Gross profit is just the starting line. The income statement then separates operating expenses (the recurring cost of running the business) from non-operating items (one-time events). That distinction produces two critical numbers — Operating Income and Net Income — and understanding the gap between them is essential for any investment analysis.
The first lesson on the income statement covered the top of the waterfall: Revenue minus Cost of Goods Sold equals Gross Profit. But the income statement doesn't end at gross profit — it continues down through the operating expenses that are required to run the business.
Piper defines Operating Expenses as 'the expenses related to the normal operation of the business and are likely to be incurred in future periods as well.' These are the recurring, predictable costs of keeping the business running: rent, insurance, wages, advertising. Subtracting them from Gross Profit yields Operating Income — what's left from the core business after paying all normal operating costs.
Operating Income (EBIT)
Operating Income = Gross Profit − Operating Expenses
Operating Income is sometimes called EBIT (Earnings Before Interest and Taxes). It measures the profitability of core business operations, excluding financing decisions and tax situations.
Piper states directly: 'In theory, Operating Income is a more meaningful number than Net Income, as it should offer a better indicator of what the company's income is going to look like in future years.' Operating expenses (rent, wages, advertising) repeat every year. Non-operating items (lawsuits, one-time write-offs, asset sales) don't. When forecasting future earnings, you should start from operating income — not net income — to avoid being fooled by noise.
Income Statement — From Revenue to Net Income
Example company · Annual figures ($K)
Revenue
Top line — total sales
100%
− Cost of Goods Sold
Direct cost of products sold
Gross Profit
83% gross margin
83%
− Operating Expenses
SG&A, R&D, D&A
Operating Income
39% operating margin — core business profitability
39%
− Interest & Taxes
Financing costs + income tax
Net Income
12% net margin — bottom line
12%
83%
Gross Margin
After direct production costs
39%
Operating Margin
After all overhead costs
12%
Net Margin
After interest & taxes
Figure 4.1 — Each layer of profit removes different categories of cost. Operating margin is often the most useful comparison metric between companies with different capital structures.
The income statement waterfall: Revenue → Gross Profit → Operating Income → Net Income.
Piper provides a concrete example that shows exactly why operating income and net income can tell very different stories. A company has $450,000 in sales, a $75,000 COGS, and $200,000 in operating expenses. But in this particular year, it also settled a lawsuit for $120,000.
| Line Item | Amount | Category |
|---|---|---|
| Sales | $450,000 | Revenue |
| Cost of Goods Sold | ($75,000) | COGS |
| Gross Profit | $375,000 | — |
| Rent | $45,000 | Operating Expense |
| Salaries and Wages | $120,000 | Operating Expense |
| Advertising | $25,000 | Operating Expense |
| Insurance | $10,000 | Operating Expense |
| Total Operating Expenses | $200,000 | — |
| Operating Income | $175,000 | Core Business Result |
| Lawsuit Settlement | $120,000 | Non-Operating Expense |
| Net Income | $55,000 | Bottom Line |
Net Income is $55,000. But Operating Income is $175,000 — more than three times higher. Which number better represents what this company will earn next year? Almost certainly Operating Income. The lawsuit is a one-time event. If you forecast next year's earnings based on Net Income of $55,000, you will dramatically underestimate the company's earnings power.
Piper is frank about the consequences of the operating/non-operating split: 'The effect of this focus on Operating Income as opposed to Net Income has been to cause many companies to make efforts to classify as many expenses as possible as Non-Operating with the intention of making their Operating Income look more impressive to investors.' Companies have a strong incentive to classify normal, recurring costs as 'non-operating' or 'special items' to make their core business look more profitable. An analyst's job is to push back on this classification and determine what truly recurs every year.
Piper defines Non-Operating Expenses as 'those that are unrelated to the regular operation of the business and, as a result, are unlikely to be incurred again in the following year.' The lawsuit settlement is his primary example. Other common non-operating items include: one-time restructuring charges, gains or losses on asset sales, write-offs of goodwill, and interest expense (treated as non-operating because it reflects financing choices, not operating performance).
In practice, interest expense on debt is listed as a non-operating expense because it reflects the company's financing decisions, not its core business operations. Two companies with identical operations but different debt loads will have the same Operating Income but different Net Incomes. This is why analysts often compare companies using Operating Income (or EBIT) rather than Net Income — it removes the noise of different capital structures and allows apples-to-apples comparison of core business profitability.
When you open a company's income statement, the standard analytical approach is to read it from top to bottom — but with a specific question at each layer:
Whenever you see a large gap between operating income and net income, your first question should be: what is in the non-operating section, and will it repeat? In Piper's example, the $120,000 gap is a lawsuit — one-time, unlikely to recur. In practice, this gap often contains interest expense (recurring if debt is permanent), tax expense, and various 'special items' that companies prefer to exclude from their own non-GAAP earnings measures. Understanding and explaining the gap is what separates a superficial reading from a rigorous one.
Key Takeaways
In Piper's lawsuit example, Operating Income is $175,000 but Net Income is only $55,000. What caused the $120,000 difference?