Why Is Net Income Sometimes Less Than Operating Costs?
Original post by Matt Petryni of Demand Media
Investors and managers are smart to keep a careful eye on operating costs and net income -- the ability of a business to deliver a profit is dependent in part on its ability to contain costs. A business does not have to be immediately profitable to be a good investment, but it must have a credible plan for containing costs and growing net income. Understanding the relationship between these numbers helps shine some light on how to assess them.
Basics of Operating Costs
Operating costs are a critical part of doing business. Every company spends a significant portion of its income on the things it does to deliver services for customers. Operating costs include payroll, the cost of renting space or land, financing costs like interest and bank fees, shipping or transportation, and the cost of materials used in production or offered for sale. The main source of operating costs varies considerably from business to business, but well-managed businesses will generally use operating costs as a basis for setting its prices.
Net income is among the most important metrics for assessing business performance. Sometimes called earnings or "the bottom line" -- after its position on the business's income statement -- net income is the total amount of revenue left over after expenses are subtracted. Growing companies design their business model, lay out strategies and make decisions with the goal of maximizing the bottom line. To deliver on this goal, the business must both collect as much revenue as possible and keep costs down. While this objective sounds straightforward, doing so often requires significant trade-offs, risk assessment and making tough decisions.
Operating Costs' Effect on Net Income
The size and extent of a business's operating costs have a direct impact on its net income. This is because operating costs are paid for with revenues before shareholders can realize any of the business's profits. An investor may notice that a business's operating costs often exceed its net income. This simply means that a large percentage of the business's revenues are consumed by operating costs, such that less than half of the original revenue remains. While a business generally wants to minimize its operating costs, it is not unusual for a business to spend a larger portion of its revenues on operations than it retains in its ending net income. A business with higher operating costs than net income often can still deliver significant equity growth for its shareholders.
Non-Operating Costs and Income
Distinguishing between operating costs and non-operating costs helps provide a clearer picture of what's going on in the business. A business whose operating costs are low is likely to become and remain profitable, even if a significant portion of its net income is consumed by other unusual expenses, such as a major asset purchase. Similarly, a business whose operating costs exceed its revenue may have a positive bottom line because of non-operating income. Because of these factors, looking at the operating income, or the revenue remaining after operating expenses, can sometimes provide more insight than the company's net income alone.
- Securities Exchange Commission: Information Matters
- AccountingCoach; Evaluating Business Investments; Harold Averkamp; 2010
- "Entrepreneur Philippines"; Operating Income vs. Net Income; Henry Ong; April 2011
- Money-Zine.com: Understanding Net Income
- Morningstar: Cash Flows from Operating Activities
- Travel Trust Association: Business Operating Costs
- "Entrepreneur":Pricing a Product
About the Author
Matt Petryni has been writing since 2007. He was the environmental issues columnist at the "Oregon Daily Emerald" and has experience in environmental and land-use planning. Petryni holds a Bachelor of Science of planning, public policy and management from the University of Oregon.