What is Operating Income?

Operating income is the net income of an entity, not including the impact of any financial activity or taxes. The measure reveals an entity's ability to generate earnings from its operational activities. Operating income is positioned as a subtotal on a multi-step income statement after all general and administrative expenses, and before interest income and interest expense. This line item appears in the following exhibit, which contains an income statement.

How to Calculate Operating Income

To calculate operating income, subtract the cost of goods sold and operating expenses from net sales. Net sales are defined as gross sales minus all sales returns and allowances. The cost of goods sold is the cost of all direct materials, direct labor, and factory overhead associated with the goods being sold. Operating expenses include all expenses associated with selling, general and administrative activities. The operating income formula is as follows:

Net sales - Cost of goods sold - Operating expenses = Operating income

The measure can be modified further to exclude non-recurring events, such as a payout associated with a lost lawsuit. Doing so presents a better view of a firm's core profitability. However, this concept can be taken too far, since incurring the occasional non-recurring expense is a normal part of being in business.

Understanding Operating Income

Operating income is closely followed by investors, who want to understand the ability of a company's core operations to grow organically and earn a profit, without extraneous financing and other issues interfering with reported results. The measure can be particularly revealing when viewed on a trend line, and especially as a percentage of net sales, to see spikes and dips in the number over time. Operating income can also be compared to that of other companies in the same industry to gain an understanding of relative performance.

The managers of a business can fraudulently alter the operating income figure with a variety of accounting tricks, such as a different revenue recognition policy, accelerated or delayed expense recognition, and/or changes to reserves.