What Are Operating Expenses?
Operating expenses are expenditures directly related to day-to-day business activities. Examples include rent, utilities, salaries, office supplies, maintenance and repairs, property taxes and depreciation.
Operating vs. Non-Operating Expenses
A company’s operating expenses, sometimes called OpEx, are reflected on its income statement. Along with non-operating expenses, they help businesses calculate their profitability. Non-operating expenses are expenditures indirectly related to operations and are the result of financing or investing activities, like interest payments on loans.
Operating (and non-operating) expenses can be fixed—unaffected by changes in production volume or service delivery—or variable, meaning they fluctuate in proportion to the changes in volume or delivery. Rent and salaries are examples of fixed operating expenses, while fuel and sales commissions are examples of variable operating expenses.
Operating Expenses vs. COGS
Operating expenses are different than cost of goods sold (COGS), which are the direct expenses a business pays to purchase or manufacture its products. COGS can be difficult to calculate depending on the complexity of the business and what it sells. In the simplest of terms, COGS include the beginning inventory plus inventory purchases minus the ending inventory. The formula includes factoring in the cost of purchasing the items, inbound freight costs, manufacturing costs (including labor), modification costs and packaging.
Capital Expenses vs. Operating Expenses
Unlike COGS and operating expenses, capital expenses do not show up on the company’s income statement. Capital expenses, or CapEx, are one-time expenditures of tangible or nontangible assets that are reflected on the company’s balance sheet. These assets usually have a lifespan of one year or more and bring longer-term value to the business.
While capital expenditures are deductible, the deduction occurs over a period of time, rather than immediately. Depreciation and amortization are the processes by which those deductions are taken. Note: In some cases for certain asset categories, 100% first-year depreciation is allowed.
- Every organization has operating expenses that come with running a business and make it possible to sell goods or services.
- Compiling these costs helps organizations measure profitability and related numbers, like operating profit margin.
- By keeping a close eye on operating expenses, finance teams can identify outliers and trends that could reveal opportunities to reduce expenses without sacrificing product or service quality.
- Accounting software makes it much easier to calculate and track operating expenses and related metrics.
Operating Expense Explained
Having a clear picture of operating expenses, COGS and non-operating expenses is crucial to figuring out whether your business is profitable. There is no hard-and-fast rule on the ideal percentage of operating costs relative to revenue. It will differ depending on the business model, industry and the business’s maturity. But as a general rule, keeping operating costs under control and selling more of your products or services creates more free cash flow for the business, which is a good thing.
What Are Operational Activities?
Operating expenses are the result of a company’s operating activities, or activities directly related to selling products or services to customers. Employee travel, marketing campaigns and repair of key equipment are all examples of operational activities.
On the cash flow statement, operating cash flow measures the cash coming into and out of the business from these operating activities. Cash comes in, for instance, from the sale of goods or services, and cash flows out to pay employees. Other classifications on the cash flow statement, like investing and financing activities, are considered non-operating expenses.
Importance of Operating Expenses
Operating expenses are necessary to run a business. But if the operating expenses exceed the company’s total revenue, the company will not make any profit. With that in mind, costs associated with people, energy, transportation and travel are four types of operating expenses companies can examine for cost-saving opportunities when they have a clear view of these expenditures.
How to Calculate Operating Expenses
Operating expenses will vary from one organization to another. Some companies have costs that others don’t have to worry about. Keeping that in mind, here’s a general formula for calculating operating expenses:
Operating Expenses = Payroll/Wages + Sales Commissions + Marketing/Advertising Costs + Rent + Utilities + Insurance + Taxes
Businesses can then use their operating expenses, COGS and non-operating expenses to measure profit. Start with this simple formula from the U.S. Small Business Administration:
Sales – Cost of Goods Sold = Gross Profit – Overhead = Net Profit
While that formula is pretty straightforward, it’s not always immediately obvious whether, for instance, a transportation-related cost should be placed under COGS or operating expenses.
COGS for a manufacturer, for instance, includes every cost associated with buying materials, freight costs to get those supplies to your warehouse or plant, expenses to make the product, modification costs and packaging. That number is subtracted from the ending inventory to arrive at the COGS. (Note that IFRS and U.S. GAAP accounting standards use different methods to get COGS.)
The next step is to subtract COGS from sales to get the gross profit. This is where operating expenses come into play. Once a company subtracts operating expenses from gross profit, it has its net profit.
Example of Operating Expenses
In a simple example of this calculation, take the ice cream shop Dig Dog Ice Cream.
Dig Dog sells $200,000 worth of ice cream annually. The COGS includes the cones, ice cream and paper wrappers minus all of the supplies that weren’t used, amounting to $75,000. Operating expenses include $2,000 in utilities, $10,000 in rent, $40,000 in salaries, $1,000 depreciation of the freezer and $2,000 for business insurance. There are no non-operating costs. That would make its net profit $70,000. (See the calculation below.)
$200,000 – $75,000 (COGS) = $125,000 (gross profit) – $55,000 (overhead) = $70,000 (net profit)
Operating Expenses on an Income Statement
Below is an income statement template provided by the U.S. Small Business Administration with a detailed list of many common operating expenses. (See highlighted section.)
This automated form is made available compliments of CCH Business Owner’s Toolkit
|[Your Company Name]
For the Year Ended [MM, DD, YYYY]
|Less:||Sales Returns and Allowances||$0.00|
|Cost of Goods Sold:|
|Cost of Goods Sold||$0.00|
|Gross Profit (Loss)||$0.00|
|Credit Card Fees||$0.00|
|Dues and Subscriptions||$0.00|
|Permits and Licenses||$0.00|
|Net Operating Income||$0.00|
|Other Income: (non-operating expenses)|
|Gain (Loss) on Sale of Assets||$0.00|
|Total Other Income||$0.00|
|Net Income (Loss)||$0.00|
How to Use Operating Expenses
Knowing the total amount of operating expenses helps the business calculate not only profit but also another valuable number: operating income, also referred to as earnings before interest and taxes (EBIT). How operating income changes over time will help the business and potential investors determine whether it’s an efficient operation.
Operating Income = Gross Profit – Operating Expenses
Once a business knows its operating expenses, it can use more complex formulas that lend insight into overall profitability, such as operating profit margin.
Operating Profit Margin = EBIT / Sales Revenue x 100
The higher the operating profit margin percentage, the more profitable the business.
What’s more, increasing sales without a significant increase in operating costs is crucial to growing profits. Thus, a knowledge of operating expenses is helpful, as finance teams can drill into expense line items to see outliers and trends and then look for ways to reign those in.
How to Cut Operating Costs
Research suggests that a 1% decrease in operating expenses can increase profitability up to 10 times more than a corresponding increase in revenue, per Capgemini. With a clear view of operating costs, you can identify areas that appear too costly, then break out and examine them to find opportunities for cost savings.
Here are a few common ways to reduce operating expenses:
- Review utilities bills—have they gone up over time? Look for energy-efficient investments, such as motion-sensor lights or HVAC upgrades.
- Evaluate options for internet/cable and insurance providers. See if another vendor offers a more competitive price.
How Accounting Software Helps Calculate Operating Expenses
To automate the process of tracking, recording and classifying expenses, most businesses turn to accounting software. The first step in the U.S. Small Business Administration’s list “Ten Basic Bookkeeping Steps” is to purchase accounting software. It’s ahead of opening a separate business checking account, reconciling that account and even tracking sales.
Accounting and financial management software are essential for monitoring revenue and expenses, generating financial reports and tracking other metrics that ensure the financial health of the business. Automation reduces errors borne of manual data entry and makes a time-consuming process much more efficient.
Above all, such a system will help a business generate accurate financial statements and reports that comply with U.S. GAAP and IFRS accounting standards.