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Operating profit represents income from a company’s normal business activities before deducting interest expenses and taxes.
What Is Operating Income?
Operating income is the amount of money that remains after operating expenses and cost of goods sold have been deducted from revenue. It’s a measure of how a company’s executive management is handling its expenses and achieving profitability.
Some companies list their operating income as operating profit or operating earnings. It is typically found as a line item after “Operating Expenses” and before “Other Income (Expenses)” on a company’s income statement. For publicly traded companies, the income statement is part of the financial statement filed on a quarterly and annual basis with the Securities and Exchange Commission.
Before delving further into operating income, it’s necessary to understand operating expenses. In a company’s income statement, revenue represents the top line figure for the amount of money generated from the sale of goods and services. From there, most of the items listed on the income statement relate to expenses, such as the cost of goods sold—namely expenses for materials—tied to the production and sale of goods and services. By subtracting cost of sales from revenue, gross profit, or gross margin, is calculated.
Operating expenses are separate from cost of goods sold in that they represent expenses associated with the normal operations of a company’s business. These include administrative expenses, salaries for executives and other white-collar positions, and costs for marketing and research and development. Another item listed as operating expense is depreciation and amortization, which are bundled together and those estimate the costs related to the devaluation of the company’s assets, such as machinery, office equipment, furniture, buildings, copyrights, trademarks, and patents.
How Is Operating Income Calculated?
Working from the top line items in the income statement, cost of goods sold is subtracted from revenue, and the difference is gross profit. All operating costs subtracted from gross profit lead to operating income, but before additional costs such as tax payments and interest expenses are included.
Operating Income = Revenue – Cost of Goods Sold – Operating Expenses
Below is an example of Tesla’s operating income. It posted losses from operations in 2018 and 2019 before turning a profit in 2020 due in great part to a surge in gross profit. As demand for electric vehicles picked up in 2020, Tesla’s revenues rose, but the company kept its expenses in check. The rate of change for cost of revenues and operating expenses were below that of revenue.
How Does Operating Income Relate to EBIT or EBITDA?
EBIT is the acronym for earnings before interest and tax, and it’s used interchangeably with operating income. EBITDA takes it a step further—and is mostly applicable to companies with large fixed assets—by excluding depreciation and amortization costs, which writes down the declining value of machinery and intangible assets such as brands and trademarks.
When a company’s bottom line, or net income—which is earnings after all costs have been deducted—is low or becomes a net loss, executive management often turns to EBIT or EBITDA to argue that the company is profitable before tax payments and interest expenses as well as costs for depreciation and amortization are tacked on.
Executive management at startups or companies that just went public would use profit on an EBIT or EBITDA basis to deflect net losses posted on their quarterly or annual income statements because they can argue that the company is profitable before tax and interest expenses—both of which can be significant—are added.
As of 2022, the U.S. corporate tax rate was 21 percent, and excluding tax payments can be put to executives’ advantage in assuaging investors’ concerns about profitability in future quarters. Debt is tied to the company’s borrowings, and depending on the interest rates for its loans, capital costs can also be a big factor. A heavily leveraged company (i.e., one that has more debt than equity) would argue profitability on an EBIT basis. Unable to negotiate lower rates on large debts, interest expenses can be a burden.
An alternative way to calculate EBIT is to add interest and tax payments, working upwards on the income statements starting with net income. For EBITDA, continue up to include depreciation and amortization.
EBIT = Net Income + Interest + Taxes
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
So, depending on one’s perspective, operating income looks at expenses tied to a company’s normal operations. From the EBIT viewpoint, it’s net income plus interest expenses and tax payments. But both will come out at the same amount of profit in the income statement.
How Is Operating Income Used?
Operating income can be used in metrics such as profitability ratios, where operating income is measured against another benchmark like sales. Operating profit margin, or operating margin, measures operating profit to sales. It’s useful in comparing companies within the same industry operating in the U.S. and abroad because the corporate tax structures differ by country.
What Are the Limitations of Operating Income?
In measuring profitability and gauging executive management performance, operating income is limited because it doesn’t include all costs. Tax payments and interest expenses are excluded.
Frequently Asked Questions (FAQ)
The following are answers to some of the most common questions investors ask about operating income.
What Are Other Terms for Operating Income?
Operating income is often referred to as operating profit, operating earnings, profit before tax and interest, and EBIT.
Is Operating Income the Same as EBIT or EBITDA?
EBIT is an acronym used interchangeably with operating income because it represents a company’s earnings before interest costs and tax payments are deducted. But operating income is not the same as EBITDA, which excludes depreciation and amortization costs.
Can Operating Income Be Negative?
Operating income can be negative if cost of sales and/or operating expenses exceed revenue.
Why Is Operating Income an Important Metric to Track?
Operating income is useful in comparing companies in the same industry but operating in different countries by removing payments on taxes, which can vary by nation. Operating income also serves in measuring the performance of executive management on how they are handling expenses associated with the company’s normal operations.
