Operating expenses: Overview, types, and how to calculate
The term "operating expenses" can be used to encompass all costs associated with running a non-manufacturing business.
However, manufacturing businesses separate the cost of goods sold (COGS) from other expenses to calculate a straightforward gross margin by separating revenue from COGS. The majority of other costs are then categorized as operating costs.
A company's overhead costs to carry out its day-to-day operations are known as operating expenses. Business owners should be aware of their operating costs and how they affect the bottom line because they significantly affect a company's profitability.
What are operating expenses?
A company's daily operating costs are often referred to as its operating expenses. Any overhead costs that support, but do not directly relate to, the production of your service or product are included in your operating expenses.
These expenses are framed on the organization's pay explanation. Operating income and net income are typically reported using the income statement. These are costs a business causes to continue to run, like wages and supplies.
They do exclude the expense of merchandise sold (materials, direct work, fabricating above) or capital consumption (higher costs like structures or machines).
Related read: Types, examples, tax deductibility and management of business expenses
What are the different types of operating expenses?
Operating expenses can be compared to the vital gears that keep the business machinery running smoothly. They encompass a variety of expenditure categories that are crucial for day-to-day operations and growth.
Let’s dissect what are operating expenses and the different categories to explore their nuances:
1. Selling and marketing expenses
Selling and marketing expenses are paramount for businesses seeking to expand their reach and customer base. These operating expenses include examples like costs related to advertising and promotional activities, sales commissions, and public relations efforts.
Advertising and promotional costs encompass expenses incurred to promote the products or services, be it through digital campaigns, print media, or other promotional events. Sales commissions and incentives motivate sales teams while fostering customer engagement. Public relations expenses are directed toward building and maintaining a positive brand image.
2. General and administrative expenses (G&A)
General and administrative expenses are the backbone of operational infrastructure. These costs encompass salaries and wages of administrative staff, rent and utilities for office space, expenditures on office supplies, and legal and professional fees.
Salaries and wages ensure the smooth functioning of administrative roles, while rent and utilities provide the necessary workspace. Office supplies are essential for day-to-day operations, and legal and professional fees cover services such as legal counsel and financial consultancy.
3. Research and development expenses (R&D)
Research and development expenses are a hallmark of innovation-driven businesses. These costs include employee salaries engaged in research and development, prototyping expenses, and investments in lab equipment.
Employee salaries account for the brainpower driving innovation, prototyping costs aid in refining product concepts, and lab equipment expenses ensure the necessary tools for experimentation and development.
4. Depreciation and amortization
Depreciation and amortization expenses reflect the allocation of costs associated with tangible and intangible assets over their useful lifespans.
Depreciation pertains to tangible assets like buildings and equipment, while amortization deals with intangible assets like patents and trademarks.
Calculating depreciation and amortization involves understanding the asset's value, expected lifespan, and applicable accounting methods.
5. Cost of goods sold (COGS)
The cost of goods sold is directly linked to a company's production process. It encapsulates the expenses tied to producing goods or services, including raw materials, labor, and manufacturing overhead.
Calculating COGS is vital for determining a business's gross profit, which is the revenue left after accounting for production costs.
6. Interest expenses
Interest expenses stem from any borrowed capital or loans used to finance business operations. These expenses encompass the interest paid on loans and credit lines.
Calculating interest expenses involves understanding the interest rate and the outstanding loan amount.
7. Other operating expenses
Other operating expenses encompass a broad category of costs that don't fit neatly into the aforementioned classifications. These can include expenses related to maintenance and repairs, insurance premiums, and other miscellaneous operational costs.
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How to calculate operating expenses?
1. Keep track of and classify expenses
Make a list of everything your business spent during the specified time frame. Utilize the list above to distinguish operating expenses from different costs.
2. Addition of operating expenses
This will provide you with a clear image of your working expenses. Salaries, costs associated with advertising and promotion, supplies, furniture, supplies, sales commission, property taxes, and insurance will be added to determine the operating expenses.
Also, the cost of goods sold and operating income can be subtracted from total revenue to calculate operating expenses.
Operating expense = Operating income - Revenue - Cost of goods sold
Let us take some examples to understand it in a better way.
● For example, A company is earning a revenue of $500,000 p/a. Its operating income is valued at $1,000,000. The Cost of Goods Sold (COGS) is $300,000.
Operating expense = Operating income - Revenue - Cost of goods sold
So, by putting the above numerical in the formula, we get,
1000000 - 500000 - 300000 = 200,000
Therefore, the operating expense of the company is $200,000.
● Let us take another example to find the operating expenses by adding all the fiscal year expenses. Suppose the sales commission of another company is $1.20M. The advertising expense is $2.00M. Salaries amount to $1.00M, and depreciation is $0.75M. They pay a rent of $0.50M, and the utility is $0.30M.
In this case,
Operating expenses = Sales Commission + Advertising expense + Salaries + Depreciation + Rent + Utilities.
So, $1.20 + $2.00 + $1.00 + $0.75 + $0.50 + $0.30 = $7.5
Therefore, $7.5 million is the operating expense.
What are the importance of operating expenses?
Operating expenses serve as a vital lens through which businesses evaluate their financial health and strategic direction.
Now that you’ve seen a list of all operating expenses above, let’s explore the ways in which these expenses hold significance:
1. Financial performance evaluation
Operating expenses are a cornerstone of financial analysis. They provide a comprehensive view of a company's profitability, helping assess its ability to generate sustainable earnings.
The amount of operating expenses a company has incurred over a particular period can help the management gauge various aspects of the organization’s financial health.
2. Budgeting and financial planning
Effective budgeting hinges on understanding operating expenses. By forecasting these costs, businesses can allocate resources judiciously and align their financial plans with operational realities.
Accurate forecasting can happen only when there is a proper record of all the current and previous operating expenses. This record will help the company gauge its future requirements and accordingly allocate budgets in the necessary manner.
3. Increases investor and stakeholder confidence
Keeping major stakeholders like investors aware of how the company funds are being utilized is extremely important to help them understand the current action plan and how the business is operating.
Transparent reporting of operating expenses fosters trust among investors and stakeholders. It demonstrates a commitment to financial transparency and responsible management.
4. Cost control and efficiency
Analyzing operating expenses is instrumental in identifying areas of cost inefficiency. This enables businesses to implement strategies for cost reduction and enhance overall efficiency.
Once the management has the necessary data to see how the operational expenses are affecting the business, they can then take the necessary measures to make systems or processes more efficient.
5. Performance benchmarking
Comparing operating expenses across similar businesses provides valuable insights. It aids in assessing competitive positioning and understanding industry norms.
Comparing can help inform the management’s decisions of whether the company should be spending more or less on certain activities that may boost business performance.
6. Operational decision-making
The operating expenses list contains various types of expenses. Decisions regarding product pricing, resource allocation, and expansion strategies are influenced by a clear understanding of operating expenses.
Only when there is a clear picture of all the operating expenses can insights be derived and used to make informed choices.
7. Long-term sustainability
Effective management of operating expenses contributes to a company's long-term sustainability. It is not only important for a business to earn more but also to be sure that they are not spending more than what is needed.
By controlling costs, businesses can weather economic fluctuations more effectively.
8. Debt management
Operating expenses include interest payments on debt. Monitoring these expenses ensures businesses maintain a healthy debt-to-income ratio and manageable financial obligations.
Your company’s debt-to-income ratio (DTI) compares how much you owe each month to how much you earn. It is also denoted by the percentage of your gross monthly income (before taxes) that goes towards payments or other debt.
9. Regulatory compliance
Adhering to financial reporting regulations requires accurate disclosure of operating expenses. Many businesses tend to use modern software solutions to track, monitor, and control these expenses so that they have an accurate record.
Compliance safeguards a business's reputation and prevents legal complications. It also helps make the audit process much faster.
10. Strategic planning
Operating expenses play a pivotal role in shaping strategic initiatives. Businesses can align investments, expansions, and innovation efforts with their financial capabilities.
Only when the ground-level data such as operating expenses are crystal clear can the management take further steps to implement broader strategic plans into action.
11. Resource allocation
Understanding the breakdown of operating expenses aids in optimizing resource allocation. This includes allocating funds for key functions such as marketing, R&D, and administrative needs. The company can allocate resources effectively only when there is a clear understanding of the expense needs of different teams and employees.
It is also important to know the operating expenses formula and how to calculate operating expenses:
Operating expense = Salaries + Promotional and advertising cost + Supplies + Furniture + Sales commission + Property taxes + Insurance
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Operating expenses vs. non-operating expenses
In financial analysis, the distinction between operating and non-operating expenses holds immense significance. Each category plays a unique role in shaping a company's financial landscape.
Let's delve into the differentiating factors that set them apart:
1. Relevance
● Operating expenses
Relevant to a company's core business operations, operating expenses directly contribute to producing goods and services. They are essential for maintaining day-to-day functionality.
● Non-operating expenses
Non-operating expenses are extraneous to core operations. They include costs that arise from activities not central to a company's primary business functions, such as interest payments on investments or losses from the sale of assets.
2. Impact on profitability
● Operating expenses
Operating expenses have a direct impact on a company's profitability. Efficient management of these costs can bolster or diminish the bottom line.
● Non-operating expenses
Non-operating expenses, while influential, do not directly affect a company's core profitability. They might impact net income but aren't tied to the primary revenue-generating activities.
3. Stability
● Operating expenses
Operating expenses tend to be more stable over time, as they're rooted in day-to-day business activities. They provide a consistent picture of ongoing operational costs.
● Non-operating expenses
Non-operating expenses can be more volatile, as they're linked to external factors like investment outcomes or asset sales.
4. Management focus
● Operating expenses
Businesses closely monitor operating expenses as they directly impact day-to-day operations. Cost control and efficiency are key considerations.
● Non-operating expenses
Non-operating expenses often receive less management attention, as they
5. Financial ratios
● Operating expenses
Operating expenses are integral to various financial ratios like the operating margin and gross profit margin. These ratios gauge a company's operational efficiency and ability to manage costs.
● Non-operating expenses
Non-operating expenses can affect ratios like the interest coverage ratio, which assesses a company's ability to cover interest payments from its earnings.
6. Investor perception
● Operating expenses
Investors view well-managed operating expenses as a sign of operational efficiency and effective cost management, boosting investor confidence.
● Non-operating expenses
Non-operating expenses might be perceived as less relevant to a company's core health and performance, but their impact on net income can still influence investor sentiment.
How to reduce operating expenses?
In the dynamic landscape of business, reducing and knowing how to control operating expenses without compromising quality is a skill every organization aims to master.
Here are actionable tips to achieve that:
1. Conduct a cost analysis
Begin with a comprehensive review of all expenses. Make sure to look at all the operating expenses across the organization and within each department.
Identify areas where costs can be trimmed or eliminated while maintaining operational efficacy.
2. Prioritize expenses
Once the cost analysis is complete, you will have to prioritize them according to your company’s current situation and gauge what is needed and not needed at the moment.
Categorize expenses as critical and non-critical. Focus on maintaining essential functions while seeking opportunities to reduce non-essential costs.
3. Negotiate supplier contracts
Engage in fruitful negotiations with suppliers to secure more favorable terms, discounts, or bulk pricing for materials and services.
Negotiating to get early payment discounts is a great way to reduce costs over the years and at the same time build stronger business relationships.
4. Energy efficiency
Invest in energy-efficient technologies and practices to minimize utility bills and promote sustainable operations. You might not see a significant impact immediately, but changing to sustainable and energy-efficient tech will save costs slowly and add up over time.
5. Negotiate supplier contracts
Engage in fruitful negotiations with suppliers to secure more favorable terms, discounts, or bulk pricing for materials and services.
Negotiating to get early payment discounts is a great way to reduce costs over the years and at the same time build stronger business relationships.
6. Energy efficiency
Invest in energy-efficient technologies and practices to minimize utility bills and promote sustainable operations. You might not see a significant impact immediately, but changing to sustainable and energy-efficient tech will save costs slowly and add up over time.
7. Telecommuting and remote work
Offer remote work options where feasible. This reduces office space needs and associated costs while promoting employee satisfaction.
Nowadays not all jobs need employees to travel to an office as they can be done remotely through a laptop. A hybrid work environment can also bring balance for employees and employers.
8. Technology optimization
Leverage technology to streamline processes, reduce manual efforts, and enhance overall efficiency. There are many repetitive tasks that are still done manually across different teams in an organization. These can easily be automated using technology so that humans have more time to do impactful and strategic tasks.
9. Outsourcing and automation
Consider outsourcing non-core tasks and automating routine processes to cut labor costs and enhance productivity.
Certain processes within an organization may not need to be eternal and can be outsourced to help the organization reduce costs.
10. Expense tracking and monitoring
Implement robust expense tracking systems to identify areas of overspending and promptly address them. This can be done in an effective manner using modern cash management systems that helps you track, monitor, and control different types of expenses across the organization.
11. Flexible work arrangements
There might be instances where the company has to pay for an employee’s commute to and from the office. This can be curbed by implementing flexible work schedules such as a hybrid schedule to accommodate employees' needs while potentially reducing operational costs.
12. Inventory management
Maintain optimal inventory levels to avoid overstocking or stockouts, minimizing storage costs and potential losses.
You should implement methods to estimate how much inventory you will need in a particular period and stock up accordingly with minimal buffer inventory to reduce storage costs.
13. Implement expense approval process
Establish a stringent approval process for expenses to ensure every expenditure aligns with organizational goals. This is an essential step that can drastically save costs by eliminating any payment that was not supposed to be made.
14. Optimize rent and office space
Reevaluate office space needs. Downsizing or relocating to a more cost-effective location can yield substantial savings. For businesses that are majorly digital in their offering, shifting to a coworking space can also be a better option overall.
15. Use lean management
Apply lean principles to identify and eliminate wasteful processes, enhancing efficiency and reducing unnecessary expenditures. Lean management applies to work processes as well as to the staff that you employ.
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Strategies for managing operating expenses
Adeptly managing operating expenses is a cornerstone of fiscal responsibility and sustainable growth. Employ these strategies to navigate the complexities of expense management:
1. Budgeting and forecasting
Create detailed budgets and forecasts that align with your business goals. Regularly monitor and adjust these projections to ensure optimal financial allocation.
Doing this is the first measure that you can put in place to ensure that operating expenses do not go beyond the planned budgets.
2. Cost control and reduction techniques
Embrace a proactive approach to cost control. Implement strategies like zero-based budgeting, which requires justifying expenses from scratch, and ensuring prudent resource allocation.
You can also implement a corporate card payment system where employees can only spend from the budget that has been allotted to their cards so that there is no overspending.
3. Negotiating with suppliers and vendors
Forging strong relationships with suppliers and vendors. Negotiate favorable terms, bulk discounts, and extended payment schedules to maximize cost savings.
One way that many businesses can reduce the cost of payments to be made to suppliers is by getting early payment discounts from them.
4. Implementing energy-saving measures
Opt for energy-efficient practices and technologies to reduce utility expenses. Simple steps like LED lighting and smart thermostats can yield substantial savings.
Choosing to go for a coworking space can also help you reduce your utility bills by a lot.
5. Outsourcing and automation
Consider outsourcing non-core functions to specialized providers, reducing in-house labor and operational costs. Automate routine tasks to enhance efficiency.
Some aspects like advertising can be outsourced as there are better creative teams available at specialized agencies.
6. Analyzing and adjusting pricing
Regularly review your pricing strategies to ensure they cover costs while remaining competitive. Be prepared to adjust pricing if expenses fluctuate significantly.
Sometimes increasing the pricing for your products or services slightly without losing customers can help cover expenses.
What are the key performance indicators for operation expenses?
Financial key performance indicators, or KPIs, are specific metrics that aid managers and financial experts in analyzing the company and determining how far the company has come toward achieving strategic objectives.
Different businesses use a wide range of financial KPIs to track their success and propel growth. Each business needs to identify the KPIs that have the greatest significance for its operations.
Best practices for running a successful business include measuring and constantly monitoring KPIs.
1. Expense-to-revenue ratio
The efficiency proportion demonstrates the expenses as a level of revenue (costs/income), with a couple of varieties — it is basically how much a partnership or individual spends to earn anything; elements should endeavor to limit productivity proportions.
2. Gross margin
It's determined by dividing gross profit by net sales and is normally communicated as a rate. Net sales less cost of goods sold (COGS), which is the direct cost of producing the goods sold, is gross profit.
It is simpler to compare profitability with that of other businesses and to examine trends in profitability over time when profit is calculated as a percentage of revenue.
3. Return on sales
The company's operating profit per dollar of sales revenue is measured using this metric. It is calculated by dividing net sales revenue by operating income, also known as earnings before interest and taxes (EBIT).
The rate at which a company converts revenue into profit is commonly measured using ROS.
4. Current ratio
This demonstrates a business's short-term liquidity. It's the proportion of the organization's ongoing resources for its ongoing liabilities. Cash, accounts receivable, and inventory are examples of current assets that can be converted into cash within a year.
All obligations that are due within a year, including accounts payable, are considered current liabilities. In most cases, a current ratio that is lower than one could indicate that the business does not have enough convertible assets to cover its short-term obligations.
5. Working capital
It compares the company's current assets to its current liabilities. In any case, it communicates the outcome in dollars rather than as a proportion. The company may have trouble meeting its financial obligations if it has low working capital.
On the other hand, a very high amount might indicate that it is not making the most of its resources.
How does expense management software help in managing operating expenses?
Expense management software is beneficial to businesses that deal with a bulk of paper receipts. When your company deals with a lot of people who need to be paid a lot of money, it's even more important to be able to keep track of expenses.
An expense management software will permit you to:
1. Improve the utility of time and funds
The greatest advantage of using software for expense management is the time it saves. Because time is money, you can save money by completing other tasks at the same time.
This isn't just about getting repaid quicker; it's also about having the option to invest more energy zeroing in on different things in your business.
2. Employee spending reports in real-time
You can track and manage expenses thanks to the software's ability to provide instant reports on employee spending. It also permits you to be repaid for overspending, restrained for exorbitant spending, or compensated for under-spending.
Having an expense policy in place is another way to avoid overspending.
You might also be interested to read: Paperless expense reporting to streamline expense management
3. Compliance
Software for expense management is essential for ensuring that directives from the IRS and other tax agencies are followed.
The software helps businesses determine which expenses they are eligible to deduct and makes documentation that is simple to access in the event of an audit.
4. Dashboards
Dashboards present unified expense data to managers in a visual format that facilitates comprehension and analysis. Constant data gives knowledge into the present status of business tasks.
Additionally, having expense data in a single location can assist finance teams in developing budgets for future expenses.
5. Custom reports
The specifics of who is spending, how much, and in which categories are examined in depth in custom reports. Trends like the time it takes to approve an expense report, the status of reports, and where they are in the approval cycle are also brought to light.
This helps finance teams find areas where they can save money, improve efficiency, and strengthen the bottom line by controlling spending.
Choose Volopay's all-in-one expense management platform for your business
Now that you know that an expense management platform is essential to run your business in optimal conditions, why would you go for a faulty system? Choose the best. Get Volopay!
Why? Because Volopay is the best expense management platform out there.
Not only does it automate all expense calculations, but it also tracks every transaction in real-time, provides state-of-the-art corporate cards, both virtual and physical, to make spending easier, generates customized reports and analytics, offers direct accounting integration, has a simple dashboard that is easy to navigate around, ensure company policy compliance and a lot more.
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FAQ's
Operating Expense = Operating income - Revenue - Cost of Goods sold
Operating expenses fund rent, payroll, inventory costs, insurance, etc.
Volopay helps streamline all your expense activity, tracks every money movement in real-time, provides corporate cards with spend controls like expense limits and category allocation, auto-categorizes expenses, and maintains an accurate database that is easily accessible.
Operating expenses can be both fixed and variable. Fixed operation costs include office rent and company insurance. Variable operating costs are labor rates, packaging costs, delivery charges, etc.
OpEx stands for Operational Expenditure
Any increase in the price of operating cost categories like rent, delivery charges, labor costs, and raw material charges will definitely affect the company's profit.
Volopay is the best software to manage operating expenses as it is an all-in-one spend management platform that offers management tools along with corporate cards for better spending management and ease of making expenses.