Operating income, also known as EBIT, is the operating income or profit of a company before expenses and interest are included. In basic terms, operating income covers only the gross profit plus the expense. Before interest and taxes are included in the equation, operating income is actually a measure of the profit of a company that consists of all expenses and incomes except those specifically tied to the payment of interest and taxes. When determining the amount to include in the formula for calculating the operating profit, there are several factors to consider.
The first factor, gross profit, is determined by adding the cost of goods sold to revenue. Goods sold are those that have been purchased and then delivered to the customer. Revenues may also be determined by taking the sales price of products and then deducting the cost of good sold. When determining operating income, it is also necessary to determine the gross margin, which refers to the difference between total revenue and the selling price of products. The last factor, operating expenses, is determined by subtracting the cost of capital employed from revenue.
The operating income includes the amount earned by the company through production, including the selling price of products, the depreciated value of fixed assets and goodwill, and payroll and rental expenses. Certain operating expenses, such as inventory turnover and loss, are not reported in gross profit, but are items that depreciate in value. Net income, which includes the net income from discontinued operations, is not a major determinant of operating income.
There are several other important metrics that are used in determining operating income. One important metric is operating cost, or cost of good sold minus total revenue. Other important metrics to include in the calculation of operating income include warranty and capital expenditures, retained earnings, and net income per company. Before the adoption of multiple metrics, many managers were forced to choose between operating profit and net income, which are not helpful. The introduction of balanced metrics greatly improved the profitability of companies with both gross and net income.
The most straightforward method for calculating operating income is the simple way, which is to add the cost of goods sold to revenue. But this is only the first step in analyzing operating income. In order to calculate profits, managers should add depreciation to revenue, which is equal to revenues less expenses. This can be done by simply dividing total revenue by the total expenses, which equals current expenses divided by total assets. This can be done by adding current assets and liabilities, which are equal to current expenses divided by current gross and current market value of stock or equity.
The next step is to subtract current expenses from gross and net income, which yields the net income. The third step is to subtract current income taxes from net income to get the net profit. All the three steps are necessary to determine the net profit and to adjust gross and net income for taxes. Additional income taxes are sometimes needed.