Operating income refers to the income derived from the firm’s normal business activities.
Operating income excludes interest expense, since interest expense is a financing cost rather than an operating cost. Operating income also excludes taxes, and any expenses or income derived from non-operating sources. Operating income differs from net income in that net income is inclusive of all revenue and expense sources, including interest and taxes.
The specific items excluded from operating income depend on the nature of the firm’s business. For example, gains or losses on the sale of financial assets would be included in operating income if the firm is in the financial business. However, gains or losses on the sale of financial assets would be excluded for a manufacturer or a retailer.
Consider the following scenario. In the month of March, a specialty grocery retailer has the following: $500,000 in sales, $300,000 in cost of goods sold, $150,000 in selling, general, and administrative (SG&A) expenses. The company sold a commercial refrigerator for a $2,000 gain. The company has a 21% tax rate and had $3,000 in interest expense. What is the operating income and net income for March?
The operating income includes only the sales, cost of goods sold, and operating expenses (SG&A), so operating income for March is:
$500,000 – $300,000 – $150,000 = $50,000.
To calculate net income we make the following adjustment to operating income: (1) add the $2,000 gain from the sale of the refrigerator, (2) subtract the $3,000 in interest expense, and (3) subtract the taxes. Net income is thus:
($50,000 + $2,000 – $3,000) x (1 – .21) = $38,710