Understanding how much money it takes to keep a company running is critical to the viabilityof all organizations. As operating expenditures increase, profitability decreases.Therefore, by being aware of and proactively mitigating the cost of operations, businesseshave the potential to better control costs and improve their financial health.
What Are Operating Expenses?
Operating costs are expenditures directly related to day-to-day business activities,excluding the processes involved in manufacturing a product or delivering a service.Examples include rent, travel, utilities, salaries, office supplies, maintenance andrepairs, property taxes and depreciation (see below for a more comprehensive list).
Operating vs. Non-Operating Expenses
A company’s operating expenses, sometimes called OpEx, are reflected in its income statement.Along with non-operating expenses, they help businesses calculate their profitability.Non-OpEx are expenditures indirectly related to operations that are the result of financingor investing activities, like interest payments on loans.
Operating (and non-operating) expenses can be fixed — unaffected by changes in productionvolume or service delivery — or variable, meaning they fluctuate in proportion to thechanges in volume or delivery. While rent and salaries are examples of fixed OpEx, fuel andsales commissions are variable ones.
Operating Expenses vs. COGS
Operating expenses are different from the cost of goods sold (COGS), which arethe direct expenses a business pays to purchase or manufacture its products. COGS can bedifficult to calculate depending on the complexity of the business and what it sells. In thesimplest of terms, COGS include the beginning inventory plus inventory purchases minus theending inventory. This formula includes the cost of purchasing the items, inbound freight,manufacturing (including labor), modification and packaging.
Capital Expenses vs. Operating Expenses
Unlike COGS and OpEx, 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 thatare reflected on a company’s balance sheet. These assets usually have a lifespan of one yearor more and bring longer-term value to the business.
While capital expenditures are deductible, the deduction occurs over a period of time, ratherthan immediately. Those deductions happen through processes called depreciation and amortization. Note: In some cases, for certainasset categories, 100% first-year depreciation is allowed.
Key Takeaways
- Every organization has operating expenses that come with running a business and make itpossible 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 andtrends that could reveal opportunities to reduce expenses without sacrificing product orservice quality.
- Accounting software makes it much easier to calculate and track operating expenses andrelated metrics.
Operating Expense Explained
Having a clear picture of OpEx, COGS and non-OpEx is crucial to figuring out whether yourbusiness is profitable. There is no hard-and-fast rule on the ideal percentage of operatingcosts relative to revenue. It will differ depending on the business model, industry and thebusiness’s maturity. But as a general rule, keeping operating costs under control andselling more of your products or services creates more free cash flow for the business,which is a good thing.
What Are Operational Activities?
Operating costs are the result of a company’s operating activities, or activities directlyrelated to selling products or services to customers. Employee travel, marketing campaignsand 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 theseoperating activities. Cash comes in, for instance, from the sale of goods or services, andcash flows out to pay employees. Other classifications on the cash flow statement, likeinvesting and financing activities, are considered non-OpEx.
What Is Included in Operating Expenses?
Operating costs, which include many of the expenses necessary to keep a business on its feet,consist of a wide array of expense categories. Here are 11 examples of these expenditures,which are related to various areas of a business’s core operations:
Office Supplies. These are items that are consistently used byoffice staff or require regular replenishment such as printer paper, invoices andsales receipts, staplers, pens, janitorial cleaning supplies and USB flash drives.
Depreciation. This refers to fixed assets bought by a company thatdepreciate in value over time. Assets that depreciate include warehouse equipmentand machinery, furniture, computer equipment, delivery vehicles, buildings and storedisplays.
Advertising. Advertising includes any money spent on marketing thecompany. For example, business cards, social media, brochures, websites, and TV,print and digital campaigns.
Property Tax. These are real estate taxes that vary based on theassessed value of a property.
Inventory. Any expenses related to ordering and storing inventory inpreparation for sale fall under operating expenses. For example, transportation anddelivery, raw materials, manufacturing overhead, storage and labor costs are allinventory expenses.
Rent. This includes any costs associated with utilizing a locationor property, unowned by business, for factory, storage, office or retail space.Within the real estate industry, the operating expense ratio (OER) is a metric usedto compare the costs associated with operating properties with the revenue that saidproperties generate. Lower OERs are preferable and indicators of increasedprofitability as they suggest that less of the property’s income is going towardOpEx.
Payroll. Any administrative expenses related to employee wages,benefits and payroll taxes are part of OpEx.
Maintenance and Repairs. This refers to all necessary andunavoidable upkeep expenses incurred to keep items in working order. This includesfixing and replacing broken equipment items, painting and the costs of cleaning andinspecting business structures.
Utilities. Utilities include business expenses from public servicessuch as water, electricity, internet, telephone, sewage, heating and waste disposal.
Insurance. This is the money businesses pay to purchase an insurancecontract and the monthly unpaid premium costs associated with said contract.
Travel. Travel expenses incurred by a company that go towardreimbursing all business-related travels are part of OpEx.
Importance of Operating Expenses
Operating expenses are necessary to run any business. But, if they exceed the company’s totalrevenue, the company will not make any profit. With that in mind, costs associated withpeople, energy, transportation and travel are four types of operating expenditures companiescan examine for cost-saving opportunities when they have a clear view of these expenditures.
How to Calculate Operating Expenses
Operating costs vary from one organization to another. Some companies have expenses thatothers don’t have to worry about, simply due to the nature of their business. Keeping thatin mind, here’s a general formula for calculating operating costs:
Operating Expenses = Payroll/Wages + Sales Commissions + Marketing/Advertising Costs + Rent + Utilities + Insurance + Taxes
Businesses can then use their OpEx, COGS and non-OpEx to measure profit. Start with thissimple 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 OpEx.
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 theproduct, modifications and packaging. That number is subtracted from the ending inventory toarrive at the COGS. (Note that IFRS and U.S. GAAP accounting standards use differentmethods to get COGS.)
The next step is to subtract COGS from sales to get the gross profit. This is where OpEx comeinto play. Once a company subtracts operating expenses from gross profit, it has its netprofit.
Example of Operating Expenses
Take the ice cream shop Dig Dog Ice Cream as a simple example of this calculation. Dig Dogsells $200,000 worth of ice cream annually. The COGS includes the cones, ice cream and paperwrappers minus all of the supplies that weren’t used, amounting to $75,000. Operating costsinclude $2,000 in utilities, $10,000 in rent, $40,000 in salaries, $1,000 depreciation ofthe freezer and $2,000 for business insurance. There are no non-operating costs. That wouldmake 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 witha 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] IncomeStatement For the Year Ended [MM, DD, YYYY] | ||||||
|---|---|---|---|---|---|---|
| Revenue: | ||||||
| Gross Sales | $0.00 | |||||
| Less: | Sales Returns and Allowances | $0.00 | ||||
| Net Sales | $0.00 | |||||
| Cost of Goods Sold: | ||||||
| Beginning Inventory | $0.00 | |||||
| Add: | Purchases | $0.00 | ||||
| Freight-in | $0.00 | |||||
| Direct Labor | $0.00 | |||||
| Indirect Expenses | $0.00 | |||||
| $0.00 | ||||||
| Less: | Ending Inventory | $0.00 | ||||
| Cost of Goods Sold | $0.00 | |||||
| Gross Profit (Loss) | $0.00 | |||||
| Expenses: | ||||||
| Advertising | $0.00 | |||||
| Amortization | $0.00 | |||||
| Bad Debts | $0.00 | |||||
| Bank Charges | $0.00 | |||||
| Charitable Contributions | $0.00 | |||||
| Commissions | $0.00 | |||||
| Contract Labor | $0.00 | |||||
| Credit Card Fees | $0.00 | |||||
| Delivery Expenses | $0.00 | |||||
| Depreciation | $0.00 | |||||
| Dues and Subscriptions | $0.00 | |||||
| Insurance | $0.00 | |||||
| Interest | $0.00 | |||||
| Maintenance | $0.00 | |||||
| Miscellaneous | $0.00 | |||||
| Office Expenses | $0.00 | |||||
| Operating Supplies | $0.00 | |||||
| Payroll Taxes | $0.00 | |||||
| Permits and Licenses | $0.00 | |||||
| Postage | $0.00 | |||||
| Professional Fees | $0.00 | |||||
| Property Taxes | $0.00 | |||||
| Rent | $0.00 | |||||
| Repairs | $0.00 | |||||
| Telephone | $0.00 | |||||
| Travel | $0.00 | |||||
| Utilities | $0.00 | |||||
| Vehicle Expenses | $0.00 | |||||
| Wages | $0.00 | |||||
| Total Expenses | $0.00 | |||||
| Net Operating Income | $0.00 | |||||
| Other Income: (non-operating expenses) | ||||||
| Gain (Loss) on Sale of Assets | $0.00 | |||||
| Interest Income | $0.00 | |||||
| Total Other Income | $0.00 | |||||
| Net Income (Loss) | $0.00 | |||||
How to Use Operating Expenses
Knowing the total amount of operating costs helps businesses calculate profit and anothervaluable number: operating income, which is also referred to as earnings before interest andtaxes (EBIT). How operating income changesover time will help businesses and potential investors determine whether it’s anefficient operation.
Operating Income = GrossProfit – Operating Expenses
Once a business knows its OpEx, it can use more complex formulas that lend insight intooverall 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 inoperating costs is crucial to growing profits. That’s why understanding OpEx is helpful, asfinance teams can drill into expense line items to see outliers and trends and then look forways to reign those in.
How to Cut Operating Costs
Research suggests that a 1% decrease in operating costs can increaseprofitability 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, thenbreak out and examine them to find opportunities for cost savings.
Here are a few common ways to reduce operating expenses:
- Review utility bills — have they gone up over time? Look for energy-efficientinvestments, such as motion-sensor lights or HVAC upgrades.
- Evaluate options for internet/cable and insurance providers. See if another vendoroffers a more competitive price.
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How Accounting Software Helps Calculate Operating Expenses
To automate the process of tracking, recording and classifying expenses, most businesses turnto accounting software.The first step in the U.S. Small Business Administration’s list of “Ten Basic BookkeepingSteps” is to purchase accountingsoftware, which is ahead of opening a separate business checking account, reconciling thataccount and even tracking sales.
Accounting and financial managementsoftware are essential for monitoring revenue and expenses, generating financialreports 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 muchmore efficient.
Above all, such a system will help a business generate accurate financial statements andreports that comply with U.S. GAAP and IFRS accounting standards.
Operating expenses are a gold mine of information that businesses can examine to reduce costsand drive efficiency across their organization. Once companies realize the sheer value ofdeeply analyzing and organizing their operational expenses, they can work toward reducingthem while maintaining product prices and quality and increasing profitability.
Operating Expenses FAQs
What is included in the operating expenses?
Operating expenses are any costs incurred through daily business activities that don't fallunder cost of goods sold. Variable operating expenses, such as packaging or shipping costs,fluctuate depending on the volume of an activity or the occupancy rate of a property.Conversely, fixed operating expenses, such as salaries or mortgage payments, remainconsistent, as they are not influenced by volume or occupancy.
What are examples of operating expenses?
Common operating expenses for a company include rent, payroll, travel, utilities, insurance,maintenance and repairs, property taxes, office supplies, depreciation and advertising.
What are the categories of operating expenses?
Operating expenses can be broken down into three categories: office, compensation and sales-and marketing-related expenses. Office-related expenses come from typical office settings,and often include things like office supplies, property taxes, rent and insurance.Compensation-related expenses consist of payroll, employee benefits, sales commissions andpension plans. Finally, marketing- and sales-related expenses are directed toward alladvertising materials, travel and entertainment.
What is not included in operating expenses?
Non-operating expenses are incurred outside of everyday business activities and related tofinancing or investing activities. Examples of non-operating costs include obsoleteinventory charges, lawsuit settlements, losses on investments, damages caused by naturaldisasters and fires, restructuring costs and interest expenses. Any costs related to makinggoods or delivering services are also not part of OpEx.
I'm an expert in finance and accounting, with a deep understanding of the concepts related to operating expenses, cost management, and financial health. I have hands-on experience in analyzing financial statements, calculating profitability metrics, and advising businesses on optimizing their operational costs. Let's delve into the concepts covered in the provided article.
Understanding Operating Expenses:
1. Operating Expenses (OpEx):
- Operating expenses are crucial costs directly linked to day-to-day business activities.
- Examples include rent, travel, utilities, salaries, office supplies, maintenance, and more.
2. Operating vs. Non-Operating Expenses:
- OpEx is reflected in the income statement and helps calculate profitability.
- Non-OpEx is indirectly related to operations, resulting from financing or investing activities (e.g., interest payments).
3. Operating Expenses vs. COGS:
- COGS (Cost of Goods Sold) are direct expenses for purchasing or manufacturing products.
- OpEx is distinct from COGS and includes ongoing operational costs.
4. Capital Expenses vs. Operating Expenses:
- Capital expenses (CapEx) are one-time expenditures for tangible or intangible assets.
- CapEx, unlike OpEx, doesn't appear on the income statement and involves depreciation over time.
Key Components of Operating Expenses:
5. Examples of Operating Expenses:
- Office Supplies, Depreciation, Advertising, Property Tax, Inventory, Rent, Payroll, Maintenance, Utilities, Insurance, Travel.
Importance and Calculation:
6. Importance of Operating Expenses:
- Essential for running a business, but if they exceed total revenue, the company won't be profitable.
7. How to Calculate Operating Expenses:
- General formula: Operating Expenses = Payroll + Sales Commissions + Marketing/Advertising Costs + Rent + Utilities + Insurance + Taxes.
8. Example Calculation:
- Using a simple example (Dig Dog Ice Cream) to illustrate the calculation of net profit.
Financial Statements:
9. Operating Expenses on an Income Statement:
- Provided an income statement template with detailed lists of common operating expenses.
Financial Analysis and Efficiency:
10. How to Use Operating Expenses:
- Operating Income = Gross Profit – Operating Expenses.
- Operating Profit Margin = (EBIT / Sales Revenue) x 100.
11. How to Cut Operating Costs:
- A 1% decrease in operating costs can significantly boost profitability.
- Recommendations include reviewing utility bills, evaluating service providers, and improving expense management efficiency.
Accounting Software:
12. How Accounting Software Helps:
- Accounting software automates expense tracking, reducing errors and enhancing efficiency.
- Crucial for generating accurate financial statements and reports compliant with accounting standards.
Conclusion:
Understanding operating expenses is essential for businesses to enhance financial health, identify cost-saving opportunities, and improve overall efficiency. The provided information covers the core concepts and practical aspects related to operating expenses, offering valuable insights for financial management.
