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A Step-By-Step Guide To Calculate Operating Income
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In the initial stage of business, the first challenging question to deal with is, ‘How to calculate operating income?’
A recent study states that around 20% of small businesses fail in their initial year of business. Profitability is the key measure to gain insights into a company’s success.
To gain profits in the first year of business is a positive indicator that you’re in the right direction.
But, how do you calculate the profitability of your business? That’s the question. Let’s dive deeper into how to calculate operating income step-by-step!
What is Operating Income?
Operating income is known by the words operating profit or operating earnings, interchangeably. To get a fair idea of a company’s income, it’s crucial to know how to calculate operating income because it provides information on the company’s core profitability and factors that derive success.
In layman’s terms, operating income is a company’s profit before interest and taxes. Let’s cut it down to understand operating income better:
- Simply put, operating income is the profit earned from a business’s continued operations.
- Operating income is calculated by subtracting operating expenses like depreciation, wages, and cost of goods sold (COGS).
- Operating income is also known as income from operations. When you subtract all operating expenses from the company’s gross income, you get the operating income.
- Operating expenses are the actual costs incurred from normal operating activities like utilities, office supplies, etc.
In short, a company generating a favourable operating income has a good reputation in the industry because it indicates greater revenue with better control of production costs, controlling expenses and overhead.
| Note: If the company does not incur any non-operational costs, interest or tax expenses, their operating income may be the same as net income. |
Recommended Read: Revenue vs Net Income Explained
Income Types Part of Operating Income
When you’re learning how to calculate operating income, you must have the following income types in mind that are part of operating income:
- Income from operations
- Operating revenues
- Operating expenses
- Cost of Goods Sold (COGS)
- Gross profit
- Revenue from sales
- Earnings before interest and taxes (EBIT)
- Earnings before interest, taxes, depreciation and amortization (EBITDA)
Simply put, sales revenue, rental income, commission income, and other primary incomes generated by business operations are a part of operating income. And, before you learn how to calculate operating income, it is vital to understand what is included in operating expenses and direct expenses.
| Operating Expenses | Direct Expenses |
| Insurance | Cost of goods sold |
| Wages and Salaries | Labour |
| Rent | Raw Materials |
| Depreciation | Packaging |
| Taxes | Freight |
| Travel Expenses | Manufacturing Overhead |
| Marketing | Inventory costs |
| Maintenance | Direct Labour and supervision |
| Office Supplies | Equipment rental |
| Utilities | Subcontractor fees |
In brief, effectively managing these expenses helps in maintaining profitability.
Importance
For sustainable growth, it is essential to understand the importance of operating income. Below are a few pointers that depict why operating income in a business is important:
- A key metric for the company’s overall income assessment
- Helps in strategic decision-making regarding cost, resource allocation, pricing strategies, etc.
- Influences investor’s confidence during stock valuation.
- Monitoring operating income helps identify areas of improvement in the operational processes.
- Identifies operational business risks and challenges to implement risk mitigation strategies.
- Set benchmarks in the industry to ensure long-term sustainability and success.
- Decides standards for setting performance targets and evaluating progress.
- Acts as a reliable tool for lenders and investors to measure a company’s ability to generate sufficient cash flow income.
- Holds management accountable for the company’s profitability, incentives and shareholder interests.
Recommended Read: The Best Ways to Find Investors For Your Business
How to Calculate Gross Operating Income
Here are the basic guidelines on how to calculate operating income. Determine the company’s total revenue from the sales/services. Now, subtract COGS i.e. Cost of Goods Sold (The direct expenses with services or goods sold).
Next, deduct all the operating expenses like utilities, rent, wages, administrative costs, marketing costs, etc. That’s how you’ll have the profit generated from the core business operations.
With the above guidelines, you can easily understand how to calculate gross operating income without hassle.
Recommended Read: Gross Profit vs EBITDA: What’s the Difference?
How to Calculate Net Operating Income
If you want to know how to calculate operating income with three alternative formulas, here’s how you can do it:
| Operating Income = Total Revenue – Direct Costs – Indirect Costs |
OR
| Operating Income = Gross Profit – Operating Expenses – Depreciation – Amortization |
OR
| Operating Income = Net Earnings + Interest Expenses + Taxes |
The second formula depicted in the table above describes how to calculate net operating income. In simple terms, you need to:
- Add all your rental income received from real estate/property, etc.
- Deduct any anticipated vacancies or estimated vacancy losses from this gross rental income.
- Now, add all expenses like maintenance costs, property management fees, property taxes, utilities or any other relevant expenses.
- Lastly, deduct the total operating expenses from the adjusted gross rental income to calculate the net operating income (NOI).
Recommended Read: Revenue vs Operating Income
How to Calculate Income from Continuing Operations
Let’s learn how to calculate income from continuing operations with an example:
Imagine a company, Quila Corporation reports its financial data for this year with its:
- Net Income – USD 500,000
- Loss from discontinued operations – USD 20,000
- One-time gain from the sale of an asset – USD 50,000
- Interest Income – USD 10,000
- Interest Expense – USD 15,000
To calculate from continuing operations, subtract one-time gain from the net income. The figure comes out to be USD 430,000. Now, add interest income and deduct interest expenses. The remaining amount is USD 435,000. This is now the profit generated by Quila Corporation through its ongoing business activities.
In a similar way, you can learn how to calculate after-tax operating income with the help of experts.
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How to Calculate Operating Cash Flow from Income Statement
In mathematical terms, operating cash flow income can be calculated using the following formula:
| OCF = Net Income + Non-Cash Expenses + Changes in Working Capital OR OCF = Net Income + Depreciation and Amortization + Changes in Working Capital |
The terms used in the formula are described below:
- Net income = Profit after expenses and taxes
- Non-cash expenses = Doesn’t involve actual cash outflows like depreciation or amortization
- Changes in working capital = Changes in current assets like inventory accounts receivable along with current liabilities like accounts payable
Note: This formula is for calculating the cash flow generated out of the company’s core operating activities to gain insights into the business’s liquidity.
Recommended Read: Financial Forecasting vs Financial Modeling
How CrossVal Can Help
With CrossVal, the future of financial modeling is here at your fingertips. We can solve all your calculation problems in less than 4 minutes and 10 seconds.
Whether you want to learn how to calculate net operating income from the balance sheet or ace your business decisions using strategic financial models, CrossVal has the key to unlocking financial strategic models faster than you can imagine.
Book a demo with CrossVal today to empower your company and make smart financial decisions
Recommended Read: The Definitive Guide To Financial Modeling
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