What is Operating Income?
The Operating Income metric represents the profitability of a company’s core operating activities over a specified time period.
The operating income of a company is determined by subtracting its direct and indirect operating costs – i.e. cost of goods sold (COGS) and operating expenses (SG&A, R&D) – from its revenue.
How to Calculate Operating Income (Step-by-Step)
The operating income metric is important since it only measures the core profitability of a company.
Therefore, the operating profit of a company is unaffected by discretionary management decisions, such as the capital structure, i.e. the mixture of debt and equity used to fund day-to-day operations, and reinvestment activities like capital expenditures (Capex).
- Capital Structure Neutral (i.e. Independent of Financing Decision)
- Neglects One-Time, Non-Operating Costs (e.g. Gains or Losses on Asset Sales)
- Unaffected by Taxes (i.e. Jurisdiction-Dependent)
Since the operating income of a company is capital structure neutral and not impacted by non-operating costs – e.g. interest expense and taxes – the operating profit metric is widely used in corporate valuation.
The operating income calculation is a two-step process:
- Step 1. Calculate Gross Profit by Subtracting Cost of Goods Sold (COGS) from Revenue
- Step 2. From Gross Profit, Subtract Operating Expenses (e.g. SG&A, R&D)
Operating Income Formula
The formula to calculate a company’s operating income is as follows.
Each input of the operating profit formula can be found on the income statement.
- Revenue: Revenue is the “top line” of the income statement and represents the sales generated by a company from selling its products and services to customers, net of any returns, discounts, and sales allowances.
- Cost of Goods Sold (COGS): The direct costs incurred by a company that are directly tied to its efforts to generate revenue.
- Operating Expenses: The indirect costs incurred by a company that are not directly tied to its efforts to generate revenue. Still, the operating expenses are essential to the company’s business model and necessary expenses (e.g. SG&A, R&D).