In the early years of its operations, the difference between net income and operating expenses is probably minimal for a small business. The same is true for most freelancers and independent contractors. However, as you grow and expand your company, you must understand how to calculate and use these two indicators of profitability.
Net income is what's left after deducting the cost of goods sold (COGS), operating and non-operating expenses, depreciation and amortization, and taxes from the total income. This is why net income is also called net earnings or a company's bottom line. On the other hand, operating income is the amount left after you deduct operating expenses from gross income. Add back operating expenses, depreciation and amortization, and you'll get the operating income amount.
Both metrics measure your company's income, except that net income also includes proceeds from additional streams of income and any non-operating expenses. Keep reading as we review operating income and net income and list the differences between the two.
What Is Operating Income?
Operating income is your company's earnings after accounting for expenses incurred during its day-to-day operations. It's a metric that allows you to see your business's profitability if you only account for ordinary operating expenses. This is why operating income is also called operating profit or earnings before interest and taxes (EBIT) because it doesn't account for taxes or interest expenses.
Operating Expense Examples
Operating expenses refer to any fixed or variable expenses that a business incurs through its normal everyday operations. Generally, operating expenses are tax-deductible. But before you go on a shopping spree and attribute the charges to your business, take note of the Internal Revenue Service's (IRS) definition of a business expense.
"A business expense must be both ordinary and necessary." An ordinary expense refers to common and accepted costs in your trade or business. A necessary expense is one that's helpful and appropriate for your business activities.
Examples of business operating expenses include:
- Rent
- Utilities
- Computers, equipment, and office furniture
- Salaries and wages
- Advertising and marketing expenses
- Insurance costs
- Software subscriptions
- Depreciation and amortization
How to Calculate Operating Income
To calculate your operating income, deduct your company's cost of goods sold (COGS), operating expenses, depreciation and amortization from the gross income or total revenue.
| Gross Income |
| − COGS |
| − Operating Expenses |
| − Depreciation & Amortization |
| = Operating Income |
Your operating income represents your business income based on fixed and variable expenses you incur as you conduct business. It gives you a picture of your business's growth. You can also compare your company's year-to-year operating income to check if something you changed yielded more profit and growth.
Aside from operating expenses, you also have the following to calculate operating income:
- COGS: It accounts for the direct costs of production, such as raw materials, direct labor, equipment and utility expenses for the production site.
- Depreciation and amortization: You'll record depreciation expenses for fixed or capital assets that have a useful life of more than a year, such as computers, equipment or vehicles. Amortization is used to expense costs of intellectual properties, such as patents, trademarks and copyrights.
Use the operating income amount to calculate your operating profit margin, as well. Here's the formula:
| Operating Profit Margin | |||
|---|---|---|---|
| = |
| ||
To illustrate, let's assume an operating income of $55,000 and total revenue of $100,000 for a freelance wedding photographer. Using the formula, you'll get:
| Operating Profit Margin | |||
|---|---|---|---|
| = |
| ||
| = | 0.55 | ||
What does this mean? It means for every dollar of revenue, the business owner in the example retains a profit of 0.55 cents after accounting for operating expenses.
As a business owner, you must understand the breakdown of where your profit comes from. Looking at your operating profit margin, you may decide to go through your expenses and see where you can cut and save. Reducing your operating expenses will allow you to keep more of your income.
For instance, if your office rent is relatively high, you can look for office-sharing opportunities or operate out of your home to reduce expenses. Or you may look at whether your advertising costs are showing any return on investment, for which you may decide to handle your social media marketing on your own.
What Is Net Income?
Net income is the amount left over after you've deducted all expenses from your total revenue for a given period. Net income is commonly referred to as the company's bottom line because it's the last line on the income statement. It's also called net earnings or earnings after tax (EAT).
The computation for net income includes operating income and proceeds from other revenue sources, such as interest income or the sale of assets. It also accounts for taxes, operating expenses, the COGS and other non-operating expenses.
Non-operating expenses or extraordinary expenses are costs you incur that are not considered ordinary or necessary to your core business operations. Examples are borrowing costs, such as interest paid on loans, losses on disposal of assets, or penalties and lawyer's fees in case of lawsuits.
How to Calculate Net Income
Calculate net income by adding up proceeds from all revenue streams and deducting all expenses and taxes within a given period. Only add or deduct amounts earned or spent within the period you want to measure - monthly, quarterly or yearly. Follow the formula below to compute your company's net income:
| Operating Income |
| + Investment Income |
| − Interest Expense |
| + Extraordinary Income |
| − Extraordinary Expenses |
| − Taxes |
| = Net Income |
Here's a breakdown of the variables included in the formula:
- Operating income: This represents income from your business's regular operations within a given period. Sales and revenue are other terms used to refer to operating income.
- Investment income: This line accounts for any income your business receives from other sources, such as investment income, dividends or interest income.
- Extraordinary income: This refers to income not earned from operations or other sources of income but may happen from time to time as part of running a business. An example is proceeds from the sale of assets.
- Operating expenses: These are ordinary and necessary expenses you incur in everyday business operations.
- Interest expense: This line item accounts for interests you paid for loans you took out to start or expand your business.
- Extraordinary expenses: These are expenses not considered ordinary but may occur as part of owning a business. Examples are losses you incur from the sale of assets or lawyer's fees from resolving a client dispute.
- Taxes: This line accounts for income taxes and self-employment taxes.
Your net income shows you the total income and expenses of your business over a specified period. It measures your company's profitability and shows you how unexpected expenses affect your bottom line. Tracking your net income will also let you compare your profit over time.
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What's the Difference Between Operating Income and Net Income?
Below is a review of the differences between operating income and net income.
Uses
Even though operating income and net income both measure your company's profitability, understanding each figure can help you make decisions for your business in specific aspects. For instance, operating income is useful for business owners to identify and reduce avoidable operating expenses. In contrast, net profit represents your company's overall profitability, which helps you determine what other expenses outside of your operating costs are reducing your bottom line.
Tax Treatment
The most considerable difference between operating income and net income is their treatment of taxes. By definition, operating income only accounts for the costs associated with the day-to-day operations of doing business and doesn't include taxes paid in its calculation. On the other hand, net income is calculated by deducting all expenses of the business, including taxes (income taxes, self-employment taxes, payroll taxes, etc.).
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Notice to the Reader
The content within this article is meant to be used as general guidelines and may not apply to your specific situation. Always consult with a professional accountant to ensure you're getting individual advice.
FAQs
Can net income be higher than operating income? ›
Usually no. Gross profit = Net sales minus cost of goods sold. If other income exists, it will increase the gross profit to that extent. So operating profit has to be lower.
How do you convert net income to operating income? ›To calculate net income, subtract all non-operating expenses from operating income.
What is the meaning of operating income? ›Operating income refers to the adjusted revenue of a company after all expenses of operation and depreciation are subtracted. Expenses of operation or operating expenses are simply the costs incurred in order to keep the business running.
What affects net income but not operating income? ›The key difference between operating income and net income is that operating income excludes interest and taxes while net income includes them. This makes operating income a more accurate measure of a company's core profitability.
Is it good to have a higher operating income? ›A company that's generating an increasing amount of operating income is seen as favorable because it means that the company's management is generating more revenue while controlling expenses, production costs, and overhead.
What is the formula to calculate operating income? ›Operating Income = Gross Income – Operating Expenses
Gross income is the amount of money your business has left after subtracting the costs of producing the product— also known as costs of goods sold.
Net profit is the leftover or the residual income left with the organisation after all debts. Operating profit is the income of the organisation that is left in the wake of taking care of all working costs or operating costs.
What is an example of operating income? ›Operating Income Example
Assume that in the current year, company ABC earned sales revenue worth $350,000. For the time period, the cost of goods sold was $50,000, rent was $15,000, maintenance fees were $3,000, insurance $5,000, and employee net pay $50,000. The operating income of the business is $227,000.
EBIT is used to analyze the performance of a company's core operations without the costs of the capital structure and tax expenses impacting profit. EBIT is also known as operating income since they both exclude interest expenses and taxes from their calculations.
What isn't included in operating income? ›Operating income excludes non-operating items such as investments in other businesses, taxes and interest payments. Sometimes businesses mask their poor operational results by using non-operating expenses. This increases the apparent profit margins.
Which is not considered an operating income? ›
Non-operating income is the portion of an organization's income that is derived from activities not related to its core business operations. It can include items such as dividend income, profits, or losses from investments, as well as gains or losses incurred by foreign exchange and asset write-downs.
What is the difference between operating income and net income quizlet? ›Operating income takes into account income taxes, whereas, net income does not take income taxes into account.
Do you want a high or low operating income? ›Higher operating margins are generally better than lower operating margins, so it might be fair to state that the only good operating margin is one that is positive and increasing over time. Operating margin is widely considered to be one of the most important accounting measurements of operational efficiency.
What is a healthy operating income? ›For most businesses, an operating margin higher than 15% is considered good.
What is a good operating income ratio? ›Typically, an operating profit ratio of about 20% is considered good, and below 5% is considered low.
Does operating income mean operating profit? ›Operating profit is also referred to as operating income as well as earnings before interest and tax (EBIT)—although wrongfully, as the latter includes non-operating income, which is not a part of operating profit.
Is EBITDA the same as net income? ›EBITDA is net income (earnings) with interest, taxes, depreciation, and amortization added back. EBITDA can be used to track and compare the underlying profitability of companies regardless of their depreciation assumptions or financing choices.
Can operating income be less than net income? ›Operating income is revenue less any operating expenses, while net income is operating income less any other non-operating expenses, such as interest and taxes. Operating income includes expenses such as selling, general & administrative expenses (SG&A), and depreciation and amortization.
How can net income be higher than operating cash flow? ›If net income is much larger than cash flow from operations, it's a signal that the company's earnings quality-the usefulness of earnings-is questionable. If cash flow from operations exceeds net income, on the other hand, the company may be much healthier than its net income suggests.
Is net income always greater than cash flow? ›Net income is an accounting metric and does not represent the economic profit or cash flow of a business. Since net profit includes a variety of non-cash expenses such as depreciation, amortization, stock-based compensation, etc., it is not equal to the amount of cash flow a company produced during the period.
Why is net income higher than cash flow? ›
Non-cash expenses, such as depreciation, amortization, and share-based compensation, must be included in net income, but those costs do not reduce the amount of cash a company generates in a given period. As a result, these expenses are added back into the cash flow statement.
Which is better operating profit or net profit? ›Net profit is the leftover or the residual income left with the organisation after all debts. Operating profit is the income of the organisation that is left in the wake of taking care of all working costs or operating costs.
What does it mean if operating income is negative? ›Operating profit is the excess of operating revenue over operating expenses. If operating income is negative, a business will likely require additional outside funding to remain in operation.
What is not included in operating income? ›Non-operating income, also known as peripheral or incidental income, include items such as. Dividend income. Gains and losses from investments. Gains and losses from the sale of assets or investments. Losses from asset impairment, write-offs, write-downs and restructuring.
What if operating cash flow is less than net income? ›When operating cash flow is less than net income, there is something wrong with the cash cycle. In extreme cases, a company could have consecutive quarters of negative operating cash flow and, in accordance with GAAP, legitimately report positive EPS.
Is net income the same as operating cash flow? ›Cash flow from operating activities is the absolute cash that an organisation gets, while the net income or net gain is income minus the costs, like the expense of undertaking the business, depreciation, taxes, compensations, interests, and other different costs.
What affects net operating income? ›NOI equals all revenue from the property, minus all reasonably necessary operating expenses. NOI is a before-tax figure, appearing on a property's income and cash flow statement, that excludes principal and interest payments on loans, capital expenditures, depreciation, and amortization.
What is the formula for operating income? ›Operating income = Net Earnings + Interest Expense + Taxes
For that period, the cost of raw materials and supplies used for the sold products was $9M, labor costs directly applied were $2M, administrative and staff salaries totaled $4M, and there were depreciation and amortizations of $1M.
Both profits and cash are important to businesses for different reasons. It's possible to show a profit and have a negative cash flow. It's also possible to have a positive cash flow and increasing sales but not make a profit.
Can a company be profitable with negative cash flow? ›For example, it's possible for a company to be both profitable and have a negative cash flow hindering its ability to pay its expenses, expand, and grow.
Why is net income not a good indicator? ›
Net income is not a good indicator of the financial success of the business because of the following reasons: (a) Net income is based on the various assumption and estimates which affect the net income calculation. (b) Net income is separate from the cash flow of the business.
Why is profit better than cash flow? ›Profit is the revenue remaining after deducting business costs, while cash flow is the amount of money flowing in and out of a business at any given time. Profit is more indicative of your business's success, but cash flow is more important to keep the business operating on a day-to-day basis.
What's more important cash flow or net worth? ›Cash flow is far more predictive of the future. Since it can be measured against cash flow in prior periods, it can indicate the ongoing health of a company in a way net worth can't. While it's true net worth can grow from one period to another, the direction is also more an indication of cash flow than anything else.