Have you ever gone through an income statement? If you have, there must have been a section labeled “Operating Expenses”. Have you ever wondered what sort of expenses are these and why these expenses are a little different from other expenses? If you have, you are in the right place. These questions are legit and that’s precisely why we are here — with straight-up facts and nothing less. So, without further ado, let’s understand what are operating expenses and how to calculate them.
Operating expenses are more than just a couple of numbers presented on the spreadsheet. Be that as it may, they are a detailed reflection of how effectively all operations are running within your business. In fact, a business can effortlessly achieve its financial objectives by controlling these expenses in the long run.
What are operating expenses?
Operating expenses, usually referred to as OpEX, are basically the costs that are largely associated with the daily operations of a business. Furthermore, these are the expenses that can include utilities, rent, payroll, and general administrative costs, among many others. You could think of it as the fuel that keeps your business’s engine running smoothly all the time.
Here are some of the common types of operating expenses you should be aware of:
- Utility expenses
- Accounting and legal fees
- Restorations
- Office supplies
- Bank bills
- Salaries and/or wages
- Sales and marketing costs
- Rent dues
- Cost of goods sold (COGS)
- Travel
Every one of these costs has an individual impact on a company’s daily operations and overall financial well-being. Also, keep in mind that the cost of goods sold is typically considered a separate category from operating expenses. The reason is that it directly relates to the production of services or goods the company provides.
But you can ask, why is it important? The reasons are plenty.
Operating expenses are imperative because they can directly impact a company’s profitability. When you manage and start understanding these expenses, your business can enhance its bottom line. That means, the profit after all the expenses are paid off.
However, you should always keep in mind that not all expenses are made equal. While a few of them are fixed, such as rent, there are others that can fluctuate more often, just like the utility bills you pay off. Simply put, this variability just means that business owners should stay more vigilant about their OpEX to retain good financial health.
Now, how do you calculate them? The following section describes that in detail!
How to calculate operating expenses?
When you dive deep into your operating expenses or OpEX, it can help you understand your company’s Operating Expense Ratio (OER). This ratio, in general, can give you a detailed understanding of how your company’s expenses compare to its revenue. As a result, it is a fantastic tool that can help you compare your business’s performance with how some industry competitors are doing. This serves, more often than not, as a detailed health check-up of your finances!
Here’s the formula of operating expenses:
Operating Expenses = Revenue – Operating Income – COGS Sometimes, operating expenses is also given as the sum of all overheads.
Operating Expenses = Wages + Marketing Costs + Rent + Utilities + Insurance + Taxes The above is a simple, straightforward equation for operating expenses. Think of it as a collection of the daily costs your business is enduring.
1. Operating Expense Ratio: The Operating Expense ratio (OER) is indicative of the efficiency of businesses in terms of their operating expenses relative to their revenue.
Here’s the operating expense ratio formula (OER):
Operating Expense Ratio = Operating Expenses / Revenues A lower OER suggests higher efficiency and profitability. That is primarily because only a smaller portion of the income has been consumed by operating expenses. On the other hand, a higher bar implies that a company is expending a massive proportion of its income on operating expenses. This, in turn, suggests a higher rate of inefficiency alongside other challenges in cost management.
Just so you can understand better, let’s assume the financial statements of ABK Retail Business looked something close to this:
| Income Statement Line Item | Amount |
|---|---|
| Revenues | $250,000 |
| Cost of Goods Sold | $60,000 |
| Gross Profit | $190,000 |
| Operating Expenses | $80,000 |
| Operating Income | $110,000 |
| Non-Operating Expenses | $15,000 |
| Net Income | $95,000 |
| OER (Operating Expense Ratio) | 0.32 |
Thus, ABK Retail Business now calculates their Operating Expense Ratio (OER) just through dividing the operating expenses (that is, $80,000) by the revenues ($250,000). Therefore, you get an OER of 0.32.
What does this mean? Well, ABK Retail Business is now spending 32 cents of each dollar they are earning on the daily costs of running the business.
Generally, after you have calculated the operating expense, take a close look at it. Here’s exactly where it gets interesting. Notice the total. Is it actually higher or lower than you predicted? When you start to understand your operating expenses, you get the real picture of your business’s efficiency. In fact, it can help you identify areas where you might want to cut costs.
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Operating expenses examples
Let’s assume there’s an ice cream shop and they are selling $250,000 worth of ice cream every year. The Cost of Goods Sold (COGS, which includes paper wrappers, ice cream cones, and the ice cream itself, boils down to $90,000.
Also, they are spending around the following as overheads:
- $3,000 on their utilities
- $12,000 on the rent
- $50,000 on salaries and wages
- $1,500 for their freezer depreciation
- And, $3,000 on their business insurance
But, here’s the good news – there are no non-operating costs to be concerned about. Therefore, their net profit now stands at $93,500. This is how you can evaluate it:
$250,000 (annual sales) – $90,000 (COGS) = $160,000 (gross profit) – $69,500 (overhead) = $93,500 (net profit).
Capital Expense vs. Operating Expense
Now you may wonder and rightly so, that if operating expenses are do not go into production costs directly, then what does? Well, your answer is capital expenses. So, what’s the difference between capital expenses and operating expenses? Capital expenses (CapEx) largely comprise major investments that a business needs to make to purchase resources that can produce revenue in the future. For example, technology upgrade or adding new features.
In contrast, operating expenses (in the long term) do not add value to the company or bring in money. Instead, they are smaller costs that are incurred to sustain ongoing operations.
Furthermore, capital expenses represent the money a company spends on acquiring, maintaining, and upgrading its physical assets. On the other hand, operating expenses are the costs a company incurs to perform its natural business operations.
Moreover, these are short-term expenses and are actually not associated with any physical assets. Some of its major instances include raw materials, labor costs, inventory costs, and much more.
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COGS vs. Operating Expenses
You would have noticed in the operating expense formula, that COGS is subtracted from revenue. So, it helps understanding the concept better if you notice the difference between COGS and Operating Expenses. While both of these expenses are known to affect a company’s performance and profit margins, they still have distinct meanings.
The cost of goods sold is a crucial component in figuring out the direct costs associated with producing goods or providing services. These are the costs harvested from the manufacturing process and involve raw materials and labor directly involved in producing the goods.
On the other hand, operating expenses revolve around the indirect costs that are made in the daily operations of your business. Moreover, these expenses are indirectly linked to the production or sale of goods and services. However, OpEX is highly essential to helping your business operations run.
So, what is the difference between Capex and COGS? Well, Capex are large expenses that will produce value in the future such as machinery or computers needed for upscaling. Whereas, COGS are expenses that go directly into producing the goods or services on a shorter term basis.
Understandably, if you look at the income statement, you can find COGS, capital expenses and operating expenses recorded as separate line items. Download free income statement excel template here.
In Summing Up
When you start to understand operating expenses, you’ll realize how they act as a GPS for your company’s financial journey. As people like to call it, operating expenses are the daily costs that keep the engine of your business hot and running. In fact, it is one of the critical areas that determines how profitable and efficient your company is.
As a result, you need to be extra meticulous about these expenses. That’s primarily because you are saving more than just money in this case. In reality, you are using your business for long-term success and growth.
Therefore, ask yourself at times: How closely are you keeping an eye on and monitoring your operating expenses these days? Never forget that every dollar you save on running costs could potentially increase your profit margin. Want to reduce operating expenses and get more profits? Why not connect with our experts with more than 12+ years of accounting expertise!
Frequently Asked Questions
1. Is depreciation an operating expense?
Yes, depreciation is generally considered an operating expense. In other words, it is the process where you allocate the cost of a tangible asset over its useful life, showing the wear and tear of that particular asset over time. When we talk about business accounting, depreciation can help to indicate how much of the value of an asset has been used up during a certain time period. You can typically find this included in the operating expenses on an income statement. Take a look at income statement cheat sheet here.
2. Is interest expense an operating expense?
No, interest expenses are not really regarded as operating expenses. In contrast, it is rather considered a financial expense. Interest expense, in simple words, emerges from a company borrowing money. Moreover, it is associated with the cost of borrowing rather than the core business operations. If you closely examine a financial statement, you can find interest expenses usually listed separately from operating expenses.
3. Is amortization an operating expense?
You’re right. Amortization is taken as an operating expense. To be precise, it is very similar to depreciation but applies for intangible assets, such as trademarks or patents. In simple words, amortization is known to distribute the cost of these intangible assets over their useful life. It helps to show the consumption or the gradual decline in value over time. Further, keep in mind that this expense is frequently listed in the operating expenses section of financial statements.
4. Is income tax expense an operating expense?
Well, no. Income tax expenses are actually not an operating expense. In other words, this is because it is more directly related to the day-to-day operations occurring in a business. But, remember, it still has the potential to affect a business’s bottom line. This makes it very important to carefully account for it. Income tax expenses are associated with the business’s earnings. Additionally, it is shown separately on the income statement, usually coming after operating income and other non-operating costs, like interest expenses.
