Operating income is a concept used in accounting. It is known as Earnings Before Interest and Taxes (EBIT). It is used to measure the profitability of a company and helps the company as well as its investors to know how much of the revenue will turn into profit.
The formula to calculate Operating income is:’
Operating income = Revenue – (COGS + Operating expenses)
Revenue is the earnings of the company or sales.
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COGS stands for Cost of Goods Sold is the direct expense spent to produce goods. It includes raw material costs, which are direct costs. Indirect costs like office expenses, electricity, rent, and wages are not calculated under COGS.
Operating expenses are the expenses that a business spends for its regular operations. This includes rent, cost of equipment and machinery, salary, and other related expenses.
How it works
Let us assume a company has a sales of $200,000. The cost of goods sold is $50,000 and the operating expenses are $110,500.
So operating income = 200,000 – (50,000 + 110,500) = $39,500.
So, the operating income in this example is $39,500. This is the profit before tax. Once you arrive at this figure, you can get an idea of what the final profit would be.
Why is it important?
Operating income or EBIT is important because it is a parameter used to measure the profitability of a company. When you calculate the operating income or operating profit, you get to know if the company is going to make profits or not. You also will know how much profit is made.
This information is important for the management of the business. A business is started with the objective of making a profit. So, it is imperative that the management knows how much profit would be made. This helps then in making various other decisions. For instance, if you are not making profits, then you will try to scale down costs. On the other hand, if you are making a profit, you may gain confidence to expand your operations and maybe launch new products. Important decisions are made based on data related to operating income and profit.
Operating income is an important parameter for investors. Anyone who wishes to invest in a company would like to know if the company is doing well. Operating income is one yardstick used by investors to assess the value of a company. This helps them to take a decision on whether to invest money or not.
It is also an indicator of efficiency. Revenue or sales come from the efficient operations of the sale process. Similar operating expenses are under the control of the company executives. An efficient organization would try to reduce expenses and increase revenue, leading to a greater profit. Operating income is thus a measure of the efficiency of the organization. It tells the functional heads what they need to do next.
Lastly, this is information that shareholders like to track. It helps them to assess how profitable the company is. The more the profitability, the higher the dividends they can get. And most importantly, profitability would increase the value of the company shares, helping shareholders to increase their wealth,
Operating income is the difference between revenue and expenses. It is an important accounting term, which tells how profitable a company is.