Operating income, also known as operating profit or earnings before interest and taxes (EBIT), is the amount of income that a business generates from its core operations, after deducting the operating expenses. Operating income is a key indicator of a company’s profitability, efficiency, and performance, as it shows how much of the revenue is left after covering the costs of running the business. In this blog post, we will explain what operating income is, how to calculate it, and why it matters for financial decision-making.

How to Calculate Operating Income

There are two main methods to calculate operating income: the top-down approach and the bottom-up approach. The top-down approach starts with the revenue or sales and subtracts the cost of goods sold (COGS) and the operating expenses. The bottom-up approach starts with the net income and adds back the interest expense and the taxes. Both methods should yield the same result, as shown in the following formulas:

Operating Income (Top-Down)=Revenue or Sales−COGS−Operating Expenses

Operating Income (Bottom-Up)=Net Income+Interest Expense+Taxes

For example, let’s say that a company has $500,000 in revenue or sales, $200,000 in COGS, $150,000 in operating expenses, $50,000 in interest expense, and $40,000 in taxes. Using the top-down approach, the operating income is:

Operating Income (Top-Down)=500,000−200,000−150,000=150,000

Using the bottom-up approach, the operating income is:

Operating Income (Bottom-Up)=(500,000−200,000−150,000−50,000−40,000)+50,000+40,000=150,000

As you can see, both methods give the same result of $150,000 in operating income.

Why Operating Income Matters

Operating income is an important measure of a company’s profitability, efficiency, and performance, as it reflects how well the company manages its costs and utilizes its resources to generate income from its core operations. A high operating income indicates that the company has a strong competitive advantage, a high demand for its products or services, or a low cost structure. A low operating income indicates that the company faces intense competition, a low demand for its products or services, or a high cost structure.

Operating income is also an essential input for many financial analysis tools and techniques, such as:

• Income statement: Operating income is the second and most important line item on the income statement, as it determines the net income of the company after deducting the interest expense and the taxes.
• Financial ratios: Operating income is used to calculate various financial ratios that measure the profitability, efficiency, and performance of the company, such as operating margin, return on sales, return on assets, and return on equity.
• Financial forecasting: Operating income is the starting point for projecting the future income and cash flows of the company, based on historical trends, market conditions, and growth assumptions.

Conclusion

Operating income is the amount of income that a business generates from its core operations, after deducting the operating expenses. It is calculated by either subtracting the COGS and the operating expenses from the revenue or sales, or by adding back the interest expense and the taxes to the net income. Operating income matters for financial decision-making, as it reflects the profitability, efficiency, and performance of the company, and influences the income and cash flows of the company.