What are operating expenses? Definition, formula, and impact
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The adage goes, “You’ve got to spend money to make money”—but this can be a dangerous motto as a business owner if you don’t know how to manage your operating expenses.
Successful operating expense management spells the difference between operating within your means and uncontrolled spending. In this article, we’ll explain what operating expenses are, how to calculate them, and how to cut down on unnecessary costs.
What are operating expenses?
Operating expenses are the necessary and unavoidable costs that pay for your business’s day-to-day operations. Without operating expenses, your business wouldn’t be able to run.
Some examples of operating expenses include:
• Office supplies
• Overhead costs
• Property taxes
• Marketing costs
Fixed vs. variable operating expenses
Operating expenses can be divided into two categories: fixed and variable expenses.
Fixed operating expenses are costs that remain constant regardless of the level of goods or services a business produces or sells. Examples of fixed costs include:
Variable operating expenses are costs that fluctuate in direct proportion to the level of production or sales activity within a business. Examples of variable operating expenses include:
• Raw materials
• Shipping and freight
• Direct labor costs
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, their pay will be considered a fixed operating expense because it’s consistent. Hourly salaries, on the other hand, are a variable expense because they fluctuate based on the number of hours worked.
Operating expenses vs. non-operating expenses
So, what isn’t an operating expense? While operating expenses are costs that a business incurs to remain functional, non-operating expenses are any costs that are not tied to a business’s day-to-day operations.
Examples of non-operating costs include interest expenses on loans, losses on the sale of assets, lawsuit settlements, and income tax expenses.
OpEx vs. CapEx
Sometimes, operating expenses (OpEx) are distinguished from capital expenditures (CapEx). Capital expenditures are funds used by a company to acquire, upgrade, and maintain physical assets such as property, buildings, or equipment.
Examples of capital expenditures include:
• Real estate
• Intellectual property
• Patents, trademarks, etc.
Capital expenses like intellectual property, copyrights, and patents will protect your business in the long term; they don’t immediately impact your day-to-day operations. Conversely, operational expenses like marketing costs do have an impact on your day-to-day operations. Striking a balance between the two is what moves your business toward profitability.
Are operating expenses on the balance sheet or income statement?
Operating expenses are recorded on a company’s income statement, not the balance sheet. That said, operating expenses have an effect on both financial statements.
On the income statement:
Operating expenses are subtracted from gross profit to calculate operating income.
They're usually listed separately from cost of goods sold (COGS) and are categorized under headings like Selling, General and Administrative Expenses (SG&A), Research and Development (R&D), and Depreciation and Amortization.
Effect on the balance sheet:
While operating expenses themselves do not appear on the balance sheet, they do impact the net income of the company, which in turn affects the equity section of the balance sheet.
For example, if operating expenses increase, net income will decrease (assuming all other factors remain constant), which will then decrease retained earnings, a component of shareholders' equity on the balance sheet.
In summary, operating expenses are a crucial part of the income statement that helps investors and management understand the cost structure of your company and its profitability from operations.
How to calculate operating expenses
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. One example formula for operating expenses 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've 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
What is a good operating expense ratio?
A good Operating Expense Ratio (OER) largely depends on your company’s industry and growth strategy. Generally, a lower OER is preferable as it indicates better operational efficiency, meaning your company is able to generate more revenue per dollar of operating expense.
Sometimes, a higher OER might be justified if a company is investing heavily in growth or operational improvements, which could lead to higher future revenues and profitability. It's important to analyze the OER in the context of industry norms, historical trends, and your company's growth strategy to determine whether you feel it’s at a reasonable level.
The impact of operating expenses on your bottom line
As a business owner, managing your operating expenses effectively is critical to remaining profitable.
High operating costs can improve the quality of your operation, helping you attract more customers and grow your business. However, 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. But then, it may become harder to operate efficiently. Establishing a healthy financial culture and creating an operating budget to account for spending will help keep your expenses in check.
Manage your operating expenses with Ramp
Ramp’s expense management software can help you manage and cut down on your operating costs. We pair with leading accounting solutions to help you control unnecessary spending and take control of your business's cash flow.
Learn more about how Ramp can help your business save.