Operating Income

Earnings Before Interest & Taxes

What is Operating Income?

Operating income also referred to as earnings before income taxes (EBIT), is the amount of revenue left after deducting the operational direct and indirect costs from sales revenue. This can also be computed using gross income less depreciation, amortization and operating expenses not directly attributable to the production of goods. Interest expense, interest income, and other non-operational revenue sources are not considered in computing for operating income.

Below is an example of income from operations highlighted on Amazon.com Inc.’s 2016 income statement.

Operating Income on the Income Statement of Amazon Inc.
Source: Amazon.com Inc.

 

What is the formula for Operating income?

There are three formulas to calculate income from operations:

 

1. Operating income = Total Revenue – Direct Costs – Indirect Costs

OR

2. Operating income = Gross Profit – Operating expenses – Depreciation – Amortization

OR

3. Operating income = Net Earnings + Interest Expense + Taxes

 

Example calculation

D Trump footwear company has earned total sales revenue of $25M for the second quarter of the current year. For that period, cost of raw materials and supplies used for the sold products was $9M, labor costs directly applied $2M, administrative and staff salaries of $4M, depreciation, and amortizations of $1M.  As a result, the income before taxes derived from operations gave a total amount of $9M in profits.

 

What are Revenue and Gross Profit?

Sales revenue or net sales is the monetary amount obtained from selling goods and services to business customers excluding the merchandise returned and the allowances/discounts offered to them.  This can be realized either as cash sales or credit sales.

Gross income, on the other hand, is the monetary result obtained after deducting the cost of goods sold and sales returns/allowances from total sales revenue.

 

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What are Direct Costs?

Direct costs are expenses incurred and attributed to creating or purchasing a product as well as in offering services.  Often regarded as the cost of goods sold or cost of sales, these expenses are specifically related costs in producing goods or services. These costs do not need to be fixed in nature as it can also be variable depending on the quantity being produced and utilized.

Examples of directs costs are:

  • Direct materials and supplies – spare parts, raw materials, manufacturing supplies
  • Direct Labor – services employed to directly manufacture a product such as machine operators, factory workers, assembly line operators, painters
  • Power and water consumption – electric bills and water usage attributed to the production
  • Cost of merchandise – purchased price of finished product for resale plus shipment costs
  • Commissions or professional fees – cost of delivering services specifically in service-oriented businesses such as insurance, real estate, consultancy and law firms

 

What are Indirect Costs?

Indirect costs are operating expenses that are not directly associated with manufacturing or purchasing a product.  These costs are frequently accumulated into a fixed or overhead cost and allocated to various operational activities.

Examples of production indirect costs are:

  • Salaries and related benefits of production managers and quality assurance staff
  • Maintenance cost and depreciation expense of factory equipment
  • Rent of factory facility
  • Utilities not directly involved in creating or purchasing goods

Examples of selling and administrative indirect costs are:

  • Salaries and benefits of corporate managers and staff
  • Office supplies
  • Depreciation of office building, equipment, furniture, and fixtures
  • Office facility rent
  • Maintenance and repairs
  • Utilities such as electricity, water, telephone lines
  • Insurance and amortizations
  • Marketing and advertising costs
  • Travel expenses

 

Operating Income = EBIT

Another way to calculate income from operations is to start at the bottom of the income statement at Net Earnings and then add back interest expense and taxes.  This is a common method of an analyst to calculate EBIT, which can then be used for valuation in the EV/EBIT ratio.

Below is an example calculation of EBIT:

  • $39,860 Earnings
  • +$15,501 Taxes
  • +$500 Interest
  • =$55,861 EBIT

EBIT vs EBITDA EBIT example

 

Learn more about EBIT and EBITDA.

 

What is the Importance of Operating income in business?

Operating income, as opposed to operating loss, represents a positive result on how efficient the business is operating.  It is an indirect measure of productiveness and its ability to generate more earnings which can be used to further expand the business. Investors are closely monitoring the operating profit expressed in various profit ratio, to understand the trend of efficiency over a period of time and make decisions. It also helps other interested parties in determining the worth of the company for a potential buyout. The higher the profit as time goes by, the more effective a company’s core business is being carried out.

 

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