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Operating expenses are a fundamental component of a company's financial statements, found on the income statement or profit and loss statement, and represent the costs associated with a company's day-to-day operations. Understanding and managing these expenses is essential to maintaining profitability and achieving financial goals. This article explains the definition of operating expenses, their types, accounting treatment, and their impact on financial statements.
What are operational costs?
Operating expenses, often abbreviated as OpEx, are the costs necessary to run a company's core operations. These expenses are essential to keep a business running smoothly and generating revenue. Unlike capital expenditures (CapEx), which are long-term investments in assets, operating expenses are short-term costs that occur on a recurring basis.
Operating Expenses and Capital Expenditures
Although both operating expenses and capital expenses are necessary to run a business, they serve different purposes. Operating expenses cover the costs necessary for day-to-day operations, such as payroll, rent, utilities, and office supplies. Capital expenses, on the other hand, typically involve the purchase or improvement of long-term assets, such as buildings, machinery, and equipment.
For a detailed comparison of these two expense categories, read our article, CapEx vs. OpEx: Capital and Operating Expenses Explained.
Types of operating expenses
Operating expenses can be broadly divided into several categories that represent different aspects of a company's regular activities. Here are some common categories:
Cost of Goods Sold (COGS)
Cost of goods sold (COGS) is a term used to refer to the direct costs associated with producing the goods a company sells. For manufacturing companies, this includes raw materials, labor, and overhead. Cost of goods sold (COS) is also a category of operating expense related to the costs incurred in acquiring or producing the goods or services a company sells, but is more commonly found in retail and service-oriented businesses.
COGS and COS are crucial in calculating a company's gross profit and typically appear as the first expense items after revenue on an income statement or operating statement.
Selling, general and administrative expenses (SG&A)
Selling, general and administrative expenses (SG&A) include costs associated with selling goods and services and managing your company. Operating expenses that are not directly related to generating revenue (COGS or COS) will likely be classified as SG&A unless they fall into one of the other specific operating expense categories defined below. This category includes expenses such as marketing, legal fees, office rent, and administrative staff salaries.
To elaborate further, selling expenses are the direct and indirect costs attributable to the sale of a product or service, other than those identified as COGS or COS. Common expenses that fall into this category are sales tax, fees, and advertising. General and administrative expenses are the costs necessary to run a business in a broader sense, such as legal fees, office supplies, utilities, and insurance.
Depreciation
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, typically referred to as fixed assets in accounting, such as buildings, machinery, and equipment. Amortization, on the other hand, pertains to non-physical or intangible assets, such as prepaid expenses, patents, goodwill, and software.
Research and Development (R&D)
Research and development (R&D) expenses are incurred in the process of creating a new product or service. These expenses include research staff salaries, lab equipment, prototype development, etc. R&D is essential for innovation and staying competitive.
Notable non-operating expenses
It is also important to distinguish between operating expenses and non-operating expenses that are not related to the company's core business. Non-recurring or one-time expenses, such as inventory adjustments and impairment of fixed assets, are a large source of non-operating expenses. Other examples of non-operating expenses include interest and financing expenses, losses on asset sales, and expenses related to restructuring. These expenses are usually recorded separately in the income statement and do not affect the calculation of operating profit.
Accounting for Operating Expenses
Accounting for operating expenses requires adherence to certain principles and guidelines to ensure accurate financial reporting.
Accrual and cash accounting
With accrual accounting, expenses are recorded when they are incurred, regardless of when the cash is paid. This accounting method provides a more accurate picture of a company's financial position by matching expenses with the revenues they generate and the period in which the expenses are incurred. In contrast, with cash-basis accounting, expenses are recorded only when cash is paid, which may not accurately reflect the timing of economic impacts and may reduce the transparency of financial statements.
Income statement presentation
Operating expenses are shown as part of the expenses section of the income statement, after sales or revenues. The expenses are ordered as follows: cost of sales or cost of sales percentage, operating expenses, and non-operating expenses. Operating expenses are usually shown separately to make it easier to derive operating profit. Operating profit, also known as operating profit or EBIT (earnings before interest and tax), is calculated by subtracting total operating expenses from gross profit and is a measure of a company's profitability from its core operations.
Calculating total operating costs
A detailed breakdown of total operating expenses can be presented as follows:
Operating Expenses = Salaries + Rent + Utilities + Insurance + Marketing + Supplies + Maintenance and Repairs
This formula is a comprehensive look at the various factors that typically affect total operating expenses. By analyzing each category, a business can identify areas where costs can be controlled or reduced. It is important to keep in mind that these categories are illustrative examples and specific operating expenses will vary based on the unique nature and requirements of each organization.
Alternatively, total operating costs can be calculated using the following formula:
Operating Expenses = Revenues − Operating Profit − COGs/COS
This formula reveals the relationship between a company's revenue, operating profit, and cost of goods sold/revenue. By subtracting operating profit and cost of goods sold/revenue from revenue, you can determine the total amount spent on operating expenses.
Impact on financial statements
Operating expenses have a significant impact on a company's financial statements and key performance indicators.
Operating Expenses Ratio
The operating expense ratio is a useful metric for assessing how effectively a company is managing its operating expenses relative to revenues. It is calculated using the following formula:
Operating Expenses Ratio = Operating Expenses / Total Revenues
A low operating expense ratio indicates that a company is effectively managing its operating expenses relative to its revenues, which indicates good financial health.
Profitability Ratio
Operating expenses directly impact profitability, such as operating margins and net profit margins. Managing these expenses efficiently improves profitability and enhances the financial stability of a company.
Liquidity Ratio
Although operating expenses don't directly affect liquidity ratios such as the current ratio and quick ratio, too many operating expenses can strain a company's cash flow and make it difficult to meet short-term obligations.
Examples of operational costs
Operating expenses vary by industry, but some common examples include:
Salary and wages
Salaries and wages are one of the most significant operating expenses for many businesses. These costs include employee compensation, bonuses, and benefits such as health insurance and retirement.
rent
Rent is the cost incurred for the right to use or occupy property that an organization does not own. The types of assets that organizations rent vary widely depending on the organization's industry, size, etc., but offices typically rent or lease various types of real estate and equipment. Along with salaries and wages, rent is usually one of an organization's largest expenses.
Software Licenses and Subscriptions
Historically, most organizations did not have a separate software line item in their operating expenses. However, software usage and purchases have grown so much in the last few years that software licenses and subscriptions are now the third-largest expense on a company's income statement, after salaries and real estate expenses.
Office Supplies and Equipment
Expenses for office supplies, furniture, and equipment needed for daily operations fall into this category. These costs can add up quickly and should be monitored to avoid overspending.
summary
Effectively managing operating expenses is essential to maintaining a company's profitability and financial health. Understanding the types of operating expenses, how they are accounted for, and how they impact financial statements can help companies make informed decisions to optimize their operations and achieve long-term success.