What it is:
Operating Earnings = revenue - cost of goods sold, labor and other day-to-day expenses incurred in the normal course of business
How it works/Example:
It is important to understand what expenses are included and excluded when calculating operating earnings. 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 earnings work, consider Company XYZ's income statement:
|Cost of Goods Sold||$500,000|
|General & Administrative Expense||$50,000|
Using this information and the formula above, we can calculate that Company XYZ's operating earnings are:
Operating Earnings = $1,000,000 - $500,000 - $300,000 - $50,000 = $150,000
Operating earnings as a percentage of sales is called operating margin. In this example, Company XYZ makes $0.15 in operating earnings for every $1 in sales.
Why it matters:
Operating earnings is important because it is an indirect measure of efficiency. The higher the operating earnings, the more profitable a company's core business is.
Several things can affect operating earnings (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, margins are also a measure of managerial flexibility and competency, particularly during rough economic times.
It is also important to note that some industries have higher labor or materials costs than others. This is why comparing operating earnings 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.