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Operating Expenses

Operating expense or OPEX are deemed essential for analysing a firm’s operational performance. Consequently, it proves useful for both management and financial analysts and helps them to gain a fair understanding of the firm’s cost and sales efficiency.

What are Operating Expenses?

Operating expenses meaning can be defined as the costs incurred while performing a company’s vital commercial or operational activities. Notably, such activities tend to differ from one industry to another. To elaborate, a business activity that is classified as functional activity in a sector may be categorised as a financial or investment activity in other industries.

Ideally, operating expenses include – inventory cost, rent, marketing, insurance, payroll, and research and development funds, among others. These expenses are mandatory for ensuring the continuance and profitability of a firm’s operations.

One can quickly identify the operating expenses of a firm by scrutinising a firm’s ledger for those costs which impact the production or service cost directly.

Types of Operating Expenses

Some of the most common operating expenses examples include –

  • Payroll for salaried personal
  • License fees
  • Rent
  • Insurance
  • Research
  • Marketing
  • Utilities
  • Legal fees
  • Sales commissions
  • Accounting fees
  • Advertising cost
  • Direct mailing cost
  • Maintenance and repair cost
  • Office supplies
  • Property tax

It must be noted that operating expenses do not include instances like the cost of goods sold, which are reported separately in an income statement. The primary reason is that the COGS relates directly to a firm’s core production as opposed to its daily operations.

However, some companies tend to include the cost of goods sold or COGS as operating expense. Typically, a company may factor in the cost of repair of facilities, direct material, and taxes on production units as operating expense. Companies usually follow this practice with the hope of expanding their operating budget to secure higher funding in the next year.

Also, other instances like amortisation, depreciation, lawsuit settlement, restructuring expenses, etc. are not included in operating expenses and are categorised as non-operating expenses.

Calculation of Operating Expense

The best way to compute the OPEX of a firm is by identifying recurring costs other than the cost of direct labour or raw material required for the production process. Subsequently, by adding the said expenses, one can easily ascertain the operating expenses of a firm in a given accounting period.

Additionally, individuals who are aware of their firm’s operating expenses will be able to calculate the firm’s operating expense ratio. Such a ratio comes in handy and helps to compare business contemporaries in a particular industry. Notably, all such expenses are summarised and reported on the firm’s income statement.

The operating expense ratio is expressed as –

OER = (COGS + OPEX) / Revenues

Example: Refer to this excerpt below and compute the operating expense ratio with the help of the given information.

Particulars Amount (Rs.)
Total revenue 35,23,80,000
Cost of revenue 16,73,00,000
Gross profit 18,50,80,000
Operating expense
Selling, general and administrative expenses 5,70,00,000
Total operating expenses 11,52,90,000
Operating income or loss 6,97,90,000
Interest expense 2,60,000
Income before tax 7,30,40,000
Income tax expenses 2,07,90,000
Income from operations 5,22,50,000
Net income 5,21,40,000

With the given information, the operating expense ratio will be –

OER = (COGS + OPEX) / Revenues

= (16,73,00,000+11,52,90,000 ) / 35,23,80,000

= 282590000/352380000

= 0.8

It must be noted that at any given time, a high operating expense ratio indicates a decline in the firm’s operating efficiency.

Importance of Operating Expenses

The following pointers highlight the importance of operating expenses.

  • Helps to identify recurring expenses which are not essential for the business operations and allows business owners to make necessary adjustments.
  • Such expenses come in handy to measure a firm’s cost and stock management efficiency. It does not just focus on the cost that a company must incur to generate revenue.
  • Operating expenses prove effective for horizontal analysis and tend to reflect a firm’s current performance more accurately.

To avail the current financial picture of a company and account for its costs and revenue more accurately, the management must review their financial reports frequently. In doing so, identifying and tweaking unwarranted expenses more effectively will become much easier.

Operating Expense versus Non-Operating Expenses

As discussed, operating expenses account for all the costs incurred by a firm and are directly related to its core operations. Alternatively, non-operating costs include those expenses which are incurred through activities that are not necessarily associated with the firm’s core operations.

The most common types of OPEX include – payments, compensation, sales, marketing, etc. Whereas, expenses like depreciation, amortisation, the interest charged, and the cost of borrowing, among others, make up non-operating expenses.

Operating expenses are mostly recurring in nature and are considered to be vital for ensuring the smooth operation of everyday activity. Conversely, non-operating expenses often tend to include uncommon costs or one-time expenses. For instance, cost incurred for a reorganisation of business, payment of lawsuit, etc.

Both operating and non-operating expenses are reported on the company’s income statement. It is considered to be a wise decision to report operating and non-operating expenses separately. A quick look at the separate non-operating and operating expenses list will prove useful for both management and investors and help them to assess a firm’s performance more effectively.

For example, it helps the management to identify unwarranted non-operating expenses, say, high-interest payments on debt, and allows them to take necessary steps to reduce it. Similarly, a company with a high operating and non-operating expense track record will enable investors to understand the profitability and operational pattern of a company in a much better way.

It must be noted that a firm with relatively high operating expenses indicates poor stock management. Consequently, business owners must try to lower their everyday operational costs and adopt cost-cutting techniques to improve efficiency successfully.

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