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Operating income is a calculation for a company of the difference between the operating revenue and the operating expenses of that company. Operating income is frequently used as a synonym for earnings before interest and taxes (EBIT), although strictly speaking EBIT includes non-operating income as well as operating income. It is an important concept both for a company to determine their own health, as well as for an investor to be able to gauge the earnings potential of a company before they invest in it.
There are two main things calculated to determine operating income at a company: the operating revenue of the company and the operating expenses. Operating revenue is any revenue that comes in through standard revenue channels, such as sales of widgets, but excludes things like interest income or dividend income. Operating expenses are the expenses incurred in the daily operations of the company, but exclude extraordinary expenses. Generally, one can look at operating revenue as the revenue from sources that recur from year to year, and operating expenses as the expenses within a class that recurs from year to year.
Expenses that may be left out of operating expenses, and therefore out of calculating operating income, include things like paying out to a class action suit. Since it is assumed this is a cost that will only happen once, it isn’t particularly relevant to looking at the potential earnings of subsequent years. Similarly, income that comes in from investments in other companies isn’t really a reflection of how well the business itself is doing, only of how well its investments are doing, and therefore is generally left out of the calculation of operating income.
For a concept like this, an example may be the best way to show the difference between the different calculations. We will look at a fictitious manufacturing company, which produces and sells widgets. As an investor, looking at buying equity in the company, we are interested in how well they do as a business, and so we want to know their operating income and their earnings before interest and taxes.
First, we look at their operating revenue. This is fairly straightforward, as we only have to look at how much money they have brought in from their sale of widgets around the world. This includes all of their store locations, their wholesaling operations, and their online sales. The total number is $5 billion US Dollars (USD).
Next, we look at their operating expenses. To make their widgets, they spend $2.2 billion USD, which accounts for the raw supplies, leases on their factories, their distribution network, and their employees. They spend another $1.1 billion USD on administrative costs, including their executive compensation, legal expenses, and other staff. Around $150 million USD goes to amortization and depreciation. And they spend about $50 million USD on miscellaneous other expenses that recur year to year. So all told their operating expenses are $3.5 billion USD.
That means that their total operating income is $1.5 billion USD, which we get from subtracting their operating expenses from their operating income. If they also made $150 million USD from things like gains through their foreign exchange and other non-operating income, we would calculate their total earnings before interest and taxes as $1.65 billion USD. From there we could also add in their net interest income and expenses, and the taxes they paid out, to figure out their total net income.