Profitability is a key measure of a company's success, especially for startups. Investors want to know if a company's core activities can result in a profit, so they can get a return on their investment.
Approximately 20% of small businesses fail in their first year of business. While becoming profitable in your first year of business is challenging, if you are profitable, it's a positive indicator that your company is heading in the right direction.
But how can we calculate profitability? This is where operating income enters the picture. Operating income is the profit left over after expenses are subtracted from a company's revenue. The resulting number is a subtotal on a multi-step income statement. The multi-step income statement provides an overview of how well a business' core business is performing.
What is operating income?
Operating income is a measure of a company's profitability. It's calculated by subtracting operating expenses from operating revenues. The resulting number is shown as a subtotal on a company's income statement. It's also known as operating profit, operating earnings, or income from operations.
Creditors and investors take a careful look at a company's operating income. The number gives them a clearer picture of the business' scalability or capacity for future growth. For example, a positive operating income shows there's room for the company to grow in its industry, while a negative operating profit could mean the business is less likely to scale up and grow.
Now that we've learned what operating income is, let's take a deeper look into the details and learn the steps to calculate your business' operating income.
Operating Income Formula
- Start with gross income.
- Subtract operating expenses.
- Subtract depreciation and amortization.
- The resulting number is operating income.
Let's define a few key pieces of the operating income formula:
1. Gross Income
Gross income is the amount of money your business earns before any taxes or other deductions are subtracted from it. Lenders use this number as an indicator of how much money you're likely to borrow. They often make sure you don't borrow more than your gross income total.
2. Operating Expenses
This is the combined total of the costs of operating your core business activities. Common operating expenses include:
- Cost of supplies
- Sales commissions
- Legal fees
- Cost of goods sold (COGS)
One key component of operating expenses is COGS (cost of goods sold.) Below is the formula for COGs:
Beginning inventory + purchases during the period – ending Inventory = COGS
Beginning inventory is the merchandise that wasn't sold in the previous year. Purchases during the period include the cost of producing more products or buying more merchandise. At the end of the year, the unsold products (ending inventory) are subtracted from the sum of the beginning inventory and purchases during the period.
3. Depreciation and amortization
Depreciation and amortization are expenses that account for the cost of assets over the life of their use. These numbers are found in the operating expense section of the income statement and are reported during the period of each asset's use.
The term "useful life" is used hand-in-hand with depreciation and amortization. Useful life is the estimated lifespan of an asset.
Depreciation is the expensing of tangible assets over their useful life. Tangible assets, or fixed assets, are physical assets such as land, buildings, vehicles, equipment, office furniture, etc. Depreciation is calculated by subtracting the asset's resale value from its original cost -- and this is expensed over the course of the asset's expected life.
For example, if a business buys a machine that costs $10,000, the business expenses the cost over the machine's 10-year lifespan. The resale value after 10 years is $2,000. The depreciation calculation would look like this:
($10,000 - $2,000) / 10 years = $800
The company will expense $800 each year until the machine is completely paid off in the tenth year.
Amortization is similar to depreciation, except it's the expensing of intangible assets. Examples of intangible assets include trademarks and patents, copyrights, franchise agreements, etc. Unlike tangible assets, these intangible assets typically do not have any resale value at the end of their life.
Operating Income Examples
Sarah's Bakery specializes in creating wedding cakes for weddings in the Boston area. Her small business is growing and she wants to move her operations to a bigger location and purchase a new space. Before she can move her business, she needs to borrow money from the bank.
She creates a multi-step income statement to show the bank how well her core business is doing. Over the course of the year, Sarah sold $80,000 worth of wedding cakes. She also had the following expenses:
- Rent: $24,000
- Utilities: $5,000
- Insurance: $1,000
- Baking supplies: $10,000
- Equipment: $700
- Depreciation and amortization: $100
Here's how Sarah calculated her operating income:
$80,000 (gross income) - $40,700 (operating expenses) - $100 (depreciation and amortization) = $39,200 (operating income)
With a positive operating income of $39,200, Sarah can show the bank she's been able to generate a profit with her business. This increases the likelihood she'll get a loan to help pay for the cost of purchasing the new location.
To get an idea of what this looks like, here's an example of Google's income statement over the past few years, including operating income.
Source: Yahoo! Finance
We can see that Google has maintained a positive operating income over the past four years. This popular search engine's high operating income is an indication of its profitability.
With the operating income and other measures of your business' cash flows and financial standing, you can gauge your business' ability to bring in a profit. The higher the operating income, the more profitable the company's core business is.
To learn more about startups, read about startup burn rates next.