We have already learnt that:

Revenue - Cost of Revenue = Gross Profit - R&D - Sales & Marketing - G&A = Operating Income
                                         ╰──────────────────────────────╯
                                                        |
                                                       OpEx

We cannot judge whether OpEx increases is good or bad by itself. If revenue growth > OpEx growth, then it is a good sign. It can be due to Operating Leverage. It means the same operation system can support bigger and bigger revenue.

Take Microsoft as an example, suppose Word, Excel, Teams have been developed. Global sales network exists. HR/Finance/Legal teams are formed. When customer size grows by 10%, revenue increases by 10%, Microsoft doesn't need 10% engineers, HR, finance or legal team. So the OpEx may increase just 1% to support 10% revenue growth. This is Operating Leverage.

To understand operating leverage, we should know Fixed Cost and Variable Cost. Fix cost are the cost that doesn't change in proportion to revenue. Salary is a fix cost. Revenue grows by 10% doesn't mean salary grows by 10%. On the other hand, variable cost changes in proportion to revenue. Copilot queries increase by 100% means GPU compute, electricity, network usage all need to grow 100%.

As we have seen, software business has very strong operating leverage. AI service has much weaker operating leverage.

Operating leverage doesn't happen only on gross margin. Consider the following:

Last year: Gross Profit = $70, Gross Margin = 70%, OpEx = $30 and Operating Income = $40, Operating Margin = 40%
This year: Gross Profit = $82, Gross Margin = 68%, OpEx = $32 and Operating Income = $50, Operating Margin = 41.6%

So Revenue +20%, Gross Margin drops due to Cost of Revenue increases. But Operating Income +25% and Operating Margin increases. This is because OpEx grows less than revenue. This is called OpEx Leverage.

This tells us that when analyzing operating income, we need to think in two layers:

• How does gross margin change? This tells us the change to product/service economics.
• How does OpEx change relative to revenue? This tells us the change to the effeiciency of running a business.

The two layers come from:

Operating Margin ≈ Gross Margin - OpEx as % of Revenue

Operating Income ≠ Net Income. Operating Income is not what finally earned. There are other items below Operating Income. The structure of the income statement is:

Revenue
  - Cost of Revenue 
= Gross Profit
  - OpEx 
= Operating Income
  ± Other Income and Expense
= Income Before Tax
  - Income Taxes
= Net Income

Typical items below Operating Income are:

• Interest Expense: the interest generated on debt. This interest is not relevant to product or service. So it is not OpEx.
• Interest Income: the interest generated from the cash of the company.

Why these incomes and expenses are below Operating Income? Because investors want to separate two questions:

• Whether the business itself is making money or not? This is what Operating Income tells you.
• How much final accouting profit is for the investors? This is what Net Income tells you.

If company A and B both have $10bn Operating Income. But B has hugh debt and generates $5bn Interest Expense, then Net Income of A could be $8bn and Net Income of B could be $4bn. You cannot say that B's business is worse than A. Because the Operating Income is the same. But they may have different Capital Structure.

Capital Structure explains where the operating money comes from. Generally speaking, it can come either from Equity, that is, money from investors or Debt, money borrowed. Different companies may have very different ratios between Debt and Equity. Interest Expense reflects financing and capital structure instead of operating performance.

Net Income is what's remained as accounting profit of a company after deducting all the expenses, non-business items and tax.

Note: don't start reading the income statement from Net Income. Net Income can be impacted by many factors such as company investment gain/loss, interest, tax or one-off items. Operating Income is a much cleaner metric to understand how well a business is. Start from Operating Income is a better practice.