Operating income and net income are both essential measures of business success. They both measure expenses but in different ways. Operating income measures the cost of a business’s everyday operations, while net income measures the cost of operating a business plus any non-operating expenses, such as debts and investments.
What is operating income?
Operating income, also called operating profit, is the remaining earnings after all operating expenses are subtracted from the total sales or revenue generated from your business’s primary operations.
Operating income doesn’t include interest expenses on debt nor income taxes. Determining your operating income is a key step in calculating net income, which you can do using a multistep income statement. You first calculate gross profit, then operating income, then finally net income.
What is included in operating income
Operating income appears near the bottom of an income statement, typically a few lines above net income, which sometimes is known as the bottom line. The components involved in calculating operating income include:
Sales or revenue
This is income received when you sell a good or service. It excludes income from non-operating sources, such as stock dividends and gains from the sale of investments or assets. These sources of income are reported separate from revenue.
Cost of goods sold (COGS)
These are direct costs of making your products. Typically, COGS consists of raw materials and labor for a manufacturing business or wholesale costs of merchandise for a retailer.
Selling, general, and administrative (SG&A) expenses
Also known as overhead, SG&A expenses are the costs of running a business that aren’t directly tied to production. These usually include the rent or mortgage for an office, the office staff, accounting and payroll, and utilities.
Depreciation and amortization
These are non-cash expenses that spread out the cost of purchased assets over time, even though the assets were paid for upfront. Depreciation is for fixed, tangible assets such as a factory, machinery, or a computer system. Amortization is for intangible assets, such as patents, trademarks, and goodwill from acquired businesses.
Operating income formula
The following formula typically is used to calculate operating income:
Operating income = Sales or revenue – COGS – SG&A – Depreciation – Amortization
For example, your business’s operating income calculation might look like this:
|Cost of goods sold
|Selling, general, admin. expense
|Staff – salaried
|Depreciation: widget machine
|Total SG&A expense
From this, you can calculate your operating profit margin, which is operating income expressed as a percentage of revenue, using the following formula:
Operating profit margin = Operating income / Revenue
In this case, operating profit margin is: 30% = ($3 million / $10 million)
What is net income?
Net income is a company’s operating income, plus or minus items not part of its business operations. These items appear below operating income on income statements. Tax payments are deducted from pretax income after all other expenses are subtracted—or added, in the case of gains—from revenue.
Sources of nonoperating income can include:
- Rent. This is payment for use of any property or assets by a third party.
- Dividends. These are payments from stock investments.
- Interest. This is income from savings, loans, or bond investments.
- Capital gains. These are any profits on the sale of assets or investments.
- Royalties. Some companies receive payments from patents or other intellectual-property rights.
Nonoperating expenses include:
- Interest. These are payments on any debt obligations.
- Capital losses. These are the opposite of capital gains and reflect losses on sales of assets or investments.
- Income tax. This is the final expense, which is determined after adding or subtracting all other income and expenses, if applicable, from operating income.
Net income formula
The formula for net income then is:
Net income = Operating income + Nonoperating income – Nonoperating expenses – Interest + Gains – Losses – Taxes
Following through with the earlier example statement, your company had nonoperating items that affected net income. The rest of its income statement, below operating income, might look like this:
|Rent, warehouse space
|Dividends, XYZ Corp. stock
|Total nonoperating income
|Interest expense, loan
|Loss on sale of asset
|Income tax, at 25%
From this, we can calculate the net income margin, also known as net profit margin, which is simply:
Net income margin = Net income / Revenue
In this case, net income margin is: 21% = ($2.1 million / $10 million)
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Differences between operating and net income
Although operating income and net income are both measures of profitability, they differ in some important respects:
Operating income includes only sales or revenue from a business’s primary operations after deducting routine operating expenses. Net income includes non-operating income, such as one-time gains from selling assets or investments.
Operating income includes only expenses associated with operating your primary business, such as the cost of goods sold (COGS) and selling, and general and administrative expenses (SG&A). Net income includes other expenses, such as interest payments on debt and income taxes, legal costs, or losses on sales of assets or investments.
Professional investors and analysts generally pay closer attention to operating income because it offers more insight into your business’s efficiency and potential for long-term success. Net income is more widely followed by the investing public because it figures so prominently in setting share prices on the stock market. But it can differ from operating income because of one-time gains or losses, or nonoperating income and expenses that may not last in the long term.
Operating income vs. net income FAQ
Which is more important, operating or net income?
Both are important in different ways. Operating income is the gauge of your company’s profitability in its primary business, especially when compared to competitors. Net income indicates how much is left for your business to add to retained earnings and build up equity, or for payment of distributions or dividends to the owners or shareholders.
What’s an example of operating vs. net income?
A basic example could be: A small business has sales of $5 million, COGS and SG&A of $3 million, and operating income of $2 million. After interest expenses of $200,000 and income tax of $300,000, net income is $1.5 million.
Are operating income and operating profit the same?
Yes, they are the same thing. Also, net income, net profit, and earnings are often used interchangeably.
Which should I pay attention to—operating or net income?
You should pay attention to both, as well as to other metrics. Operating margin tells you how efficiently a company makes and sells its products based on operating expenses. Net income tells you how much a company earned after every expense item is subtracted—or added, in the case of unusual or one-time gains.