Operating Expenses: Meaning, Formula & Calculation

Operating Expenses, often abbreviated as OPEX, are the ongoing costs that a business incurs in its day-to-day operations to generate revenue and maintain its core activities. These expenses are not directly related to producing goods or delivering services but are necessary for the smooth functioning of the company’s operations.

Examples of OPEX include employee salaries and benefits, rent or lease payments for office space, utilities, insurance premiums, advertising and marketing expenses, office supplies, travel expenses, and depreciation of assets used in the business.

What are Operating Expenses?

Operating Expenses (OpEx) are the ongoing costs that a business incurs as part of its regular operations to generate revenue. These expenses are not directly tied to the production of goods or services but are necessary to maintain day-to-day business activities and support the core operations.

Some common categories of operating expenses are Marketing and Sales Expenses, Rent and Utilities, Office Supplies and Expenses, Research and Development (R&D), Employee Expenses, Travel and Entertainment, Depreciation and Amortization, and Administrative Expenses.

Operating Expenses (OpEx) is a key component of the Income Statement of a company. Monitoring OpEx helps companies identify areas where cost-cutting measures can be implemented. By managing these expenses effectively, businesses can improve their profit margins and overall financial performance.

Operating Expenses Formula

There is no specific formula to find the Operating Expenses. To calculate the total OpEx, you simply add up all these individual expense items that can be classified under OpEx.

However, by subtracting the Cost of Sales and Non-Operating Expenses from Total Expenses, a company can arrive at its Operating Expenses.

Operating Expenses = Total Expenses – Cost of Sales – Non-Operating Expenses

Remember that operating expenses exclude costs directly related to producing goods or delivering services (Cost of Sales or Cost of Goods Sold) and focus on the ongoing expenses associated with running the business.

List of Operating Expenses

The types of expenses included in Operating Expenses depends on several factors, most notably the industry in which the company operates and the distinct characteristics of its business operations. The same type of expense can fall under “Operating Expenses” for one company, while it may be categorized as a part of the “Cost of Sales” for another.

For example, in the case of a Software Development company, web hosting expenses may be categorized as Operating Expenses. These costs are incurred to maintain the company’s website and support online communication, which are essential for its day-to-day operations. In contrast, for a web hosting service provider company, these very same expenses are considered part of the Cost of Sales. This is because, for them, these expenses directly contribute to delivering core services, such as hosting client websites.

Here are some of the most common types of operating expenses:

1. Selling, General, and Administrative (SG&A) Expenses:
   • Sales-related expenses such as sales commissions, sales salaries, and sales office costs.
   • General and administrative expenses including office supplies, insurance, legal fees, and accounting costs.
2. Marketing and Advertising Expenses:
   • Costs associated with promoting products or services through advertising, digital marketing, and promotional campaigns.
3. Research and Development (R&D) Expenses:
   • Costs related to developing new products, improving existing products, and conducting research initiatives.
4. Employee Expenses:
   • Salaries and wages of employees across different departments.
   • Employee benefits such as health insurance, retirement plans, and bonuses.
5. Rent and Lease Costs:
   • Rent for office space, manufacturing facilities, warehouses, and other properties.
   • Lease payments for equipment, vehicles, and machinery.
6. Employee Training and Development:
   • Expenses related to training programs, workshops, and professional development for employees.
7. Technology Expenses:
   • Costs of software licenses, technology services, and IT infrastructure maintenance.
8. Maintenance and Repairs:
   • Costs of maintaining and repairing equipment, machinery, and facilities.
9. Insurance Premiums:
   • Premiums for various insurance coverage, including liability, property, and employee benefits.
10. Travel and Entertainment Expenses:
    • Business travel expenses, accommodation, meals, and entertainment costs.
11. Depreciation and Amortization:
    • Allocating the cost of long-term assets (e.g., equipment, vehicles) over their useful life.

Operating Expenses and Cost of Sales

Operating expenses do not include the Cost of Sales, also known as Cost of Goods Sold (COGS). They represent different types of expenses.

In industries like manufacturing, the demarcation between direct production costs (considered as Cost of Sales) and indirect operational expenses (classified as Operating Expenses) is generally well-defined. This distinction is straightforward since manufacturing involves tangible goods with tangible production expenses.

On the other hand, in service-based industries, the distinction between Cost of Sales and Operating Expenses can sometimes be less evident. This is because services are intangible, and the costs associated with delivering them may overlap with general operational expenses. In such cases, companies may choose to aggregate these expenses under the umbrella of Operating Expenses for the sake of simplicity and clarity in their financial reporting.

The decision to combine Cost of Sales with Operating Expenses doesn’t necessarily imply a lack of financial transparency. Rather, it reflects the practicality of accurately delineating expenses in certain business models.

How to Calculate Operating Expenses

To calculate operating expenses, you need to sum up all the individual expenses that are directly related to the day-to-day operations of a business.

1. Gather Expense Information: Collect detailed information about all the expenses incurred by your business during a specific period. This can include expense records, receipts, invoices, and financial statements.
2. Categorize Expenses: Group the expenses into categories such as employee expenses, marketing, rent, utilities, office supplies, research and development (R&D), and any other relevant categories.
3. Remove Non-Operating Expenses: Identify and remove any non-operating expenses that were incurred during the period. Non-operating expenses include interest payments and taxes.
4. Remove Cost of Sales: Identify and remove any direct expenses directly associated with producing or delivering a company’s goods or services.
5. Sum up Operating Expenses: Add up all the expenses that fall under operating categories. These are the expenses directly related to the core operations of your business.

Examples of Operating Expenses

Various expenses for a fictional company manufacturing electronic products like mobiles, tablets, PCs, and other accessories is given below:

Expense Type	Description	Amount (USD)
Raw Materials	Components and materials for product assembly	$500,000
Manufacturing Labor	Wages for workers involved in production	$200,000
Packaging Material	Materials for packaging products	$30,000
Employee Salaries	Salaries of administrative and sales staff	$140,000
Rent	Office and manufacturing facility rent	$80,000
Utilities	Electricity, water, and other utility costs	$10,000
Marketing and Advertising	Advertising campaigns and promotions	$60,000
Research and Development	R&D initiatives for product innovation	$25,000
Office Supplies	Materials like stationery and office supplies	$5,000
Employee Benefits	Health insurance, retirement plans, etc.	$20,000
Depreciation	Depreciation of manufacturing equipment	$15,000
Interest Expenses	Interest on loans and financing	$18,000
Tax Expenses	Corporate income tax payments	$37,000

Raw Materials, Manufacturing Labor and Packaging Material are direct expenses associated with producing goods. Hence they come under Cost of Sales.

Interest Expense and Tax Expenses are not directly related to core business operations. Hence they are Non-Operating Expenses.

All the remaining items represent the costs incurred to maintain and run the core operations of the business. Hence they are the Operating Expenses for the above company.

Operating Expenses = Employee Salaries + Rent + Utilities + Marketing and Advertising + Research and Development + Office Supplies + Employee Benefits + Depreciation

Operating Expenses = Employee Salaries + Rent + Utilities + Marketing and Advertising + Research and Development + Office Supplies + Employee Benefits + Depreciation
= $140,000 + $80,000 + $10,000 + $60,000 + $25,000 + $5,000 + $20,000 + $15,000
= $355,000

What Does Operating Expenses Tell You About a Company?

Efficiency of Operations: Operating expenses represent the costs incurred to maintain and run the core operations of the business. By analyzing these expenses, you can gauge how efficiently the company is utilizing its resources. Lower operating expenses relative to revenue can indicate operational efficiency.

Cost Management: Operating expenses encompass various categories, including employee salaries, marketing costs, rent, utilities, and more. A company that effectively controls these expenses demonstrates prudent financial management and an ability to maintain profitability even in challenging market conditions.

Profitability: Operating expenses directly impact a company’s profitability. The difference between gross profit and operating expenses gives you the company’s operating income or operating profit.

Operating Expenses Related Metrics and Ratios

Operating Expense Ratio

The Operating Expense Ratio (or Operating Expenses to Sales Ratio), is used to assess a company’s efficiency in managing its operating expenses in relation to its revenue. It is expressed as a percentage and helps evaluate how effectively a company is controlling its day-to-day expenses in proportion to the revenue it generates.

Operating Expense Ratio = (Operating Expenses / Net Revenue) * 100

A low ratio suggests that the company is effectively managing its operating expenses in relation to its revenue. This can be a positive sign, indicating efficient cost control and the potential for higher profitability.

A high ratio indicates that a significant portion of the company’s revenue is going towards operating expenses. This might suggest inefficiencies in cost management, which could impact profitability.

Operating Ratio

The Operating Ratio is used to evaluate a company’s cost-efficiency by comparing the company’s total Operating Costs, which include both the Cost of Sales (COGS or COS) and Operating Expenses (OpEx), to its Net Sales or Revenue.

Operating Ratio = (Operating Expenses + Cost of Sales) / Net Revenue

or

Operating Ratio = (Operating Expenses + Cost of Goods Sold) / Net Sales

A lower Operating Ratio indicates that a smaller portion of a company’s revenue is being used to cover OpEx and COGS. This means the company is efficient in managing its costs.

A higher Operating Ratio suggests that a larger proportion of the revenue is being eaten up by OpEx and COGS. This is a sign of inefficiency in cost management.

Operating Income (Operating Profit)

Operating Income, often referred to as Operating Profit, represents the profitability of a company’s core business operations before accounting for interest expenses and taxes.

Operating Income = Gross Profit – Operating Expenses

As you know, Gross Profit = Net Revenue (Net Sales) – Cost of Sales (COGS or COS).

Operating Income = Net Revenue (Net Sales) – Cost of Sales (COGS or COS) – Operating Expenses

We will discuss more about Operating Income (Operating Profit) in the next article.

Selling, General, and Administrative Expense Ratio (SG&A Ratio)

This ratio assesses the efficiency of a company’s spending on selling, general, and administrative expenses in relation to its total revenue.

SG&A Ratio = (Selling, General, and Administrative Expenses / Net Revenue) * 100

How to Use Operating Expenses in Investment Decisions

The absolute value of operating expenses doesn’t provide meaningful insights on its own. To assess the financial health and efficiency of a company, investors need to consider operating expenses in relation to other financial metrics, such as revenue, profit margins, and industry benchmarks.

Compare the company’s OpEx and margins with industry benchmarks. Companies with lower OpEx relative to their revenue compared to industry peers may be more efficient and competitive.

Operating expenses are just one component of the equation. What investors are ultimately interested in is the company’s profitability and its ability to generate returns for shareholders. A company with higher operating expenses might still be highly profitable if it has strong revenue growth and efficient cost management.

Operating and Non-Operating Expenses

Having covered OpEx, let’s now directly address Non-Operating Expenses.

Non-operating Expenses, as the name suggests, are costs not directly linked to a company’s core business activities. They arise from secondary or peripheral activities.

These expenses often include:

1. Interest Expense: Costs related to interest on loans or debt.
2. Losses on Investments: Any losses incurred from investments in stocks, bonds, or other assets.
3. Lawsuit Settlements: Costs associated with one time legal settlements or fines.
4. Restructuring Costs: Expenses related to significant changes in a company’s operations, like layoffs or facility closures.

Operating Expenses (OpEx) and Capital Expenditures (CapEx)

Capital Expenditures (CapEx) represent significant investments made by a company in assets that have a long-term useful life and provide future benefits. These investments aim to improve or expand the business. CapEx includes expenditures such as purchasing or upgrading equipment, acquiring real estate, and constructing new facilities.

CapEx is recorded on a company’s balance sheet as assets. These assets are depreciated or amortized over their useful life, meaning their cost is spread out over several years, corresponding to their estimated useful lives. The annual depreciation and amortization expense is recorded in the income statement as a component of Operating Expenses (OpEx).

Gallop Insights

• Operating expenses directly affect a company’s profitability. Higher operating expenses can reduce profits, while effective cost management can lead to higher margins.
• The context in which operating expenses are viewed is crucial. For ex, Start-up companies may have high operating expenses due to growth investments, while established companies might focus on cost containment.
• Operating expenses can vary from company to company, and they are typically categorized into several subcategories such as selling expenses, general and administrative expenses, and research and development expenses.