Why Operating Income is Important for Small Businesses

Operating income, sometimes known as net operating income, operating earnings, or operating profit, is designed to measure profitability from core business operations.

Operating income is an important metric for business owners, investors, and financial institutions, as it measures the true effectiveness of the business.

Overview: What is operating income?

There are dozens of metrics that can be used to measure the financial performance of your business, but none are equal to the operating income metric.

This simple calculation measures business performance as a whole, concentrating on business performance and profitability, while leaving a lot of unnecessary items out. When measured over time, operating income can pinpoint business growth, efficiency, and the ability of your business to pay off its debts.

Because operating income is one of the best metrics for determining operational success, it’s frequently used by outside agencies and investors to determine the financial health of your business.

Operating income can be calculated whether you use cash basis or accrual basis accounting, though operating income that is calculated using cash basis accounting is not considered GAAP compliant.

Operating income is also one of the more important metrics used when examining a company for a potential buyout.

Operating income is determined by calculating sales revenues and subtracting operating expenses.

The operating income formula is:

Gross Income - Operating Expenses = Operating Income

Operating income vs. EBIT: What's the difference?

In many cases, the terms operating income and earnings before interest and tax (EBIT) are used synonymously, and for many businesses, the outcome will be the same.

The major difference between the two calculations is that EBIT includes non-operating income and expenses, while operating income only includes income and expenses from operations, giving you a more accurate depiction of business health and profitability.

In addition, the operating income metric is GAAP-compliant while EBIT, though a helpful metric, is not.

If you have other income or expenses and want to calculate EBIT, the EBIT formula is:

Gross Income - Operating Expenses + Other Income (if any) - Other Expenses (if any) = EBIT

How to calculate operating income

Calculating operating income is simple. We’ll use the following income statement as a reference point for calculating operating income for JB Services.

You can see that operating income and EBIT are different in the income statement.

Step 1: Calculate sales revenue

Before you can calculate your operating income, you need to calculate sales revenue. This is the revenue received for selling goods and services. Only operational income should be included in your gross revenue, with other sources of income listed separately.

Gross revenue or revenue from sales should always be at the top of your income statement.

Step 2: Calculate cost of goods sold

Cost of goods sold (COGS) is the cost of purchasing or manufacturing products with the intent to sell those products. Only materials and direct labor are included in the COGS calculation, which is a five-step process:

1. Obtain beginning inventory from your balance sheet for the beginning of the accounting period. If you’re calculating COGS for June, you will need to run a balance sheet dated June 1 in order to obtain beginning inventory. If you’re using a manual accounting system, you will need to use your inventory count as of June 1.
2. Add any inventory that was purchased during the period. If you purchased additional items from a distributor or manufactured additional products, they will have to be added to the inventory total for the month of June.
3. Factor in direct labor costs, if any. If you had two employees involved in the direct manufacturing of the products created in June, their wages should be included in your COGS calculation. If you’re not manufacturing products, you can skip this step entirely.
4. Obtain your ending inventory balance from your balance sheet dated June 30. If you’re using a manual system, you will need to do a count of all products or materials still on the shelf at month end and value them appropriately.
5. Calculate cost of goods sold. Now that you have all of the information needed, you can calculate your cost of goods sold using the following formula:

Beginning Inventory + Inventory Purchases + Direct Labor (if any) - Ending Inventory = Cost of Goods Sold.

Step 3: Subtract cost of goods sold from sales revenue

This is an easy calculation. Just subtract your cost of goods sold from your gross revenue to obtain your gross income, which is your income before factoring in any of your operating expenses. Your gross income number is the first part of the operating income calculation.

Step 4: Calculate operating expenses

Operating expenses reflect the cost of doing business. These are the expenses that your business incurs on a regular basis and can include the following:

• Administrative payroll
• Utilities
• Postage
• Travel
• Rent expense
• Office supplies
• Repairs and maintenance
• Professional fees
• Depreciation expense

Though one-time expenses can be included when calculating EBIT, they should be excluded when calculating operating expenses. Once you’ve completed Step 4, you’re ready to calculate your operating income.

Step 5: Calculate operating income

Now that you’ve calculated gross income, cost of goods sold, and operating expenses, you’re ready to calculate your operating income. Using the income statement above, your operating income will be calculated as follows:

$58,000 - $8,740 = $49,260

If you want to calculate EBIT using the income statement, the calculation would be:

$58,000 - $8,740 + $8,700 = $57,960

Because of the one-time asset sale, the EBIT total is $8,700 higher than your operating income. While this one-time sale will increase your net profit for the month, it is not an accurate reflection of the profitability of your business operations.

Operating income is an important metric for your business

Whether you’re a sole proprietor, a thriving small business, or multi-national corporation, operating income is an important metric for measuring the profitability of your business. Even more important, operating income tells you whether your business is earning enough money to cover its bills.

Because operating income focuses solely on operations, it provides a much clearer picture of the business than EBIT, which includes both income and expenses from other sources such as asset sales or a one-time purchase.

If you’re tired of keeping track of business income and expenses on a spreadsheet or in multiple journals, take a few minutes to check out The Ascent’s review of some of the top small business accounting software applications on the market today.