What are operating expenses? Definition, examples, and formula

What are operating expenses?

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Understanding operating expenses can help your business plan its budgets, forecast future spending, and allocate resources where they’re needed most. In this article, we’ll explain the different types of operating expenses, how to calculate them, and how to cut down on unnecessary costs.

Understanding operating expenses

Operating expenses are the essential recurring payments that fund your business’s operational activities. They’re day-to-day costs your business incurs to remain functional and generate revenue. However, they’re not directly tied to the production of goods or services. For that reason, they’re listed separately from cost of goods sold (COGS) on your income statement.

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Let’s look at some common examples of operating expenses and compare them to various other business expenses.

Fixed vs. variable operating expenses

Operating expenses can be divided into two categories: fixed and variable expenses.

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Fixed operating expenses are costs that remain constant regardless of business activity or production. Examples of fixed costs related to business operations include:

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• Taxes
• Rent
• Salaries and wages
• Marketing and advertising
• Insurance
• Legal costs
• Office supplies
• Depreciation

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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:

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• Utilities
• Shipping and freight
• Sales commissions
• Credit card processing fees

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Some operating expenses can be either fixed or variable. For example, wages could be fixed or variable depending on whether an employee is paid hourly or receives a full-time salary.

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If the employee is salaried, their pay will be considered a fixed operating expense because it’s consistent. Hourly wages, on the other hand, are a variable expense because they fluctuate based on the number of hours worked.

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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.

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Examples of non-operating costs include:

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• Interest expenses on loans
• Losses on the sale of assets
• Lawsuit settlements
• Income tax expenses

OpEx vs. CapEx

Sometimes, operating expenses (OpEx) are distinguished from capital expenditures (CapEx). Capital expenditures are the business costs of acquiring, upgrading, and maintaining assets such as property, buildings, equipment, or intellectual property (IP).

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Examples of capital expenditures include:

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• Real estate
• Equipment
• Furniture
• Intellectual property
• Copyrights, patents, trademarks, etc.

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Capital expenses like IP, 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 the costs to advertise the products or services that result from your capital expenditures do have an impact on your day-to-day operations.

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Striking a balance between these two types of expenses is crucial to achieving your long-term growth plans and moving your business toward profitability.

How to record operating expenses on your income statement

You record operating expenses on your company’s income statement. Operating expenses are subtracted from your gross profit to calculate your operating profit. Here’s an example income statement we generated using Ramp’s income statement template, with OpEx highlighted in yellow:

How to calculate operating expenses

There are a few different formulas to 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 those listed in this specific formula, so it’s essential to first identify all your operating expenses and before adding them all together for your final sum.

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Once you've calculated your operating expenses, you can calculate your operating expense ratio (OER). Your operating expense ratio is a good indicator of your business's efficiency.

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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 Expenses / Total Revenue

What is a good operating expense ratio?

A good operating expense ratio largely depends on your company’s industry and growth strategy. Generally, a lower OER is ideal because it indicates better operational efficiency, which means your company generates more revenue per dollar of operating expense.

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Sometimes, a higher OER might be justified if a company is investing heavily in growth or operational improvements, which could yield higher future revenues and profitability. For example, many growth-stage startups invest heavily in sales and marketing to create awareness and attract new customers, which could lead to a higher operating expense ratio.

That’s why it's important to analyze your operating expense ratio in the context of industry norms, historical trends, and your company's growth strategy to determine whether it’s at a reasonable level.

Managing operating expenses

As a business owner, effectively managing expenses is critical. Low operating costs can save your business money and improve your bottom line, but this could also make it harder to operate, which impacts your competitiveness.

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High operating costs can improve the quality of your operations, helping you attract more customers and remain competitive in the market. However, your profit margin will shrink if you spend too much on operational expenses.

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Consider the following strategies to strike a balance between reducing operating costs and remaining competitive:

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1. Track your operating expenses: Get in the habit of tracking your operating expenses as soon as you incur them. This will give you a clear picture of your business spending habits, which can help you recognize and eliminate excess spending more quickly.
2. Look for opportunities to renegotiate: In some cases, you may be able to renegotiate the terms of your existing agreements to reduce your operating expenses. If that isn’t possible, explore your options—you may be able to get a similar level of service from a new partner or supplier at a lower cost.
3. Review spend data regularly: Use data to inform your decision-making around operating expenses. Is your advertising spend producing results? Could that money be better spent elsewhere? Reviewing your growth strategies in this context can help you maximize ROI to generate more revenue.

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Establishing good financial health and creating an operating budget to account for spending will help keep your business expenses in check.

Get better insights into your operating expenses with Ramp

Ramp’s modern expense management software automates business expense tracking and reporting, helping you manage and reduce operating costs in a targeted way. We’ve analyzed millions of business transactions to help you understand whether you’re paying too much for software subscriptions, for example.

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Our platform also offers integrations with leading accounting solutions like Quickbooks and Sage Intacct to help you immediately identify unnecessary spending and take control of your business's cash flow.

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Learn more about how Ramp saves businesses an average of 5% a year.