What Are Operating Expenses?

Every company has a section of the income statement dedicated to “operating expenses.” These costs are critical to a business’s long-term survival and success. For a business to generate profits, it needs to invest money into its employees, marketing programs, products, and services.

Every company has a section of the income statement dedicated to “operating expenses.” These costs are critical to a business’s long-term survival and success. For a business to generate profits, it needs to invest money into its employees, marketing programs, products, and services.

So, what are operating expenses, and why are they such a hot topic of conversation for company executives? We dive into everything you need to know about operating expenses in this article.

What Are Operating Expenses?

An operating expense is an incurred expense during the normal course of operations. Abbreviated as OPEX, these costs could include equipment, rent, marketing, inventory, insurance, payroll, and research and development.

Company leaders are constantly searching for ways to decrease their operating expenses without losing their competitive advantage. However, firms will deploy innovative strategies to reduce their OPEX and produce a product cheaper than their competitors.

A firm must incur these expenses to exist and stay running for the long term. The biggest challenge that companies face is learning how to reduce these costs while not sacrificing product quality or integrity. When firms can strike the ideal balance, they can offer financial and operational rewards in the long run.

There are several innovative strategies for businesses to reduce operating costs:

  • Shop around and evaluate competing interest rates to find the lowest cost
  • Conduct a market analysis and look at renting out a more cost-efficient location
  • Convert the company into a 100% remote working style to decrease utility and rent costs
  • Establish meaningful relationships with vendors by negotiating friendly contract rates
  • Capitalize on discounts for paying invoices earlier than the due date
  • Identify subscriptions that are not being used and cancel them
  • Instead of racking up travel expenses, turn to video conferencing as a more cost-effective option for meetings
  • Look into automating or outsourcing administrative activities, such as payroll, human resources, and bookkeeping.

Operating costs are divided into two types: fixed costs and variable costs.

Fixed Costs

Fixed costs do not fluctuate with the output level of goods or services. These expenses remain the same regardless of how many goods are produced, hours are worked, or customers are served. The business will always pay its fixed costs unrelated to the given activity.

Fixed costs are set by cost schedules, contract agreements, or other policies. These types of operating costs do not go up or down throughout the life of the cost schedule or service agreement. Rent expenses fall into this category because it is a predetermined amount between the company and the landlord. Other fixed operating cost examples include:

  • Leases or rentals
  • Employee salaries
  • Interest expenses
  • Insurance
  • Depreciation
  • Various utilities
  • Property taxes

Variable Costs

Variable costs include any operating expenses that change with the output level. Expenses will go up or down depending on the level of production, hours worked, or customers served. Variable costs could involve utility costs, direct labor, sales, commission, or the cost of packaging or raw materials.

Variable operating costs are a little more challenging to forecast because there is a whole new factor introduced into the value. It is important to note that the per-unit variable will remain constant, but the output level will usually be different.

For a specific activity, the per-unit variable expense will always increase as the output level increases.

Operating Expense Examples

Operating expenses include all costs to maintain business operations. Below is a mini breakdown of the different operating expenses and their definition:

  • Accounting fees – costs incurred to prepare financial statements, remain compliant with regulations, hire an accounting firm, or use subscription-based accounting software.
  • Insurance – cost incurred to protect your business against getting sued and other risks, including workers’ compensation, product liability, natural disasters, and other threats.
  • Legal fees – fees associated with hiring a legal team if you get sued are suing someone else, or dealing with other legal affairs.
  • Advertising and marketing – all costs related to print marketing materials, digital advertising, email marketing campaigns, promotional events, public relations, and any actions taken to grow the brand.
  • License fees – costs associated with licensing a product or the ability to utilize an asset or property.
  • Office supplies – all expenses related to stocking the office with paper, writing utensils, staplers, folders, portfolios, and other items to help office employees do their job better.
  • Maintenance and repairs – costs related to fixing company equipment, vehicles, or building fixtures.
  • Rent – the fixed amount of money paid to the landlord to use a property, building, or piece of land.
  • Salaries and wages – the variable cost to pay employees of the company to work for the business.
  • Travel – the costs associated with employees or leaders traveling to meet with clients, visit other company buildings or property, and all related costs of the business trip.
  • Property taxes – all taxes paid on the property owned by the business or legal entity.
  • Vehicle expenses – if employees use a company car, these operating expenses include all costs of maintaining the vehicle, gas, and repairs.

Why Are Operating Expenses Important?

Operating expenses are critical for many reasons. First, they help determine a company’s stock management and cost-efficiency. OPEX outlines a cost level that a business needs to hit to produce revenue. When a company is conducting short- and long-term forecasting, operating expenses are a critical factor in success.

Operating expenses also help with benchmarking against the competitors. For example, a company may have much larger operating expenses to sales compared to its top three competitors.

One downside of operating expenses is its unit of measurement. OPEX is reported as an absolute number instead of a percentage or ratio, making it difficult to compare metrics with another company in the same space. However, operating expenses are insightful for companies to analyze their current and historical performance.

Operating Expenses’ Role in the Financial Statements

Companies will prepare an income statement to report their net income, track income sources, and outline all expenses during a set period. Income statements break expenses down into six main categories:

  • Cost of goods sold
  • Selling, general, and administrative expenses
  • Depreciation and amortization
  • Other operating expenses
  • Income taxes
  • Interest expenses

All the groups above could fall under operating expenses. However, firms will exclude income taxes and interest expenses when evaluating their operating income.

Operating Expenses vs. Non-Operating Expenses

Any costs incurred outside of normal business operations are referred to as non-operating expenses. Non-operating expenses include any of the following:

  • Cost to dispose of assets
  • Cost of borrowing
  • Cost of losses on assets
  • Interest charges

When accountants analyze a firm’s financial health, they will exclude non-operating expenses. Removing the non-operating expenses provides a clearer snapshot of business performance.

Operating Expenses vs. Capital Expenses 

Capital expenses, referred to as CAPEX, include business purchases meant to be an investment. These expenditures could be associated costs with upgrading or acquiring assets. Whether it is an investment in an intangible or tangible asset, it will qualify as a capital expense.

Intangible assets typically include copyrights, trademarks, patents, or any form of intellectual property.

Tangible assets purchased by the business could be any of the following:

  • Large factory equipment
  • Real estate
  • Office furniture
  • Computers or technology
  • Any other physical assets

Another key difference between operating expenses and capital expenses is how the Canada Revenue Agency addresses them. Businesses can write off operating expenses that are both necessary and ordinary, as defined by the CRA. Ordinary applies to anything accepted or common within business trade. Necessary means anything helpful or appropriate in business trade.

Calculating Operating Expenses

Although a business cannot compare the total operating expenses amount to industry competitors, it can compare ratios. Most businesses will calculate their “operating expense ratio” to compare their expenses to their income. It involves a simple calculation:

  • Add the cost of goods sold and operating expenses
  • Divide by total revenues

For example, a business owner wants to evaluate how the equipment rental company stacks up to others in the area. The cost of goods sold is 60,000 CAD, operating expenses are 80,000 CAD, and revenues are 300,000 CAD. The business owner performs a quick calculation:

(60,000 CAD + 80,000 CAD) / (300,000 CAD) = approximately 0.47. Therefore, the business is spending 0.47 CAD for every CAD to run the business. Now, the business owner can compare this information to other companies in the industry to see where it can improve.

Final Wrap Up

As you can see, operating expenses are critical in making sure a business functions in the long run. However, the most successful companies strategically manage their costs and investments to outperform their competitors.

Companies can invest in process automation to save money on administrative tasks. They can form a strong vendor network to secure the best rates for their products. Businesses can hire a productive workforce to minimize salary and wage expenses.

The key lies in having a plan of what you can control and cannot control. The most diligent companies outline their strengths and weaknesses while choosing the best resources to elevate their brand above the rest.

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