How to Determine Operating Income for Your Company

Operating income, often referred to as Earnings Before Interest and Taxes (EBIT), is a key financial metric. It reveals a company’s profitability derived directly from its primary business activities. This figure demonstrates how effectively a business manages its day-to-day operations and generates earnings before considering the costs associated with its financing structure or tax obligations. It isolates the profitability generated purely from selling goods or services and managing related expenses.

Core Components of Operating Activities

Determining operating income begins with understanding the financial components directly tied to a company’s core operations. Revenue, also known as sales, represents the total money earned from selling goods or services during a specific period. It reflects the gross inflow of cash or receivables from the company’s primary commercial activities.

Cost of Goods Sold (COGS) encompasses the direct costs attributable to producing the goods or services a company sells. These costs include the raw materials used, the direct labor involved in manufacturing or service delivery, and manufacturing overhead. Examples of manufacturing overhead are factory rent, utilities for the production facility, and depreciation on production equipment. Subtracting COGS from revenue yields gross profit, which indicates the profitability of sales before considering broader operational costs.

Operating expenses are the costs incurred in running the business beyond the direct costs of production. These expenses are grouped into categories such as Selling, General, and Administrative (SG&A) expenses. SG&A includes costs like salaries for administrative staff, marketing and advertising expenditures, office rent, and utility bills for non-production facilities.

Depreciation and amortization also fall under operating expenses, though they are non-cash charges. Depreciation allocates the cost of tangible assets, such as buildings or machinery, over their useful life, reflecting their wear and tear. Amortization applies similarly to intangible assets, like patents or copyrights, spreading their cost over their economic life. Both reflect the consumption of assets used in core operations and are recognized on the income statement, reducing reported income.

Items Excluded from Operating Income

When calculating operating income, certain financial items are excluded because they do not reflect a company’s core business activities. Interest expense, which is the cost a company pays on its borrowed money, and interest income, which is money earned from investments, are typically separated. These items relate to a company’s financing decisions and capital structure, not its day-to-day operations. Their exclusion ensures that operating income purely reflects operational efficiency, uninfluenced by how the company chooses to finance itself.

Income tax expense is another exclusion from operating income. Taxes are a statutory obligation calculated on a company’s taxable income, which comes after accounting for both operating income and interest expenses. Because tax expense is a post-operating deduction and often depends on overall profitability and various tax credits or deductions, it is not considered part of the operational performance.

Additional non-operating gains or losses are also excluded from the operating income calculation. These include profits or losses from the sale of assets not central to the company’s main business, such as selling an old building or equipment. Investment income or losses from financial instruments, not part of primary revenue generation, are also typically separated. Furthermore, one-time or extraordinary events, such as a large legal settlement or a gain from an unusual event, are generally considered non-operating. Their exclusion ensures that operating income provides a clear view of sustainable profitability from regular business activities.

Step-by-Step Calculation

Calculating operating income involves a formula and sequential steps. The formula is: Operating Income = Revenue – Cost of Goods Sold – Operating Expenses. This equation accounts for all direct and indirect costs associated with running the primary business.

To begin the calculation, first identify the company’s total revenue. From this total revenue figure, subtract the Cost of Goods Sold (COGS). The result of this subtraction is the gross profit, which indicates how much profit a company makes from each sale after covering the direct costs of production. For example, if a company has $1,000,000 in revenue and $400,000 in COGS, its gross profit would be $600,000.

Next, from the calculated gross profit, subtract all operating expenses. These expenses include selling, general, and administrative costs, as well as depreciation and amortization. Continuing the example, if the company’s gross profit is $600,000 and its operating expenses (including SG&A, depreciation, and amortization) total $250,000, then the operating income would be $350,000 ($600,000 – $250,000). This final figure represents the earnings generated purely from the company’s core business operations.

All the necessary figures for this calculation—revenue, cost of goods sold, and operating expenses—can be found on a company’s income statement. This financial document, also known as a Profit and Loss (P&L) statement, summarizes a company’s revenues, expenses, and net income over a specific period, typically a quarter or a year.