In this lesson, we are going to understand the journey from revenue to operating income. First thing to remember: revenue is not profit.

Revenue - Cost Of Goods Sold (COGS) = Gross Profit

COGS, or Cost of Revenue, is the cost that is directly related to revenue generation. If you take cost to produce a product but the product is not sold in the reporting period, the cost is not considered part of COGS in that period.

Gross Margin = Gross Profit / Revenue

Gross Margin tells you how profitable a buiness is.

Revenue grows doesn't mean profit grows as much. This is because gross margin compression: COGS growth outpaces revenue growth.

Operating Expense (also known as OpEx) usually contains R&D, Sales & Marketing and General & Administration. After OpEx, we have:

Operating income = revenue - COGS - OpEx

and

Operating margin = operating income / revenue

The difference between gross margin and operating margin is:

• Gross margin is a metric on the goods itself. It measures the economics of the goods.
• Operating margin includes the economic of the goods but also include the operation and management of the company.

If a company has excellent revenue and gross margin but extremely high R&D or G&A, then the operating margin could be low and the entire company is still not very profitable.

The next concept is Operating Leverage. A company can have a relative fix OpEx. For example, the cost of developing a good software is relative fix and once-off but the software can continue to boost up revenue. So the revenue and gross profit can continue to increase but the OpEx stays the same. This is to leverage the old OpEx to generate future revenue.

AI's gross margin can be lower than software because AI's COGS is high: you not only need to spend money on R&D but every token costs money so the usage of AI continuesly increases COGS.

When you read income statement, you need to follow the map:

Revenue → COGS → Gross Profit → OpEx → Operating Income
                      ↓                       ↓
                 Gross Margin          Operating Margin

Revenue itself is not a story. How revenue is generated is a story. Revenue growth is not the end. How revenue is turned into profit is the key.

What's the difference between Cost of Revenue and OpEx:

• Cost of Revenue is the cost to deliver product/service that customers pay for.
• OpEx is the cost to R&D, obtaining customers and run the company.