What Is Included in Operating Income? A Breakdown

Operating income provides a window into a company’s financial performance, focusing on profitability derived from its primary business activities. This metric helps stakeholders understand how effectively a business generates earnings from its core operations, separate from financing decisions or non-recurring events.

Understanding Operating Income

Operating income, often referred to as earnings before interest and taxes (EBIT), represents the profit a company generates from its regular business activities. It excludes interest expenses, taxes, and non-operating gains or losses. This figure appears on a company’s income statement, positioned after the calculation of gross profit.

Operating income isolates the profitability of a company’s day-to-day operations, free from its capital structure or tax obligations. It provides insight into how well management controls costs and generates revenue from core activities, allowing for direct comparison of operational performance between different companies.

Operating Revenues: The Core Inflows

Operating revenues represent the financial inflows a company generates directly from its primary business activities. These are the top-line figures before any expenses, reflecting the company’s main source of income. They are distinct from non-operating revenues, which arise from incidental or secondary activities.

Common examples include sales revenue from selling goods, service revenue from providing services like consulting, and rental income if the company’s core business involves leasing properties or equipment.

Operating Expenses: Costs of Core Operations

Operating expenses are the costs a business incurs in running its core operations to generate revenue. These expenses are directly tied to the production and sale of goods or services. They are subtracted from operating revenues to arrive at operating income.

Cost of Goods Sold (COGS)

Cost of Goods Sold (COGS) includes the direct costs for producing goods or providing services. For a manufacturing business, this encompasses raw materials, direct labor, and manufacturing overhead like factory rent, utilities, and equipment depreciation. For a retail business, COGS includes the merchandise purchase price and costs directly incurred to bring the goods to the point of sale, such as freight-in.

Selling, General, and Administrative (SG&A) Expenses

Selling, General, and Administrative (SG&A) expenses are indirect costs necessary for the overall operation and management of the business. Selling expenses include marketing, advertising campaigns, sales commissions, and product delivery. General and administrative expenses encompass administrative salaries, office rent, utilities, office supplies, and professional fees for legal or accounting services.

Depreciation and Amortization

Depreciation and amortization are non-cash operating expenses that allocate the cost of tangible and intangible assets over their useful lives. Depreciation applies to tangible assets like machinery, buildings, and vehicles, reflecting their wear and tear. Amortization applies to intangible assets such as patents, copyrights, and trademarks, spreading their cost over their legal or economic life. Both are included in operating expenses because they represent the consumption of assets used in core business operations to generate revenue.

Distinguishing Operating from Non-Operating Items

Operating income focuses on core business profitability, so items not directly related to a company’s primary operations are excluded. These non-operating items are reported separately on the income statement, below the operating income line.

Interest income and interest expense are common non-operating items. Interest income is earned from investments, while interest expense is incurred on borrowed funds. Both relate to financing activities, not the company’s main business. Income tax expense is also excluded from operating income because it is a government levy on overall profitability, not a cost of core operations.

Gains or losses from investments are another category of non-operating items, arising from the sale of investments not central to the company’s primary business. Extraordinary or unusual items are also excluded, referring to events that are both infrequent and unusual in nature, such as a one-time legal settlement.

The Analytical Value of Operating Income

Operating income serves as an analytical tool for stakeholders, offering a clear view of a company’s operational efficiency. It allows analysts and investors to assess how well a business generates profit from its fundamental activities, independent of its financing structure or tax environment. This makes it a purer measure of operational performance compared to net income.

This metric facilitates comparisons between companies, even those in different industries or with varying capital structures. By removing the effects of debt (interest expense) and government levies (taxes), operating income highlights the effectiveness of management’s decisions in controlling costs and generating revenue from core operations. It underscores a company’s ability to sustain profitability from its ongoing business model, making it an indicator for evaluating long-term viability and management effectiveness.