Operating Expense definition
Businesses of all shapes, sizes, and types run up operating expenses of some sorts. Managing these operating expenses is an integral part of limiting your spending and keeping your profit margins high. However, the concept of operating expenses is a little more complicated than it first appears. Here, we take a look at how we can define operating expense and what kind of expenditure is classified as an operating expense.
What does operating expenses mean?
An operating expense is any outgoing a business makes that is not directly linked to the production of goods or services. Typically, expenses are associated with the general compensation of non-production employees (e.g. a worker in a business’ cafeteria), administrative and office-related expenditures, or sales and marketing expenses. In all of these cases, the expenditure is a by-product of the production of services and goods, rather than directly associated with it.
Operating expense is often shortened to OPEX, and this type of expense is an essential consideration for any business that hopes to remain competitive. One of the biggest challenges faced by a company’s management team is how to reduce operating expenses without negatively impacting the business’ profit margin, productivity, product quality, or staff morale. Many businesses employ individuals who have built their entire career on minimising companies’ operating expenditures and who can strike the perfect balance between cutting back and maintaining standards.
What are operating expenses examples?
There is an extensive array of operating expenses that can be used as examples of the type of expenditures businesses have to make. Due to the vast number of examples, it’s easiest to group them and then compare a few critical categories. For instance, in the marketing and advertising category, one might find the cost of sales materials, travel, advertising, and direct mailing. In the administrative group, you're likely to see the cost of insurance, rent, accounting services, office supplies, legal fees, property taxes, and utility bills. Finally, in the compensation category, you'll find the cost of sales commissions, pensions and benefits of non-production employees, and the payroll expenses for non-production employees.
How to calculate operating expenses
The easiest means of calculating operating expenses is by using dedicated accounting software. However, if your business has no such software, it will be necessary to perform the calculations manually. This involves identifying every operating expense your business makes by collecting, organising, and referencing each receipt your business has accumulated.
At the same time, you should be separating each of the expenses into one of the three categories listed above. These are “general,” “selling,” or “administrative.” Not only does attributing each expense a category give you a deeper insight into how your business in managing its costs, but it also prepares you for the task of filling out your balance sheet.
Operating expenses on balance sheet
Operating expenses are listed on a balance sheet and usually categorised in the manner mentioned above. However, some income statements will break expenses down into a larger number of categories. These may include “depreciation and amortisation” and the rather vague “other operating expenses,” as well as general, selling, and administrative expenses.
On the balance sheet, you’ll fill in figures for all of the categories you’ve chosen to include, as well as a total amount for all of the operating expenses. This will be subtracted from gross profit to provide you with a figure for income from operations.
Operating expense ratio
The operating expense ratio (OER) is a means of measuring what it costs to operate an asset compared to the income that asset provides. In its most common form, it is expressed as;
Operating Expenses / Revenue = Operating Expense Ratio
For instance, if a factory costs £35,000 a month to operate and generates revenue that totals £100,000, the calculation would like this;
£35,000 / £100,000 = 0.35
As the OER is typically expressed as a ratio, the final answer would be 35%.
The OER is useful because it allows a business to compare its expenses over a long period. While a lower OER suggests that an asset is being managed effectively and that it is generating sufficient revenue to justify investment in it, a higher ratio may indicate an inefficient or costly asset. If a ratio fluctuates, you may need to monitor the ratio over a protracted period of time. If it keeps on rising, it may suggest that operating costs are escalating and steps need to be taken to reduce them.
Operating expense vs capital expense
There is an important distinction to be made between operating expenses and capital expenses. Whereas operating costs are those expenses that are not directly associated with the production of services or goods, capital expenses (often shortened to CAPEX) are expenditures that can be considered investments. These include costs associated with acquiring or upgrading property, factory equipment, digital systems, copyrights, patents, and other intellectual properties. Capital expenses are treated differently to operating expenses in regards to tax and accounting.
Is depreciation an operating expense?
Generally, depreciation is considered an operating expense. This is due to the way in which depreciation is thought of as the conversion of a fixed asset into an expense over a long period. However, because these assets are typically purchased up front, there is no outgoing cash flow associated with this expense. This makes it easy to forget or miss when calculating operating expenses. This is also true for amortisation.
Research and development operating expense
Research and development are also typically thought of as an operating expense. Defined as the any planned activity performed by a business with the intention of solving problems, inventing new goods, or improving older ones, research and development is an essential part of preparing a business for the future. In the tech and manufacturing industries, R&D expenses can be astronomical, but for smaller firms, they'll often be non-existent. However, in both cases, they'll be categorised under operating expenses and included in the OER calculations.