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In this article, we will clear up the confusion many have regarding an accounting term known as operating income. We will discuss what operating income is and is not from an accounting point of view. In addition, you will learn which financial statement is needed in order to determine operating income. The article continues on with a definition of operating income. Finally, you will discover a number of operating income examples. Let’s now begin our discussion on operating income.
Operating Income has been confused by many as net income after taxes, net income before depreciation, and net earnings after depreciation, to name but a few. Others have tried to extrapolate operating income from the balance sheet and even from the cash flow statement.
In its simplest form, operating income is net income before taxes which is also referred to as NIBT. A number of accounts are needed in order to determine operating income. These accounts are found on the income statement; not the balance sheet nor the cash flow statement. Furthermore, operating income is found by using the following income statement accounts:
If your business does not carry inventory, then you’ll not consider cost of goods sold when determining operating income. Examples of types of businesses that don’t use a cost of goods sold account include accounting firms, dentists, taxi services, bookkeeping services, and the like.
On the other hand, if your business carries inventory then cost of goods sold is considered when determining operating income. Examples of businesses carrying inventory include: clothing stores, flower shops, convenience stores, shoe stores, movie theatres, and service operators who also sell tangible products to end consumers.
In the following illustrations, you will discover how to calculate operating income. Assume you own a clothing store with total revenue of $800,000 in the past year. In addition, assume the cost of goods sold, also referred to as cost of merchandise sold, amounted to $300,000. Therefore, gross margin equals $500,000 ($800,000 - $300,000 = $500,000).
The final piece of information required in order to determine operating income is the company’s operating expenses. Assume the operating expenses amount to $400,000. Using the above information, the operating income or net income BEFORE tax for the past year is $100,000 (IE $800,000 - $300,000 – 400,000 = $100,000 operating income).
To summarize, operating income is arrived at by subtracting the operating expenses and cost of goods sold from the revenues. The taxes would then be subtracted from the operating income to arrive at the net income after tax. Again, operating income is the same as net income BEFORE taxes.
Now assume you own an internet company which only sells electronic books (eBooks) over the net. In other words, when someone purchases one of your books, the book is immediately emailed to the customer in electronic or digital format. As a result, you never carry an inventory since all your books are in PDF or some other digital format which enables you to email them directly to the end consumer. Since your internet company does not carry inventory, then cost of goods sold is not be considered when determining your operating income.
A manufacturing or processing business will always use cost of goods sold when determining operating income. Moreover, it’s the nature of a manufacturer or processor to transform raw materials into finished products.
In conclusion, income statement components are used when determining operating income. Operating income is achieved by subtracting operating expenses and cost of goods sold from revenues. Businesses who don’t carry inventories will not consider cost of goods sold when determining operating income. Manufacturers and processors will always use cost of goods sold when identifying operating income. Finally, operating income is the very same value as net income before taxes which is also referred to as net earnings before taxes.
Below depicts the operating income formula:
* Operating Income is the same as Net Income before tax.