Written By:
Denise Elizabeth P
After learning about what an operating expense is from one of our previous articles (Operating Expense – Defined and Some Examples), the next step would be to know how to compute for it.
It would also be good to know what to do with the operating expenses figure, so in addition to knowing the formula, we will also be discussing one of the financial ratios that are related to it: the operating expense ratio.
To recap, an operating expense is any expense that is incurred by a business through its operating activities and does not directly contribute to the cost of sales (products or services).
It is often unavoidable and necessary for the daily operations of a business.
Common examples of operating expenses are salaries and wages, rent, utilities (e.g. light, water, heating), travel and transportation costs, supplies expenses, repairs and maintenance, etc.
While these expenses don’t necessarily add to the value of a business’s products or services, they are still necessary.
For example, if you don’t pay for the salaries and wages of your employees, they will quit on you, or even worse, sue you.
If your business does not have any employees and you, as the owner, are left alone to run it, its growth will be limited to what your capacity is.
Not to mention the administrative functions that you probably already have, and why you need to pay salaries and wages for your employees.
The Operating Expense Formula
Having an understanding of operating expenses is important in order for you to be able to compute for it.
The operating expense formula will depend on what expenses the business incurs.
For example, let’s say that company VP has the following operating expenses:
In the above example, the operating expense formula would be:
Operating Expense = Salaries & Wages + Rent Expense + Insurance Expense + Repairs & Maintenance Expense + Utilities Expense + Travel Expense + Supplies Expense
And by using the formula, let’s compute for company VP’s operating expense:
Operating Expense = 200,000 + 60,000 + 57,300 + 23,970 + 33,370 + 12,590 + 9,570
Operating Expense = 396,800
If we were to compute for it using a program such as Microsoft Excel, it would look like:
As seen from the above computations, company VP’s operating expense is $396,800.
If we were to create a formula that would be applicable to any type of business, it would be:
Operating Expense = the sum of all operating expenses
Let’s use another example.
Below is an excerpt of Intel Corporation’s consolidated statements of income for the year ended December 2020 with the figure for operating expenses whited out:
Using our formula, let’s compute for Intel Corporation’s operating expense:
Operating Expense = the sum of all operating expenses
Operating Expense = Research and development + Marketing, general and administrative + Restructuring and other charges
Operating Expense = $13,556,000,000 + $6,180,000,000 + $198,000,000
Operating Expense = $19,934,000,000
So as per our computation, Intel Corporation’s operating expense for the year ended December 2020 is $19,934,000,000.
If we were to compute for it using Microsoft Excel:
And we arrive at the same figure of $19,934,000,000.
Let’s check if we got it right.
Below is Intel Corporation’s consolidated statements of income for the year ended of December 2020 with the operating expense highlighted:
Deriving the operating expenses from the income statement
The above computations can be approached if we have information on the operating expense accounts of a business.
But what if we were given every information from the financial statements except the operating expense accounts?
Can we still compute the operating expense?
Let’s try with an example.
You wanted to know how much Facebook, Inc. spent on its operating expenses for the year 2020, but this is all the information that you can find:
As seen from above, the operating expense accounts are missing their figures.
Can we still compute the operating expense?
Let’s try presenting Facebook, Inc.’s income statement (up to operating income) in formula form:
Revenue – Cost of Revenue – Operating Expense = Income from Operations
From the above formula, we can derive the operating expense:
Revenue – Cost of Revenue – Operating Expense = Income from Operations
– Operating Expense = – Revenue + Cost of Revenue + Income from Operations
And we will arrive at the operating expense formula of:
Operating Expense = Revenue – Cost of Revenue – Income from Operations
Now we replace all the variables of the formula with figures from the income statement:
Operating Expense = $85,965,000,000 – $16,692,000,000 – $32,671,000,000
Operating Expense = $36,602,000,000
As per the above computation, we gather that Facebook, Inc. spent $36,602,000,000 on its operating expenses for the year ended December 2020.
If we compute for it using Microsoft Excel, it would be:
And we arrive at the same operating expense figure of $36,602,000,000.
Let’s take a look once again at Facebook Inc.’s consolidated statements of income for the year ended December 2020 to compare:
Since they pooled the cost of revenue and operating expense together, we need to derive the operating expense by subtracting the cost of revenue from the total costs and expenses:
Operating Expense = Total Costs and Expenses – Cost of Revenue
Operating Expense = $53,294,000,000 – $16,692,000,000
Operating Expense = $36,602,000,000
Facebook, Inc.’s operating expense for the year ended December 2020 is $36,602,000,000.
With the computation we made above, we can derive the operating expenses from the operating income (or income operations) by using the formula:
Operating Expense = Total Revenue – Cost of Sales – Operating Income
*Net Revenue can also be used instead of Total Revenue
The Operating Expense Ratio
One of the financial ratios that are related to the operating expense is the operating expense ratio.
It is a metric that measures the effectiveness and efficiency of a business in managing its operating expenses.
It can be arrived at by dividing the operating expense over the total revenue.
Put into formula form, it would look like this:
Operating Expense Ratio = Operating Expense ÷ Total Revenue
The operating expense ratio is one of the financial ratios that measure a business’s efficiency.
It is a great tool for assessing whether a business is managing its expenses well or is already overspending.
The higher the operating expense ratio is, the higher the operating expense is in relation to its total revenue.
Now while the standard level for operating expenses will vary from industry to industry, it is universally not a good sign if the operating expense ratio is very high (think about 80% and above) considering that we still have to account for the cost of sales, and the non-operating expenses (e.g. interest expense).
The operating expense ratio is also a good measure of knowing whether the business is generating enough revenue for the level of operating expense that it is incurring.
For example, a fast-food chain maintains multiple branches expecting that it would generate more revenue by doing so.
Each branch has its share of operating expenses such as salaries and wages of the employees, rent, and utilities expenses.
Needless to say, the operating expense of operating multiple branches when compared to just one store is very high.
If it so happens that one or more of the branches are generating less revenue than expected, the operating expense ratio will increase.
It can be remedied by making sure that all branches are operating at the expected levels (bonus if more), or by finding ways of reducing operating expenses (one of which is to reduce the number of branches being maintained).
While the operating expense ratio on its own is not enough to give you the whole picture of a business’s financial performance, it is still important to monitor.
If your business’s operating expense ratio is increasing even if your level of revenue is also increasing, it might mean that your operating expenses are increasing at a higher rate than your revenue.
This would need a review of your operating expenses to see what is causing this inconsistency.
The operating expense ratio is also useful for comparing with other businesses within the same industry.
As an illustration, below are the income statements of company B and company W which are operating in the same industry:
As can be seen from above, company B and company W had the same level of gross revenue, but company B had a higher gross profit than company W.
But since company B had a higher operating expense ratio, it had a lower operating profit than company W.
This means that company B is either not generating enough revenue for its level of operating expense, is inefficient in managing its operating expenses, or both.
