What It Is:
How It Works/Example:
The formula for calculating operating income is:
It is important to understand what expenses are included and excluded when calculating operating income. It typically excludes interest expense, nonrecurring items (such as accounting adjustments, legal judgments, or one-time transactions), and other income statement items not directly related to a company's core business operations.
To see how operating margin works, consider Company XYZ's income statement:
Using this information and the formula above, we can calculate that Company XYZ's operating income is:
Operating Income = $1,000,000 - $500,000 - $250,000 - $50,000 = $200,000
Operating income as a percentage of sales is called operating margin. In this example, Company XYZ makes $0.20 in operating income for every $1 in sales.
Why It Matters:
Operating income, or EBIT, is important because it is an indirect measure of efficiency. The higher the operating income, the more profitable a company's core business is.
Several things can affect operating income (such as pricing strategy, prices for raw materials, or labor costs), but because these items directly relate to the day-to-day decisions managers make, operating income is also a measure of managerial flexibility and competency, particularly during rough economic times.
Operating income provides investment analysts with useful information for evaluating a company’s operating performance without regard to interest expenses or tax rates, two variables that may be unique from company to company, and enables one to analyze operating profitability as a singular measure of performance. Such analysis is particularly important when comparing similar companies across a single industry where those companies may have varying capital structures or tax environments.
It is also important to that some industries have higher labor or materials costs than others. This is why comparing operating income or operating margins is generally most meaningful among companies within the same industry, and the definition of a "high" or "low" ratio should be made within this context.