The expenses incurred regarding a business’s operational activities
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Written byCFI Team
What are Operating Expenses?
Operating expenses, operating expenditures, or “opex,” refers to the costs incurred by a business for its operational activities. In other words, operating expenses are the costs that a company must make to perform its operational activities.
Operating expenses are essential for analyzing a company’s operational performance. It is therefore important for both internal and external analysts to identify a company’s opex, to understand its primary cost drivers, and assess management efficiency.
Summary
- Operating expenses reflect the operational activities, not the investing or financing activities of a company.
- Operational activities are a company’s key commercial activities in generating revenue.
- It is important to distinguish between operating expenses and capital expenditures as the two are treated differently for accounting purposes.
What are Operational Activities?
Before calculating a company’s operational expenses, it is essential to identify the operational activities or the primary revenue-producing activities of the business and other activities that are not financing or investing activities.
The operating activities primarily cover the commercial activities of the company. For example, the main operating activity for a manufacturing company is to produce the product from raw materials, while for a trading company, it is to buy products from the supplier and sell them to the end-users.
It is critical to note that operational activities differ greatly among industries. A business activity can be classified as operational in one industry, but financing or investing in another. For instance, buying a building is typically an investing activity in most industries. However, it is an operational activity for real-estate companies, given that the purchased building is intended for resale.
Example
An example of Amazon.com‘s income statement is shown below. Encompassed by a red border, Amazon’s operating expenses include the cost of sales, fulfillment, marketing, general and administrative, technology and content, and other operating expenses.
Operating Expenses and Capital Expenditures
For businesses, operating expenses may typically include supplies, advertising expenses, administration fees, wages, rent, and utility costs. When it comes to capital or physical asset-related costs, however, it is important to make a distinction between operating expenses and capital expenditures as the two are treated differently for accounting purposes.
Capital expenditures are assets that are purchased and have a multiyear life, and are used in the operations of the business. Purchasing machinery, for example, is considered a capital expenditure, whereas, repair and maintenance of the machinery is considered an operating expense.
Fixed Costs and Variable Costs
When it comes to analyzing operating expenses, managers classify the expenses as either fixed or variable. In such a way, a manager can better understand the nature of the expense. A fixed cost remains the same no matter what the production level is, while variable cost does vary with the number of products or services that a company produces.
For example, fixed costs are things such as rent, lease payments and insurance expense, while labor, raw materials and sales commissions are variable costs.
It is noteworthy that the same category of an operating expense can be either a fixed cost or a variable cost, depending on the situation. For example, the wage for a full-time office employee is a fixed cost to the company, while the wage for an assembly line factory worker can be identified as a variable cost. Understanding the distinction can help managers to better control the operating expenses while considering the timeframe.
Importance of Operating Expenses
Operating expenses are important because they can help assess a company’s cost and stock management efficiency. It highlights the level of cost that a company needs to make to generate revenue, which is the main goal of a company.
If a company incurs relatively higher opex as a percentage of sales compared to its competitors, that may indicate they are less efficient at generating those sales.
The disadvantage of looking at a company’s opex is that it is an absolute number, not a ratio. Therefore it is unreasonable to be used as a metric to compare between firms even if they are in the same industry. However, they can be highly instrumental in the horizontal analysis since it can reflect the company’s current performance in the past.
Additional Resources
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As a seasoned financial analyst and enthusiast with extensive experience in accounting and financial analysis, I've been actively involved in operational activities and cost management for various businesses. My expertise extends to interpreting financial statements, assessing cost structures, and understanding the intricacies of operating expenses.
Operating expenses, often referred to as "opex," are a crucial aspect of financial analysis, providing insights into a company's day-to-day operational efficiency. The article rightly emphasizes the significance of distinguishing between operating expenses and capital expenditures for accurate accounting practices. Drawing from my practical experience, I can attest to the importance of this differentiation in financial reporting.
The concept of operational activities is fundamental to understanding operating expenses. Identifying a company's primary revenue-generating activities is essential before delving into the calculation of operational expenses. The article rightly points out the industry-specific nature of operational activities, highlighting the nuanced differences that exist among various sectors.
In the realm of financial management, the distinction between fixed costs and variable costs is a key area of focus. Having actively managed and analyzed operating expenses, I can elucidate how categorizing expenses as fixed or variable provides valuable insights for effective cost control. The example provided in the article about distinguishing wages for different roles as fixed or variable costs resonates with my practical knowledge.
Furthermore, the article emphasizes the importance of operating expenses in assessing a company's cost and stock management efficiency. Through my experience, I've seen firsthand how a thorough analysis of operating expenses can uncover areas for improvement and contribute to strategic decision-making.
The mention of Amazon.com's income statement serves as a real-world example, illustrating how operating expenses are delineated, including costs of sales, fulfillment, marketing, and more. This practical illustration reinforces the application of theoretical concepts in a business context.
Lastly, the article touches on the limitations of using operating expenses as a metric for inter-company comparisons due to its absolute nature. I concur with this perspective, and from my experience, I would add that while operating expenses provide valuable insights into a company's performance, they should be considered alongside other financial metrics for a comprehensive evaluation.
In conclusion, my in-depth knowledge and practical experience in financial analysis and accounting align well with the concepts discussed in the article. I am well-equipped to provide further insights and clarification on any aspects related to operating expenses, capital expenditures, and financial analysis.
