One of the key responsibilities of management is to determine methods to reduce operating expenses without compromising the competitive edge. It’s essential to understand operating expenses and their effect on your business. This guide is designed to help you learn how to identify, monitor, and control operating expenses for your company’s ongoing growth and financial well-being.
Operating expenses, or OPEX, are critical for analysing a company’s operational performance. They provide essential insights for management and financial analysts, helping them understand the company’s cost structure and sales efficiency.
What are Operating Expenses?
Operating expenses are incurred during a company’s key commercial or operational activities. These activities can vary significantly across industries. For instance, a business activity considered operational in one sector might be considered a financial or investment activity in another.
Typically, operating expenses encompass costs such as inventory, rent, marketing, insurance, payroll, and research and development funding. These expenses are crucial for maintaining the continuity and profitability of a company’s operations.
To identify a firm’s operating expenses, one can examine the company’s ledger for costs that directly affect the production or service cost.
Also Read More About Difference Between Operating and Non-Operating Expenses
What Are Included in Operating Expenses?
Operating expenses cover a broad range of costs essential for the day-to-day management of a business. Some of the most frequent operating expenses examples are:
- Salaries for employees (not including labour costs for manufacturing)
- Insurance premiums
- Licensing costs
- Lease payments
- Research activities
- Marketing (including on social media platforms like Facebook)
- Fees for accounting services
- Maintenance and repairs of buildings
- Supplies for the office
- COGS (Cost of goods sold)
- Costs for utilities
- Fees for legal services
- Taxes on property
- Expenses related to vehicles
- Costs for business travel
It’s important to note that operating expenses don’t include costs like the cost of goods sold (COGS), which are listed separately on the income statement. This is because COGS is directly tied to a company’s main production activities, not daily operations.
However, some businesses include expenses such as facility repair costs, direct materials, and taxes on production units as operating expenses. They do this to increase their operating budget, hoping to get more funding next year.
Also, costs like amortisation, depreciation, lawsuit settlements, and restructuring expenses are not counted as operating expenses. Instead, they are categorised as non-operating expenses.
How To Calculate Operating Expenses?
Now that we understand what constitutes an operating expense, let’s explore how to calculate it and use this information in other valuable formulas.
Calculating operating expenses for your organisation involves simply summing them up. For a small business, the basic OpEx formula might look like this:
Formula for Calculating Operating Expenses
To calculate operating expenses, you can use the following simple formula:
Operating Expenses=Total Expenses−Cost of Goods Sold (COGS)−Non-Operating Expenses
Here, Total Expenses refer to all the costs a company incurs during a specific period. Cost of Goods Sold (COGS) includes direct costs attributable to the production of the goods sold by a company. Non-operating expenses are costs unrelated to the core business operations, such as interest expenses, taxes, and one-time items like lawsuit settlements.
Example of Calculating Operating Expenses
Suppose a company has the following financial details for a year:
Total Expenses: ₹10,00,000
Cost of Goods Sold (COGS): ₹6,00,000
Non-Operating Expenses (including interest and taxes): ₹50,000
To calculate the Operating Expenses:
Start with the Total Expenses: ₹10,00,000
Subtract the Cost of Goods Sold (COGS): ₹10,00,000 – ₹6,00,000 = ₹4,00,000
Subtract the Non-Operating Expenses: ₹4,00,000 – ₹50,000 = ₹3,50,000
Therefore, the Operating Expenses for the company are ₹3,50,000 for the year.
This calculation helps in understanding how much the company spends on its day-to-day operations, excluding the cost of producing its goods and any non-operating costs.
How To Use Operating Expenses?
Once you’ve accurately determined your operating expense total, you can use this figure along with several other metrics to gain deeper insights into your business’s performance.
1. Calculating Operating Costs
Operating costs provide a broader view of a company’s everyday expenses by combining operating expenses and the cost of goods sold. This formula is:
Operating Costs = Cost of Goods Sold (COGS) + Operating Expenses
This metric is another method to evaluate a business’s financial health and identify potential savings or budget reductions to enhance profits.
2. Calculating Operating Income (EBIT) and Operating Margin
Operating income, also known as earnings before interest and taxes (EBIT), is a valuable calculation that uses operating expenses to determine the cash flow from primary business activities. The formula is:
Operating Income (EBIT) = Gross Profit – Operating Expenses
Operating margin, calculated using EBIT, helps assess a business’s financial performance relative to previous periods and competitors. The formula is:
Operating Margin = EBIT / Revenue
Both metrics are useful for understanding a company’s financial status and how it compares to others in the same sector.
3. Calculating Operating Ratio
Once you’ve determined your operating expenses, you can calculate your operating expense ratio. This ratio is a significant indicator of your business’s efficiency. Generally, a low operating expense ratio suggests a more efficient company, while a high ratio often indicates less efficient business operations. The formula for this ratio is:
Operating Expense Ratio = Operating Expense / Total Revenue
A favourable Operating Expense Ratio (OER) depends largely on the industry your company operates in and its growth strategy. A lower OER is typically seen as better because it shows that your company generates more revenue for each dollar spent on operating expenses.
However, there are instances where a higher OER might be acceptable, especially if a company invests heavily in growth or operational enhancements that could result in increased future revenues and profitability. Evaluating the OER against industry standards, historical trends, and your company’s specific growth plans is crucial to decide if it’s at an appropriate level.
Importance of Operating Expenses
The points below underscore the significance of operating expenses:
- Aids in pinpointing recurring costs which are not crucial for daily business activities, enabling business owners to implement necessary modifications.
- These expenses are valuable for assessing a company’s efficiency in cost and inventory management. They look beyond just the expenses a company incurs to generate revenue.
- Operating expenses are beneficial for conducting horizontal analysis, which helps provide a more accurate representation of a company’s current performance.
To accurately grasp a company’s current financial status and manage its costs and revenues, management should regularly review their financial statements. This frequent review aids in more effectively identifying and adjusting unnecessary expenses.
Bottom Line
Operating expenses (OPEX) are vital for managing and understanding a company’s financial health and operational efficiency. By accurately identifying and calculating these expenses, businesses can effectively control costs, optimise operations, and improve profitability.
Operating expenses also play a crucial role in strategic planning, enabling companies to make informed decisions that foster long-term growth and competitiveness. Regular analysis and management of these expenses are essential for maintaining a healthy financial outlook and achieving business objectives.
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FAQs
What are examples of operating expenses?
Operating expenses include rent, utilities, payroll, insurance, and marketing costs. These are costs necessary for daily business operations but not directly linked to production.
What do you mean by operating expenses?
Operating expenses are the costs a business incurs through its normal business operations. They ensure the company’s smooth day-to-day functionality and include costs like rent, utilities, and salaries.
Is wages an operating expense?
Yes, wages are considered an operating expense when they are not directly associated with the production of goods or services. This includes administrative and sales personnel salaries.
What are operating expenses classified as?
Operating expenses are classified as the costs necessary for the daily maintenance and administration of a business. They do not include costs associated with the production of goods or capital expenditures.
