How to calculate operating income and maximize your profits

Operating income is the profit your business earns from its core operations after subtracting operating expenses before deducting taxes and interest. It helps you understand how well your business runs without considering non-operating costs like loans or investments.

Unlike net income, operating income only looks at revenue minus operating costs. This includes costs like wages, rent, and production expenses.

Operating income is also known as Earnings Before Interest and Taxes (EBIT) because it measures a company’s profitability before factoring in interest payments and taxes. Since it focuses only on sales revenue and operating expenses, EBIT helps businesses understand how well their core operations generate profit without the influence of financing or tax-related costs.

A higher operating income means your business earns more from its core operating activities. A lower number could mean rising costs or slowing net sales.

On average, businesses keep about 11.5% of their revenue as operating income. This means for every dollar earned, they keep around 11 cents in profit before other expenses. However, this varies based on the industry you are operating in.

Investors and business owners use operating income to check financial health, cost control, and profitability. Since it focuses only on core business operations, it gives a clearer picture of how efficiently you run things.

Key elements of an operating income

Operating income depends on three main factors: revenue, cost of goods sold (COGS), and operating expenses. Each one plays a direct role in determining how much operating profit your business generates. A higher revenue boosts operating income, but only if costs remain in check. On the other hand, high COGS and operating expenses can reduce your earnings even when sales are strong.

Revenue

Revenue is the total money your business brings in before deducting any costs. It sets the upper limit for how much profit you can make. The more revenue you generate, the greater your potential operating income, as long as expenses don't rise at the same rate.

If your revenue increases while costs stay stable, your operating income grows. But if sales decline, your operating income will shrink, even if expenses remain unchanged. Businesses that maintain strong revenue while controlling costs achieve higher operating margins.

COGS

COGS includes all direct costs of making a product or providing a service, such as raw materials and labor. It's deducted from revenue to determine your gross profit, directly impacting operating income.

If COGS is too high, it cuts into your profit margins. Lowering these costs through better supplier negotiations, improved production efficiency, or alternative materials can help boost operating income.

Operating expenses

Operating expenses include rent, salaries, marketing, utilities, and other overhead costs. These costs don't directly contribute to production but are essential for day-to-day operations. It also includes non-cash costs like depreciation expense, which accounts for the gradual reduction in asset value over time.

Reducing unnecessary expenses, automating processes, or optimizing staffing can help increase operating income without needing higher sales. Keeping these costs under control ensures more of your revenue turns into profit.

If operating expenses rise without a matching increase in revenue, operating income declines. Cutting unnecessary expenses, like renegotiating rent or reducing marketing waste, can improve margins.

How to calculate operating income

Calculating operating income helps you track profitability and make better financial decisions. Large corporations analyze it every quarter, while small businesses may review it annually or during key financial planning periods. Calculating your operating income is easy and usually takes less than an hour if your financial records are organized.

Top-down approach

The top-down approach starts with your total revenue and subtracts expenses step by step to find your operating income. It gives you a clear view of profitability by breaking down earnings from the top.

The formula for the top-down approach is:

Operating income = Gross profit – Operating expenses

This method works well if your business focuses on revenue growth. It helps you see how much of your earnings remain after expenses. You may need to cut costs or adjust pricing if your revenue is high, but operating income is low.

Bottom-up approach

The bottom-up approach calculates operating income by starting with expenses and adding up profits. Instead of working down from revenue, you build up from costs to see how much profit remains after covering expenses.

The formula for the bottom-up approach is:

Operating income = Total revenue – (COGS + Operating expenses)

This approach helps you focus on cost control. It allows you to track spending and understand how much revenue is needed to stay profitable. If expenses are too high, you may need to cut costs or increase prices to improve your operating income.

Cost accounting approach

The cost accounting approach calculates operating income by focusing on direct and indirect costs tied to your business operations. This method helps you analyze expenses in detail and make smarter cost-cutting decisions.

The formula for this approach is:

Operating income = Revenue – (Direct costs + Indirect costs)

This method works well for manufacturers, service providers, and businesses with complex cost structures. It gives you a clear breakdown of expenses, helping you see which costs impact profitability the most.

Managing direct and indirect costs efficiently helps businesses maintain accurate management reports and income statements. Many companies use software to categorize transactions automatically and ensure that each cost is recorded correctly. With Ramp's expense management, businesses can track expenditures in real-time, making financial reporting more accurate and reducing the risk of missing key costs.

How operating income differs from gross income, net income and gross profit

Operating income, net income, and gross profit all measure profitability. However, they focus on different stages of your business's finances.

Gross profit shows how much money remains after subtracting the cost of goods sold (COGS) from revenue. It does not include operating expenses like rent, salaries, or marketing. A high gross profit means your business generates strong revenue after covering production costs. But it doesn't tell you if your business is profitable.

Operating income takes gross profit and subtracts operating expenses. It shows how efficiently your core business activities generate profit. Since it excludes interest and income taxes, it gives you a clear view of operational performance.

Businesses also use EBITDA to assess profitability. While operating income accounts for operating expenses, EBITDA goes a step further by adding back non-cash expenses like depreciation expense and amortization expense, offering a broader picture of cash flow.

Operating income focuses only on revenue and expenses directly related to core business operations. It excludes non-operating expenses, such as interest expenses, losses from asset sales, or costs related to investments.

Gross income, on the other hand, is the total amount of money an individual or a business earns before any deductions or expenses are applied. It represents the full earnings generated from all income sources without any reductions for taxes, benefits, or other withholdings.

Net income is your final profit after deducting all expenses, including interest, taxes, and one-time costs. Your business can have a high operating income but a low net income if you carry heavy debt or pay high taxes. In 2023, U.S. businesses' average net profit margin was around 8.5%, proving how much final earnings can shrink after additional expenses.

The gross profit helps you measure production efficiency. Operating income shows how well you manage costs. Net income gives you the full financial picture. Tracking all three helps you make smarter business decisions.

Factors that influence operating income

Operating income depends on both internal decisions and external market conditions.

• Operational efficiency: It affects how well you manage resources. Your operating income increases when you streamline processes, reduce waste, or improve productivity. However, inefficiencies, like delays in production or poor inventory management, can raise costs and lower profits.
• Product pricing: If your prices are too low, you may struggle to cover costs, reducing operating income. If they're too high, customers may turn to competitors. Finding the right balance ensures you stay competitive while protecting your profits. Businesses that adjust prices based on market trends can maintain strong margins.
• Expense management: High operating or administrative expenses, such as rent, salaries, and utilities, can eat into profits. Keeping these costs under control without hurting operations boosts profitability. Regularly reviewing expenses and cutting unnecessary costs helps maintain financial stability.
• Inflation and supply chain costs: These impact the cost of goods and business expenses. Rising raw material prices or higher wages increase costs, reducing your operating income unless you adjust prices or find cost-saving solutions. Businesses that rely on imported goods or complex supply chains often feel these effects the most.
• Industry competition: This affects your pricing power and total sales. In highly competitive markets, businesses may lower prices to attract customers, reducing profit margins. In markets with little competition, you have more pricing control and can maintain higher operating income.
• Economic conditions: These are customer spending and business growth. During strong economic periods, people spend more, leading to higher sales and greater operating income. In a downturn, demand may drop, forcing you to cut costs or adjust pricing. Adapting to economic shifts helps you keep your operating income stable.

Maximizing your financial performance with operating income

To improve financial performance, businesses must track key financial metrics like operating income. It shows how well your business runs. It impacts cash flow, profitability, and growth. A strong operating income directly impacts your bottom line, ensuring your business generates enough profit to cover expenses and reinvest in growth.

Higher operating income improves cash flow, giving you more flexibility to expand, invest, or manage unexpected costs. Businesses with steady cash flow rarely face funding shortages. Instead of relying on debt, they use profits to grow.

It also strengthens profit margins, making your business more efficient and sustainable. When margins are high, you can handle rising costs without cutting into profits. You also have more control over pricing and expenses, keeping your business competitive.

Monitoring and improving operating income requires clear financial insights. Businesses that automate accounting and reporting can make better decisions based on accurate data. You can use Ramp's reporting and expense management tools to reduce manual errors and gain real-time visibility into spending patterns.

Over time, consistent operating income supports business expansion. You can hire more employees, open new locations, or invest in better technology. You build a strong, scalable, and financially secure business by tracking and improving your operating income.