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Operating Expenses Explained: Types, Examples, Accounting, & More

by | Jul 1, 2024

Operating expenses are a fundamental component of a company’s financial statements, presented in the income statement or statement of profit and loss; they represent the costs associated with the day-to-day operations of a business. Understanding and managing these expenses is crucial for maintaining profitability and achieving financial goals. In this article, we will explore the definition of operating expenses, types, accounting treatment, and impact on financial statements.

What are operating expenses?

Operating expenses, often abbreviated as OpEx, are the costs required to run a business’s core operations. These expenses are essential for keeping the business running smoothly and generating revenue. Unlike capital expenditures (CapEx), which are long-term investments in assets, operating expenses are short-term costs that are incurred regularly.

Operating expenses vs. capital expenditures

While both operating and capital expenditures are necessary for business operations, they serve different purposes. Operating expenses cover costs such as salaries, rent, utilities, and office supplies, which are required for daily operations. In contrast, capital expenditures generally involve the purchase or improvement of long-term assets like buildings, machinery, or equipment.

Read our article, “CapEx vs. OpEx: Capital and Operating Expenses Explained,” for a more in-depth comparison of these two expense categories.

Types of operating expenses

Operating expenses can be broadly grouped into several categories, each representing different aspects of a company’s recurring activities. Here are some of the common categories:

Cost of goods sold (COGS)

Cost of goods sold, or COGS, is a term meaning the direct expenses related to the production of items an entity sells. For manufacturing companies this includes the cost of raw materials, labor, and overhead. Cost of sales (COS) is also an operating expense category related to the cost of acquiring or producing the goods or services sold by an entity, but is more commonly seen with retail or service-oriented businesses.

COGS and COS are crucial for calculating the gross profit of a business and will typically be presented as the first expense line item after revenue on an income statement or statement of operations.

Selling, general, and administrative expenses (SG&A)

Selling, general, and administrative (SG&A) expenses include costs related to selling goods & services and managing the company. Any operating expense not directly related to the production of revenue, i.e. COGS or COS, are most likely classified as SG&A unless they fall into one of the other specific operating expense categories defined below.This category encompasses expenses such as marketing, legal fees, office rent, and salaries of administrative personnel.

For further explanation, selling expenses are the direct and indirects costs attributable to selling a product or service, aside for those identified as COGS or COS. Expenses typically seen in this category are sales taxes, commissions, and advertising. General and administrative expenses are costs required to run the business in a broader sense, for example legal fees, office supplies, utilities, and insurance.

Depreciation and amortization

Depreciation and amortization are non-cash expenses that allocate the cost of tangible and intangible assets, respectively, over their useful lives. Depreciation applies to physical assets, commonly referred to as fixed assets in accounting, like buildings, machinery and equipment; while amortization pertains to non-physical or intangible assets such as prepaid expenses, patents, goodwill, or software.

Research and development (R&D)

Research and development (R&D) expenses are incurred in the process of creating new products or services. These costs include salaries of research personnel, laboratory supplies, and prototype development. R&D is vital for innovation and maintaining a competitive edge.

Notable non-operating expenses

It’s also important to distinguish operating expenses from non-operating expenses, which are not related to core business operations. Non-recurring or one-time costs such as inventory adjustments or the writedown of fixed assets, are a significant source of non-operating expenses. Other examples of non-operating expenses include interest and financing expenses, losses from the sale of assets, and costs associated with restructuring. These expenses are typically recorded separately on the income statement and do not impact the calculation of operating income.

Accounting for operating expenses

Accounting for operating expenses requires adherence to specific principles and guidelines to ensure accurate financial reporting.

Accrual basis vs. cash basis accounting

Under the accrual basis of accounting, expenses are recorded when they are incurred, regardless of when the cash is disbursed. This accounting method provides a more accurate picture of a company’s financial health by matching expenses with the revenue they generate and in the period they occur. In contrast, the cash basis of accounting records expenses only when the cash is paid, which may not accurately reflect the timing of the economic impact and detracts from the transparency of the financial statements.

Income statements presentation

Operating expenses are presented on the income statement after sales or revenue as part of the expense section. Expenses are ordered by COGS or COS, followed by operating expenses, then non-operating expenses. Operating expenses are generally shown separately to easily derive operating income. Operating income, also known as operating profit or EBIT (Earnings before Interest and Taxes), is calculated by subtracting total operating expenses from gross profit and is an indicator of a company’s profitability from its core business operations.

Calculating total operating expenses

A detailed breakdown of total operating expenses can be represented as:

Operating Expenses = Payroll + Rent + Utilities + Insurance + Marketing + Supplies + Maintenance and Repairs

This formula provides a comprehensive view of the various components commonly contributing to total operating expenses. By analyzing each category, businesses can identify areas where costs can be controlled or reduced. It is important to note these categories are illustrative examples and specific operating expenses will vary based on the unique nature and requirements of each organization.

Alternatively, total operating expenses can also be calculated using the formula:

Operating Expenses = Revenue − Operating Income − COGs/COS

This formula highlights the relationship between a company’s revenue, operating income, and cost of goods sold/sales. By subtracting operating income and COGS/COS from revenue, we can determine the total amount spent on operating expenses.

Financial statement impact

Operating expenses have a significant impact on a company’s financial statements and key performance metrics.

Operating expense ratio

The operating expense ratio is a useful metric for evaluating a company’s efficiency in managing its operating expenses relative to its revenue. It is calculated using the following formula:

Operating Expense Ratio = Operating Expenses / Total Revenue

A lower operating expense ratio indicates a company is effectively managing its operating costs relative to its revenue, which is a sign of good financial health.

Profitability ratios

Operating expenses directly affect profitability ratios such as operating profit margin and net profit margin. Efficient management of these expenses can improve profitability and enhance a company’s financial stability.

Liquidity ratios

While operating expenses do not directly impact liquidity ratios like the current ratio or quick ratio, excessive operating costs can strain a company’s cash flow, making it challenging to meet short-term obligations.

Examples of operating expenses

Operating expenses vary across industries, but some common examples include:

Salaries and wages

Salaries and wages are among the most significant operating expenses for many businesses. These costs include compensation for employees, bonuses, and benefits such as health insurance and retirement contributions.

Rent

Rent is the cost incurred by an organization for the right to use or occupy an asset they do not own. The types of assets an organization may rent can vary significantly across industry, size, etc. of organization but generally offices rent or lease various types of real estate and equipment. Similar to salaries and wages, rent is typically one of the largest expenses of an organization.

Software licenses and subscriptions

Historically, software has not had its own line item in many organization’s operating expenses. With the significant rise in the use and purchase of software over the last several years, however, software licenses and subscriptions are now the third largest expense on company income statements behind payroll and real estate costs.

Office supplies and equipment

Expenses for office supplies, furniture, and equipment necessary for daily operations fall under this category. These costs can add up quickly and should be monitored to avoid overspending.

Summary

Effectively managing operating expenses is crucial for maintaining a company’s profitability and financial health. By understanding the different types of operating expenses, their accounting treatment, and impact on financial statements, businesses can make informed decisions to optimize their operations and achieve long-term success.

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