Operating Income and Expenses#

After gross profit, the next layer of the income statement reveals how efficiently a company runs its operations. Operating expenses and operating income tell you whether the business model is sustainable.

Operating Income shows profit from core business operations—before interest and taxes. It's often called EBIT (Earnings Before Interest and Taxes) and is considered one of the most important profitability metrics.

Operating Expenses: The Cost of Running the Business#

Operating expenses (OpEx) are the costs of running the business that aren't directly tied to producing goods or services. These are subtracted from gross profit.

Main Categories#

Category	What It Includes
Selling, General & Administrative (SG&A)	Sales team, marketing, executives, rent, legal, HR, accounting
Research & Development (R&D)	Scientists, engineers, product development, testing
Depreciation & Amortization	Spreading the cost of assets over time

SG&A (Selling, General & Administrative)#

SG&A is typically the largest operating expense category. It includes:

Selling Expenses#

Sales team salaries and commissions
Marketing and advertising
Trade shows and promotional events
Sales software and tools

General & Administrative#

Executive compensation
Corporate headquarters costs
Legal and accounting fees
Human resources
Office rent and utilities
Insurance

SG&A Efficiency

Compare SG&A as a percentage of revenue across competitors. A company with lower SG&A % is more efficient—it needs less overhead to generate each dollar of revenue.

Research & Development (R&D)#

R&D expenses are investments in future products and improvements.

Industry	Typical R&D % of Revenue
Pharmaceuticals	15-25%
Technology	10-20%
Automotive	4-8%
Consumer Goods	2-4%
Retail	<1%

Analyzing R&D Spending#

High R&D isn't automatically good or bad. Consider:

Is the company in an innovation-driven industry?
What returns are they getting from R&D investments?
How does it compare to competitors?
Are they maintaining or increasing investment?

R&D Cuts

When a company significantly cuts R&D spending, it might boost short-term profits but could hurt long-term competitiveness. Always ask why.

Depreciation & Amortization#

These are non-cash expenses that spread asset costs over time:

Term	Applies To	Example
Depreciation	Tangible assets	Buildings, equipment, vehicles
Amortization	Intangible assets	Patents, software, goodwill

Why It Matters#

Even though D&A doesn't use cash today (the cash was spent when the asset was bought), it represents real economic costs:

Equipment wears out and needs replacement
Patents expire
Software becomes obsolete

Some analysts focus on EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) to compare companies with different asset bases. But remember—D&A represents real costs that will eventually require cash.

Calculating Operating Income#

Operating Income = Gross Profit - Operating Expenses

Or equivalently:

Operating Income = Revenue - COGS - Operating Expenses

Example Calculation#

Line Item	Amount
Revenue	$500,000
COGS	$200,000
Gross Profit	$300,000
SG&A	$150,000
R&D	$50,000
Depreciation	$20,000
Total Operating Expenses	$220,000
Operating Income	$80,000

Operating Margin#

Operating Margin = (Operating Income ÷ Revenue) × 100

This tells you what percentage of revenue becomes operating profit.

Company	Revenue	Operating Income	Operating Margin
Company A	$100M	$20M	20%
Company B	$100M	$10M	10%

Company A converts twice as much of each revenue dollar into operating profit. That's significant competitive advantage.

Industry Benchmarks#

Industry	Typical Operating Margin
Software	20-35%
Pharmaceuticals	20-30%
Consumer Staples	10-20%
Retail	3-8%
Airlines	5-15%
Restaurants	5-15%

One-Time vs. Recurring Items#

Not all expenses are created equal. Distinguishing between recurring and one-time items helps you understand sustainable profitability.

Recurring Items#

Normal operating expenses
Happen every period
Should be included in analysis

One-Time (Non-Recurring) Items#

Restructuring charges
Legal settlements
Acquisition costs
Impairment charges
Natural disaster costs

Serial One-Time Items

Some companies report "one-time" charges quarter after quarter. If restructuring charges appear every year, they're not really one-time—factor them into your analysis.

Operating Leverage#

Operating leverage describes how changes in revenue affect operating income.

High Operating Leverage#

High fixed costs, low variable costs
Small revenue increase = big profit increase
But: Small revenue decrease = big profit decrease
Example: Software companies, airlines

Low Operating Leverage#

Low fixed costs, high variable costs
Profits scale more linearly with revenue
More stable, less dramatic swings
Example: Consulting firms, retailers

High operating leverage is a double-edged sword. It magnifies both gains and losses.

Analyzing Operating Income Trends#

Look for these patterns:

Positive Signs#

Operating margin improving over time
Operating income growing faster than revenue (improving efficiency)
Consistent margins through economic cycles

Warning Signs#

Operating margin declining
Revenue growing but operating income flat or falling
Operating expenses growing faster than revenue
Frequent "one-time" charges

Example Trend Analysis#

Year	Revenue	Operating Income	Operating Margin
2022	$100M	$15M	15.0%
2023	$120M	$20M	16.7%
2024	$150M	$28M	18.7%

This company shows excellent operating leverage—as revenue grows, margins improve. The business is becoming more efficient at scale.

Key Takeaways

Operating expenses include SG&A, R&D, and depreciation/amortization
Operating income (EBIT) shows profit from core business operations
Operating margin reveals efficiency in converting revenue to profit
Compare operating margins to industry peers
Distinguish between recurring expenses and one-time items
High operating leverage magnifies both gains and losses
Look for improving margins as a sign of business strength