Need to calculate operating income and looking for more information about the formula? Here is everything you need to know.
Operating income can also be referred to as Earnings Before Interest & Taxes or EBIT. It's the amount of revenue you have left once you have deducted all the indirect and direct costs from your sales revenue.
There are three different formulas for calculating operating income. The most commonly used one is Operating income= Net Earnings + Interest Expense + Taxes.
Hearing about and calculating operating income for the first time can be confusing. This guide is aimed at making sure you have all the information you need to calculate operating income using a simple formula. We will also include some sample calculations so you can practice figuring out your operating income.
What Is Operating Income?
Operating income refers to the revenue you have left once you have subtracted the indirect costs and operational direct costs. It's usually computed using several different things, including operating expenses not related to the production of goods, amortization, and gross income less depreciation.
Some things not considered in figuring out operating income are non-operational revenue sources like interest income and interest expenses.
Formulas For Operating Income
As mentioned before, you can use three different formulas for operating income. They all lead to the same outcome, but some might be easier for you to use depending on the numbers you want to use.
Here are the formulas you can use:
- Operating income= Net Earnings + Interest Expense + Taxes
- Operating income= Gross Profit – Operating Expenses – Depreciation – Amortization
- Operating income = Total Revenue – Direct Costs – Indirect Costs
We will explain what each of the terms is above and how to find them. If you aren't sure which one to use or how to find the numbers above, you can always ask an accountant or financial planner to help you.
Just looking at the formulas and numbers can be confusing without a real example. Here is a sample calculation you can take a look at to help you calculate operating income.
Let's say there is a clothing company that earned a total of $25 million in total sales revenue. They spent $9 million on raw materials and supplies and about $2 million on labor costs. The staff salaries totaled $4 million, and there was a total of one million in depreciation and amortizations.
This gives the company about $9 million in profits once all the expenses have been subtracted from the revenue.
Operating Formula Costs Explained
Some of the terms above can be confusing. However, you need to know what all of them mean so that you can compute the operating formula correctly. Knowing the definitions of all the terms can also help you explain the formula to employees.
Revenue And Gross Profit
Sales revenue is defined as the monetary amount you get from selling services and goods to customers. It does not include merchandise returned or discounts that your company gives to customers. You might also hear sales revenue called net sales. It includes credit sales and cash sales.
Gross profit is the monetary result your company has after you have deducted the costs of sales and goods that you sell. It also includes the deduction of returns and allowances.
What Are Direct Costs?
Direct costs are those that you incur from creating and purchasing products and offering services. You might also hear it called costs of goods sold or cost of sales. All these expenses are related to the cost of producing the services and goods.
Direct costs can be fixed or variable depending on the business you own and the services you sell to customers.
Here are some examples of direct costs:
- Cost of merchandise: cost of the finished product and the resale plus the shipment costs
- Power and water consumption: includes water and electric bills that are contributed to the production of goods
- Commissions or professional fees: this is the cost of delivering services and applies more to service-oriented businesses such as law firms, real estate, and insurance
- Direct labor: these are services you pay for manufacturing products, including factory workers, painters, and any other laborers
- Materials and supplies: these are all the parts, manufacturing supplies, and raw materials
All direct costs are exactly how they sound. They must be directly involved in the spending and costs of the business.
What Are Indirect Costs?
Indirect costs are a little different from direct costs. They are not directly related to purchasing goods or manufacturing. These costs are usually put into a fixed or overhead cost and are used for many different operational activities.
Examples of indirect costs:
- Rent of the factory or facility you use
- Maintenance costs or costs involved with the depreciation of factory equipment costs
- Salaries and other benefits of quality assurance staff or production managers
- Utility bills that are not directly involved in purchasing or creating goods
Indirect costs can also be related to selling and administrative costs, including:
- Office Supplies
- Office facility rent
- Insurance and amortizations
- Travel expenses
- Marketing and advertising costs
- Maintenance and repairs
- Telephone lines
- Depreciation of things like furniture, fixtures, office buildings, and equipment
- Salaries and other benefits of managers and staff
Operating Income And EBIT
Operating income and EBIT are the same, so you might hear people using these terms interchangeably for the same thing.
While the three income formulas above are the most used ways to calculate the operating income, you can also calculate the income from operations by starting at the bottom of the income statement where you see Net Earnings. You then need to add in the interest expense and taxes.
Many analysts use this when they want to calculate the EBIT.
Is Calculating The Operating Income For Businesses Important?
Knowing how to calculate the operating income for your business is extremely important. It shows whether your business is operating efficiently or not. It also is a good indicator of your company's ability to make more earnings as well as showing if your company is productive or not.
Investors are the main people that will look at your operating income since it shows the efficiency of your business over a given period of time. Operating income or operating profit is different from your company's gross profit or net profit because it's a more accurate financial metric of if your company might be worth buying out or not.
The higher your operating income, the more effective your company is doing business, especially if the operating income is increasing each year.
Steps For Calculating The Operating Income
Knowing how to accurately calculate the operating income will ensure you know how well your business is doing at any given time. It can also help you talk to investors if you're interested in selling your company or if someone is interested in buying you out.
Here are some of the steps you can take to make sure you are calculating the operating income correctly:
- You first need to know your total revenue. This is found on your profit and loss documents. You can also find it by multiplying the number of units produced with the average price per unit.
- You also need to find the costs of goods sold which is also on the profit and loss account. Or you can add the raw material purchased during your accounting period to the beginning inventory. After, you can deduct the cost of the closing inventory.
- You also need to find the operating expenses from the profit and loss accounts. You will see them listed, such as things like labor, administrative expenses, and depreciation.
- Lastly, you should have the EBIT by subtracting the costs of goods sold and the operating expenses from the total revenue.
Operating Income Calculators
Finding all these numbers and plugging them in can be a pain, especially when you have a million other things happening with the business. That's why many people choose to use operating income calculators. You can find them online or with accounting calculators.
All you have to do is plug in the numbers and then see the operating income listed once the calculator has done the work for you.
Operating Income is important for all businesses because you need to know how your business is performing. Operating income can tell you if your business is operating efficiently or not. With the help of a financial planner, you can know how to run your business more effectively by using the operating income.
One way you can find the operating income of your business is by adding your net earnings, interest expenses, and taxes. This is one of the most common formulas to use, but there are a few other ones you can try. You can also use operating income calculators or software if you don't want to deal with all the numbers yourself.
Shawn Manaher is a former financial advisor, has founded 5 online businesses, and is a coach, speaker, podcast host, and author. He's been featured on Forbes, The Consults Corner on TAE Radio, The Writing Biz, What's Your Story, and more.