29 Net Operating Income

Profit is important to every single business. It wouldn’t make sense to sell your products for less than it costs you to produce them, yet some companies unwittingly do this, simply because they haven’t calculated their profit by using the profit equation.

The profit equation:

$\text{profit}=\text{sales}-\text{variable expenses}-\text{fixed expenses}$

Net operating income is defined as sales less all ordinary expenses of a business, before interest and taxes.  Ordinary expenses of a business include the variable costs used in creating each product, along with all of the general fixed expenses. This number is useful , as it is pretty consistent from month to month and year to year in identifying growth in your business.

Now that we have our equations and definitions, let’s look at some examples of calculating net operating income utilizing the profit equation:

1. Let’s assume that Monte Corporation sells their widgets for $10 each. The variable cost per widget is $4. Fixed expenses for the company are $400 per month. What would be Monte Corporation’s profit if they sold 200 units?
   • (200 × $10)= Sales $2000
   • (200 × $4) = Variable costs of $800
   • Fixed costs of $400 are incurred
   • So $2000 − $800 − $400 = $800 PROFIT or net operating income
2. But what if Monte Corporation only sold 100 units?
   • (100 × $10) = Sales $1000
   • (100 × $4) = Variable costs of $400
   • Fixed costs of $400 are incurred
   • So $1000 − $400 − $400 = $200 profit or net operating income
3. Now finally, what if Monte Corporation only sold 50 units?
   • (50 × $10)= Sales $500
   • (50 × $4)= Variable costs $200
   • Fixed costs of $400 are incurred.
   • $500 −$200 − $400= −$100, so Monte Corporation lost money when they sold only 50 units.

So even though the selling price of the widget has not changed, the profit goes down.  As a manager, it may be your responsibility to monitor costs or selling prices to insure that a profit is being made on sales.  Watching this profit, or net operating income, over time is a useful tool to assess the health of the company. If you are a sales manager, it might be your responsibility to keep sales numbers at a certain level. Using CVP analysis helps you to better understand the importance of selling more product.