have large incomes or losses from the "other" category, the differences can be substantial.