Are you an experienced business owner? Or are you just beginning your journey as an entrepreneur? Then, do you know that there are different costs involved in owning and conducting a business?
If you look into your business's income statement, you might notice a section dedicated to running expenses. The section appears to be separated from other cash inflow statement items too. Have you ever questioned what it implies? Have you ever wondered why operational expenses or operational costs are shown separately in that statement?
If you are still confused about your operating expenses, here are a few examples to guide you. Staff salaries and office supplies fall under the category of operating expenses incurred by a firm to ensure that it functions properly. However, materials and supplies, direct labor, and factory overhead account for the costs of products sold and they do not come into the classification of operating expenses. The capital expenditures associated with building rents and infrastructure maintenance are also not counted as operating expenses.
Are you looking for a guide to help you understand operating expenses better? Then you have reached the right place! This article will help you learn all the basic to advance concepts regarding operating expenses. Learning these concepts would also help you in managing your business in a way smoother way.
This article will carry on its discussion regarding the following topics:
- What are Operating Expenses?
- What are the Operational Activities that Contribute to Charging Operating Expenses of a business?
- Operating Expenses Examples
- A Brief Discussion About Operating Expenses and Capital Expenses
- With Regards to Operating Expenses, What are Non-Operating Expenses?
- What Does it Mean when Operating Expenses Rise?
- How to Work Out Your Operating Expenses?
- How to Figure Out Operating Expenses
- How to Evaluate Operating Expenses on the Income Statement of a Business Entity?
- Key Takeaways
What are Operating Expenses?
Operating expenses refer to all costs payable during normal business operations. Understanding the concept of operating expenses is very simple because this example lies in our daily life business operations. The income statement of a company always recognizes the operating expenses as the business expenses that occurred in a certain period.
Operating expenses are also recognized in different terms including Selling, General, and Administrative (SG&A) expenses. Operating expenses incurred by a corporation do not relate to the manufacturing of product costs. Operating costs have a serious influence on a company's financial performance. In other words, The expenditures incurred by a company for its operational processes are described as operating expenses, operating expenditures, or "opex."
What are the Operational Activities that Contribute to Charging Operating Expenses of a business?
If you want to determine the operating expenses of your business, first you need to recognize the operational activities that your company performs and the resulting operating expenses. These activities generally comprise the principal and profitable activities of your business. The company's commercial operations are principally covered by the operating activities.
A manufacturing company's major operational activity, for instance, is to manufacture a commodity using raw materials. On the other hand, a trading company's main operating exercise is to purchase products from suppliers and market them to end-users.
It's important to remember that operational functions vary widely amongst industries and enterprises. In one industry, a commercial activity may be labeled as operational, whereas in another, it may be characterized as financing or investment. In most businesses, purchasing a building is considered an investment activity. Given that the procured building is meant for reselling, it is, however, an operational activity for real-estate businesses.
Operating Expenses Examples
Operating expenses that reflect on the company's income statement include:
- Payroll for employees (excluding labor for the manufacturing process)
- Fees for insurance
- Fees for insurance
- Rent and leases
- Rent and leases
- Fees for accounting
- Building repairs and upkeep
- Office equipment
- Utilities and services
- Fees for lawyers
- Real estate property taxes
- Expenses for travel
- vehicle or transportation expenses
If your company rents equipment instead of purchasing it, that expense is treated as an operational expense of the company. If your business structure requires you to carry on general repairs and upkeep of the fixed assets owned by the company, these expenses also go under the operating expenses. The fixed assets represent business buildings, equipment, and machinery required for business purposes.
During the process of doing commercial operations, a corporation may have the option of spending an operating or capital expenditure. If it requires more storage capacity for its information, it can either focus on new storage media as a capital expense or rent data center space as an operating expense.
A Brief Discussion About Operating Expenses and Capital Expenses
Running a business requires lots of investments, reinvestments, and spending expenses to streamline the production process. These aspects help to build the foundation of a business. So, there are different types of expenses that are considered mandatory to help the business go uphill. Operating expenses and capital expenses are among the expenses that you need to master if you run a business. Otherwise, your business will collapse due to money mismanagement.
We have mentioned both terms, including operating expenses and capital expenses, a few times. Both are business expenses. However, there is a major factor that distinguishes them.
It is vital to distinguish between operating expenses and capital expenditures when it pertains to the matter of tangible asset-related costs. This is important because these two expenses are considered differently for account calculation and taxation purposes.
So, Let's learn about the differences between operating expenses and capital expenditures now.
We have already learned that Operating expenses on the balance sheet refer to all the running expenses for a firm including Supplies, advertising expenditures, administration payments, payroll, rent, energy expenses, etc.
If your business possesses purchased assets and broadly utilizes them in business operational processes over a long period of time, the expenditure made on the assets is known as capital expenditure. One of the greatest examples of capital expenditures includes machinery purchases. However, the expenditure spent on repairing and upkeeping the machinery would fall under the operating expenses category.
With Regards to Operating Expenses, What are Non-Operating Expenses?
With regards to operating expenses, Non-operating expenses are those incurred by a company that is unrelated to its core operations. The core operations refer to the day-to-day business activities of a financially stable company. Non-operating expenses include the following:
- Interest charges
- Charges for obsolete inventory
- Settlements of lawsuits
- Losses resulting from asset sales
- Expenses for restructuring
It is a useful and functional approach to isolate these items from the business's operational results. This is considered the right method since the non-operating expenses are not included in the company's main activities. Adding to that, these expenses are recognized very rarely on the balance sheet.
What Does it Mean when Operating Expenses Rise?
A business's profitability and revenue turnover decrease when operating expenses rise. Operating expenses are frequently analyzed and scrutinized by companies since they are less stable than non-operating expenses, production costs, and capital costs.
Top leadership personnel holding senior management positions at a corporation may strive to cut operational costs by outsourcing certain functions or enabling work-from-home facilities for some employees. This reduces the amount of physical space taken up in the office by employees. The management and maintenance of the office also reduce costs, leading to lower costs of operating expenses. Management may also take cost-cutting measures such as automating and digitizing parts of the firm or lowering new recruits' wages.
How to Work Out Your Operating Expenses?
You may compute your company's operating expense ratio (OER) by learning and analyzing your operating expenses (OPEX).
The OER takes your firm into account and compares it with other competitors belonging to your industry by directly comparing your expenses to your revenue. The operating expense ratio can be derived from the following formula:
(COGS + OPEX)/Revenues = OER
As an example, suppose Cotton's Craft Cottage's financial statements in 2021 looked like this:
- $200,000 in profits and revenue turnover
- $50,000 in goods sold
- $150,000 in earnings
- $70,000 in operating expenses
- $80,000 in operating profit
- $10,000 in non-operating expenses
- $70,000 in net income
Cotton wants to know how well her company stacks up against the competition, so she measures her company OER as follows using the above-mentioned formula:
($50,000 + $70,000) / $200,000 = 0.60
As a result, Carly spends 60 cents per dollar she makes on day-to-day company expenses. If Cotton wants to evaluate whether such a result is good or bad, she needs to look for the current industry standard to get a clear picture.
Compare your OER to industry standards if you compute it for your company. This would help you understand where your business stands as compared to the competitors' brands. If you struggle to gather information regarding your industry standards, you should know that industry benchmarks are frequently available from trade groups, chambers of commerce, or trade associations. Keep an eye out for an OER that takes time and effort. A growing OER may indicate a reduction in your company's operating performance from year to year. So you will want to examine your operations closely to figure out what the reason behind this is.
How to Figure Out Operating Expenses
The income statement clearly summarises a firm's operating expenses. It actually devotes a separate section to mentioning the operating expenses. Depending on the business type, volume, and setup, each company has distinct running expenses.
Examine your accounting records for costs that do not immediately influence the profitability of producing your product or service to uncover your industry's running expenses.
How to Evaluate Operating Expenses on the Income Statement of a Business Entity?
Some entrepreneurs don't have financial statements or don't segregate expenditures into the cost of products sold, operating expenses, and non-operating expenses on their income statement. You may still get an idea of how much funding it requires to run and own your firm in this situation. Simply review your general balance sheet, ledger, or budget report for any recurring charges that are not directly related to labor and raw material costs.
Then add together all of your expenses to determine your company's running costs. Analyze whether you can minimize operating costs to boost your bottom line after you have done the math and crunched the numbers.
Expenses are an inevitable aspect of running a company. General and administrative expenses, research and development costs, and the cost of goods sold are all examples of operating expenses. If your operating expenses grow higher, then it seems to lower the business profitability of the company. Here are some suggestions that can help you minimize your business's operating expenses.
- To save money on rent and bills, consider renting a less expensive location. Or, you can hire remote workers willing to work from home
- Look for lower insurance premiums by researching around
- When merchants give deals for paying invoices promptly, reap the benefits of it. Cancel unneeded subscriptions and contracts
- Outsource or automate administrative operations including accounting, payroll, and human resources
- As an alternative to traveling for meetings, try video conferencing. Travelling charges huge costs whereas video conferencing requires minimal costs
How can Deskera Help You?
Deskera Books is an online accounting, invoicing, and inventory management software that is designed to make your life easy. A one-stop solution, it caters to all your business needs, from creating invoices and tracking expenses to viewing all your financial documents whenever you need them.
- Running a business successfully requires lots of factors to maintain greatly. Expenses are one of the most crucial factors among them that need constant monitoring to stabilize the company's financial health
- If you are a business owner or if you aspire to be one, you are entitled to learn about operating expenses that account for business financial health. Operating expenses are mentioned in the income statement of a company. If you want to analyze them in detail, you can refer to the income statement
So, if you want to manage the operating expenses smoothly, you need to pay attention to some internal factors including-
- Pointing out the operational activities and determining their costs
- Segregate the expenses into two categories including operating expenses and capital expenditure
- Calculate the OER or operating expenses ratio to figure out your business position as compared to the competitors
- Since higher operating expenses denote lower revenue turnover, it is important to cut out unnecessary operating expenses