To run a company is an expensive job; before it can earn any revenue, it has to pay many expenses incurred. One such expense is an operating expense. Operating expenses help keep the business running. It is also vital for analysing a company’s operational performance. Some examples of operating expenses include payroll, inventory costs, insurance, travelling expenses, rent, bank charges, and legal fees. These expenses are listed in an Income Statement under Selling, General & Admin Costs (SG&A), and Cost of Goods Sold (COGS).
These expenses are not directly linked with the production of goods or services. If a company can control its operating expenses without ruining its product, then it can retain more cash in its business.
Let’s discuss operating expenses meaning. A company incurs a cost for performing its operational activities known as an operating expense or OMEX. The operational activities of a company are its key commercial activities for generating revenue. An operating expense is an unavoidable expense. Since this expense does not directly link with the production of goods or services, they do not directly impact the product’s price or quality. You can find operating expenses in the company’s Income Statement. You can review the general ledger for expenses that do not directly affect the cost of creating a product or service.
Operating expenses are different for every industry. They are listed under Selling, General & Admin Expenses (SG&A). Some operating expenses are office supplies, salaries & wages, maintenance & repairs, advertising & marketing, etc.
Office-Related | Compensation-Related | Sales & Marketing Related | Cost of Goods Sold |
Legal fees | Sales commission | Entertainment cost | Freight in and freight out |
Office supplies | Payroll | Travel cost | Direct labour |
Depreciation | Pension Plan | Direct mailing cost | Direct material |
Insurance Cost | Benefits for non-production employees. | Advertising cost | Rent of production facilities. |
Accounting Expenditure | Sales material cost | ||
Property Tax | |||
Utility Cost |
The operating activities are revenue-producing and cover a company’s core business activities. Operating activities include both operating revenues and operating expenses. They also provide a good portion of cash flow and determine whether a company is profitable or not. However, they are different from investing or financing (issuance of bonds) activities of a company that helps it optimally function over the long term. An operating activity differs from industry to industry.
For example, Buying a building may be an investing activity for any industry. However, purchasing a building for resale is an operating activity for a real estate company.
A company calculates operating expenses or OMEX to identify recurring costs other than raw materials and direct labour used in the manufacturing process. Adding all the expenses together, you get the company’s operating expenses for an accounting period. Once you know your operating expense, you can calculate the operating expense ratio (OER). The OER helps directly compare income with expenses; therefore, you can compare your business with others. Operating expenses calculation can be done by a simple formula.
Operating expense formula or operating expense ratio (OER): COGS+OPEX/Revenues
Income Statement | Amount |
Revenues | $250000 |
COGS | $50000 |
Gross Profit | $200000 |
Operating Expenses | $60000 |
Operating Income | $70000 |
Non-Operating Expenses | $10000 |
Net Income | $130000 |
Operating expense calculation (OER) = $50000+$60000/$250000 = 0.44
Compare your OER to the industry benchmark to analyse if it’s good or bad. An increasing OER signals a decline in the operating efficiency of the business. So, watch out for the operating expense ratio from time to time. You can calculate total operating expenses by this formula:
Operating expense= Salaries & wages + Insurance Expense + Rent + Repairs & Maintenance + Travel + utilities + Supplies
It’s easy to get confused between the two. The operating expense ratio is for the real estate industry, and it measures the cost of the property against the income it generates. It helps to compare expenses of similar kinds of properties.
The operating ratio compares the company’s total expenses against revenues or net sales generated. The operating ratio helps to analyse companies in different industries.
From an income-tax perspective, companies typically favour OPEX over CAPEX. For example, rather than buy computers and laptops directly for $800 apiece, a company may choose to lease them from a vendor for $300 apiece for three years. This is because buying a piece of equipment is referred to as a capital expense. Now, even though the company pays $600 for the equipment, it can only deduct $250 as an expense in that year.
On the other hand, the total amount of $300 paid for leasing to the vendor is an operating expense because it was incurred as part of the daily business operations. The business can, therefore, deduct the cash it spent that year.
The benefit of deducting expenses is that it lowers income tax, which is levied on net income. Another benefit is the time value of money, i.e., assuming that the cost of capital is 5%, then saving $100 in taxes this year is better than saving $104 in taxes next year.
However, tax may not be the only consideration. If a public company wishes to boost its book value and earnings, it may choose to make a capital expense and only deduct a small part of it as an expense. This will result in a higher asset value on its balance sheet and a higher net income that it can report to investors.
Here are some ways for small business owners to reduce their operating expenses.
An operating margin or return on sales (ROS) represents how much profit a company makes through its core operations. It is calculated by dividing operating income by net sales. The higher the ratio, the better a company is in illustrating that it is efficient at turning sales into a profit. It tells that a part of the revenue can cover the non-operating expense. The company’s past operating margins can tell investors and lenders if the company’s performance is getting better or not.
However, it can be improved through efficient use of resources, better management control, effective marketing, and improved pricing.
Operating Margin = Operating Earnings / Revenue
There are various types of operating expenses. Operating expenses fall under Selling, General & Admin Expenses, and COGS. Let’s discuss all of them in detail.
These are charged in Profit & Loss as Travelling expenses. When the staff travels for an event, supplies, or to meet clients, the company pays travelling expenses or reimburses them for conveyance.
These are charged in the Profit & Loss account of the company. All the utility bills like water and electricity used for daily operating activities are considered utility expenses.
Charged under the P&L account, these expenses are incurred on mobile phones, internet, and landlines. Companies also reimburse employees for telephone expenses.
These are day-to-day expenses incurred on purchasing office supplies like pens, papers, folders, files, clips, etc.
Companies have to pay property tax on their properties. It is also an operating expense.
Banks charge fees for the general transactions that happen in the business, such as transaction charges for cheques, etc.
A company does a lot of research on new products, and the expenses incurred on the research are treated as research expenses. They are recorded under the P&L account.
It includes daily expenses like stationery, cleaning charges, petty cash, transport, etc.
The direct material used to make the product is treated as direct material cost. It is a direct, unavoidable cost that is paid regularly.
Advertising expenses help increase sales as it promotes and advertises the product. However, this operating expense does not include a company’s trade discount to its customers.
The asset that is used for production undergoes regular repair and maintenance. Such operating expense is treated as repair and maintenance expense. It includes repair of vehicles or machinery, etc.
These are costs incurred for selling the product and increasing the sales like a discount on sales, sales commission, etc.
The cost of goods sold is the cost that is incurred for products or goods sold by the company during a specific period.
Depreciation expenses
A tangible asset is prone to wear and tear. Such a reduction in the cost of an asset is treated as a depreciation expense and falls under COGS.
Product cost
Product costs are incurred to make the product to sell it to the customers. It includes direct material, direct overhead, and direct labour.
Freight in & Freight out Cost
The shipping cost for the purchase of merchandise is the freight-in cost. It is considered a part of the merchandise cost. However, if the merchandise is not sold, it is considered in the inventory.
The cost of the transportation is the Freight-out cost. It includes delivery of the goods from suppliers to customers.
Rental cost
The properties that provide support for the production are eligible for rental costs — for example, salaries, wages, other benefits given to staff for producing goods, etc.
House rent allowance
It is an allowance given to the employee by an employer for staying in a rented house. It is a part of the CTC and can be claimed.
Salaries
It is one of a company’s key fixed expenses to pay its employees’ salaries. It also includes provident fund, pension, gratuity, etc.
Now that we have discussed operating expenses, we also need to about its counterpart, i.e., non-operating expenses. It is important to understand how operating and non-operating expenses differ.
Features | Operating Expenses | Non-operating Expenses |
Key distinction | These are regular, recurring expenses to run the business’s daily operations. | These expenses are not related to normal business activities but to meet certain financial obligations. |
Examples | Telephone charges, travel expenses, office admin and supplies expenses, salaries, wages, etc. | Cost of relocating, interest expense, the cost to pay damages for a lawsuit, etc. |
Decision-making | Operating expenses are controllable and can measure the operational performance of a company. | Non-operating expenses are not controllable and cannot measure the performance of management. |
Classification | These are classified in Income Statement under Selling, General & Admin Expenses (SG&A). | These are recorded in the Profit & Loss Account and are subtracted from operating income. |
Analysing operating expenses gives an accurate picture of the company’s financial position and provides a better comparison with competitors. A low OER, i.e., Operating expense ratio, allows a company to expand in the future. Generally, when a company is new, its OPEX will be quite high since they have to spend on human resources, infrastructure, and marketing expenses heavily. However, this ratio tends to shrink when the company starts generating significant revenues. Similarly, at the time of liquidity, OPEX plays a crucial role in decision-making. The departments that incur higher OPEX possibly shut down while the departments with lower OPEX continue.
Non-operating expenses are not related to the daily operational activities of a business. They are related to financing or investing activities like the cost of relocation, interest expense, lawsuit settlements, restructuring costs, obsolete inventory charges, damages caused by fire and natural disasters, loss on investments, etc.
A business’s operating expenses can be fixed as well as variable costs. A fixed cost tends to remain the same irrespective of production level. In comparison, variable cost varies with the number of products or services a firm produces. For example, salaries, rent, and insurance expenses are fixed costs. Variable costs include labour, raw materials, and sales commissions. A manager must analyse the type of operating expense to control it better. For example, a full-time employee's salary is a fixed cost while the wage of a factory worker is a variable cost.
There are many ways small businesses can control operating expenses, such as outsourcing when necessary, automating specific tasks, opting for video calls rather than travelling, encouraging remote work, considering a four-day work week to improve productivity and eliminating variable overhead expenses, etc.
A rise in operating expenses means that a business will earn less profit. Operating expenses are constantly under scrutiny as opposed to non-operating expenses, capital expenditures, and manufacturing costs. And that is why the management tends to find ways to cut the operating expenses by reducing salaries for freshers, giving internship opportunities, etc.
Operating expenses are liabilities that a business must pay. The company loses money if the business assets are insufficient to cover liabilities.
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