September 22, 2022
Explainer

What are operating expenses? Learn how to calculate yours and weed out unnecessary expenses

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Business owners need to understand operating expenses and how to manage them to run a successful company. Too many small and medium-sized businesses fail because of poor operating expense management. Living by the old adage "you've got to spend money to make money" can be a dangerous motto for business owners if they don't understand how to prioritize operating expenses.

Your employees and customers depend on your ability to operate within your means. But unauthorized and uncontrolled spending on operating expenses can sink your business. In this article, we’ll dive into operating expenses and how to calculate, manage, and save on associated costs.

What are operating expenses?

Operating expenses are costs that your business incurs to remain functional. Operating expenses pay for your business's day-to-day operations. If you didn't have operating expenses, your business would not run. Calculating and controlling operating expenses is crucial for small and medium-sized companies to remain operational. 

It’s worth keeping in mind that unauthorized and out-of-policy spending are the primary culprits of struggling and failed businesses. To help remediate this or avoid it entirely, you should take control of your operating expenses with corporate cards, good spending policies, automation, and more. We’ll get into these later. 

Operating expenses overview

All businesses incur operating expenses. If they didn't, they wouldn't be able to operate. Operating expenses are what keep your business running—they are usually unavoidable. Still, you control your operating costs and how you manage them. Companies typically keep track of these expenses with their income statements. Income statements track revenue, expenses, profit, and loss over time. Smart business owners will also keep track of their spending with a balance sheet and practice good p&l management.

Why are operating expenses important?

Understanding how operating expenses impact your business is crucial to remaining profitable. The ability to differentiate operating and non-operating costs is also critical for small and medium-sized business owners. Non-operating costs are any expenses that are not related to the company's day-to-day operations. These can include things like:

• Interest expenses

• Legal expenses

• Restructuring costs

• Gain or loss from asset sales

Business owners that understand their operating and non-operating costs can make smarter decisions by reducing costs effectively and efficiently. Smart owners will remain competitive by balancing business operations and cost-saving measures to stay profitable.

Operating expenses examples

Examples of operating expenses are:

• Rent

• Utilities

• Salaries

• Wages

• Office supplies

• Overhead costs

• Property taxes

• Marketing costs

• Depreciation

A typical operating expense is marketing costs. Successful businesses are always trying to grow their customer base. Marketing and advertising can get your business in front of the right customers, but it will come at a cost.

Factoring in your marketing costs when calculating operating expenses will give you a better grasp of your net income. Take a look at this example income statement to see where other operating and non-operating costs fit and how they impact net income:

The impact of operating expenses on your bottom-line

A key challenge for small and medium-sized business owners is managing their operating expenses to avoid unnecessary spending without losing market share.

High operating costs can improve the quality of your operation, helping you attract more customers and grow your business. However, your operating costs have a direct impact on profitability. Your profit margin will shrink if you spend too much on operational expenses.

Low operating costs can save your business money and improve your bottom line. However, it may become harder to operate efficiently with a low operating cost. Savvy business owners will rely on an operating budget to account for spending. Managing your operating budget is an essential aspect of remaining profitable. Operating budgets typically include revenue, fixed costs, and variable costs.  

The problem with high operational costs

High operational costs cause many small and medium-sized businesses to fail—primarily due to reckless, unauthorized, and unaccountable spending. Many business owners don't recognize the importance of having clear-cut spending policies, leading them to make poor financial decisions. In most cases, it's too late to rectify reckless spending on operational costs because of continued neglect. Establishing a healthy financial culture will set your business up for success.

Ramp offers solutions for business owners to regain control of their expenses and improve their bottom line, including company cards, spend policies, automated and on-demand approvals, and transaction-flagging.

Company cards

Integrate your accounting, create seamless workflows, and build accountability with Ramp's commercial and corporate cards. It's everything you need, all in one place.  

Spend policies  

Save time and resources with Ramp's flexible expense report policies. Empower employees to spend what's necessary and only review when necessary. Get alerts, start conversations, request payments, and automatically lock cards with Ramp's expense policies.

Automated and on-demand approvals

Automate your expense approval workflow to allow certain purchases and review others. Build pre-approved expenses into your company card, approve payments before they clear, and review any out-of-policy purchases with real-time reporting.

Transaction flagging  

Flag out-of-policy, accidental, and fraudulent transactions to keep spending in line. Set up automated flagging for faster and easier spend tracking.

Operating expenses vs. non-operating expenses

Operating expenses are costs that a business incurs to remain functional. Examples of operating costs include rent, utilities, marketing costs, etc. Non-operating costs are any expenses that are not related to the company's day-to-day operations.

Non-operating costs include interest expenses, legal expenses, restructuring costs, etc. Both types of expenses can take a business owner by surprise if they aren't keeping an eye on the cash flow within the company. Understanding how operating and non-operating expenses will impact your bottom line is important.

OpEx vs. CapEx

Capital expenditures (CapEx) are business costs that will provide long-term benefits for the company. Operational expenses (OpEx) typically provide more short-term value to the business. Examples of capital expenditures include:

• Real estate

• Equipment

• Furniture

• Intellectual property

• Copyrights

• Patents, trademarks, etc.

Capital expenses like intellectual property, copyrights, and patents will protect your business for the long term; they do not immediately impact your day-to-day operations. Conversely, operational expenses like marketing costs will have an impact on the day-to-day operations of your company. Striking a balance between the two is what moves your business toward profitability.

Fixed vs. variable operating expenses

Operating expenses typically fall into two categories: fixed and variable.  

Fixed operating expenses are consistent expenses businesses account for in normal core operations. Fixed expenses are generally predictable expenses like:

• Taxes

• Rent

• Salaries

• Insurance

Companies plan for fixed costs to remain constant.

Variable operating expenses are more flexible and can change based on several factors. Variable costs will typically fluctuate alongside increasing or decreasing production and sales. Variable expenses include:

• Utilities

• Materials

• Shipping and freight

• Commissions

Businesses plan for variable costs to fluctuate.

Some operating expenses can fluctuate between fixed and variable. Wages can be fixed or variable, depending on whether the employee is paid hourly or receives a full-time salary. If the employee is salaried, they will classify as a fixed operating expense because their pay remains consistent. Hourly employees classify as a variable expense because their income fluctuates based on their work hours. Businesses also need to account for hourly employees that work overtime.

Operating expenses formula and calculator

Smart business owners need to calculate operating expenses correctly to remain profitable. A few different formulas can help you calculate your operating costs. The most straightforward way is to add together all of your operating expenses for a final sum. An example formula is:

Operating Expenses = Wages + Rent + Utilities + Insurance + Marketing

Each business operates differently. Your operating expenses could include more items than listed in this specific formula. It is vital to identify your operating expenses and then add them together for a final sum.

Once you have calculated your operating expenses, you can calculate your operating expense ratio. Your operating expense ratio is a good indicator of your business's efficiency. A low operating expense ratio is typically indicative of an efficient company. A high operating expense ratio is usually a sign of inefficient business practices. The following formula represents your operating expense ratio:

Operating Expense Ratio = Operating Expense / Total Revenue

Smart business owners will also invest in business budgeting software to manage their operations. Ramp can pair with many leading business budgeting software solutions to help you control unnecessary spending and retake control of your business's finances.

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