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What are Operating Expenses and How are they Calculated?

  • Pragya Soni
  • Mar 05, 2022
What are Operating Expenses and How are they Calculated? title banner

Businesses and companies run on expenses. While running a business independent of its size the company has to meet a variety of expenses. And it is essential for the companies to manage these expenses else it can act as a leak in the progress and development of the business. 

 

Expenses are classified into different categories; major ones are capital expenses and operating expenses. In order to manage expenses, it is essential for the analysts and accountants to know and understand them. 

 

In this blog, we will study about operating expenses, how they are calculated, and why it is different from the capital expenses.

 

(Also Read - Types of Economic Systems)


 

What are Operating Expenses?


 

Operating expenses are often abbreviated as OPEX. They are defined as the expenses done by a business to incur its normal business operations. The basic operating expenses are money spent on rent, equipment, inventory costs, marketing, payroll, insurances and funds utilized for the research and development of the products.

 

In simple words, expenses done on operating activities of a company are known as Operating Expenses. It is an important part of business, as it is used as a measure to analyze a company’s operational performance. 

 

Understanding and identifying the operating expenses of a company will help the analysts to understand the primary cost drivers and management efficiency of the business.

 

Operational Activities

 

You might be wondering the meaning of operating activities. It is essential to identify the operational activities of a company to calculate its operational expenses. Operational activities are also known primary revenue producing activities. 

 

It includes all the activities of the company other than financing or investing activities. In simple words, operating activities cover all the commercial activities of the company. These activities differ from industry to industry. 

 

For consideration, the primary operating activity of a production company is to produce goods from raw materials, and a trading industry will consider purchase and selling of products as its primary operational activity. Thus, a business activity can be an operational activity for one industry and financing or trading activity in another industry. 

 

(Also Read - Fundamental Analysis)

 

Difference between Operating and Non-Operating expenses

 

  1. Operating expenses include all the operational costs of the company. While a non-operating expense is the expense done by business on an activity that is unrelated to the business’s core activities. 

 

  1. Examples of non-operating expenses are loss of assets, or loan interest charges. Sometimes, while analyzing the performance of the business, the accountants ignore the non-operating expenses.

 

  1. The examples of operating expenses include legal fees, license fees, payroll expenses, insurance, and R & D funds. On the other hand, non-operating expenses may include amortization, depreciation, interest expense, obsolete inventory charges, lawsuit settlements, losses from the sale of assets and restructuring expenses.

 

Reduction of Operating Expenses


Operating expenses are an essential part of businesses and most of the time are unavoidable. Reducing operational expenses can compromise the integrity and quality of the operations. But, at the same time, reduction in operational charges is important for a company to gain a competitive advantage in the market and increase its earnings. 

 

The Internal Revenue Service (IRS) permits the businesses to diminish their operating expenses. This is done so that the company can maintain its profits. It is the essential duty of management to find ways to reduce operating expenses, without affecting the core activities of the businesses. 

 

It should also not affect the company’s stability and its ability to compete with its competitors. It can be difficult, but analysts and accountants should find a perfect way to strike a balance between the two requirements.

 

By following measures, the operating expenses can be reduced for the company:

 

  1. Opting virtual meeting modes, instead of physical meetings.

 

  1. Rent a less costly location for the company.

 

  1. Loan at the lower legal rates.

 

  1. Don’t take unnecessary subscriptions from the vendors.

 

  1. Purchase stock amount of raw material to avail more discounts.

 

(Also Read - Production Management)

 

 

Calculation of Operating Expenses

 

The operating expenses can be simply calculated by summing up all the expenses incurred by the company in its day-to-day operational activities. Following expenses are counted while calculating the total operating expenses.

 

  • Accounting fees

 

  • Advertising and marketing

 

  • Insurance

 

  • Legal fees

 

  • License fees

 

  • Office Supplies

 

  • Maintenance and repairs

 

  • Rent

 

  • Salaries and wages

 

 

  • Travel

 

  • Utilities

 

  • Vehicle Expenses

 

 

Formula for calculating operating expenses

 


Formula for Operating Expense Ratio is shown in the figure.

Formula for Operating Expenses


 

Knowing the operating expenses of your organization will help you to identify the operating expense ratio or OER for your organization. The formula is defined as:

 

(COGS + OPEX) / Revenues = OER

 

Where, COGS is the cost of goods sold, OPEX is the sum of total operating expenses, and OER is the operating expense ratio.

 

For example, consider the following income statement of a company.

 

Income statement

Amount

Revenues

$100,000

Cost of goods sold

$50,000

Gross profits

$50,000

Operating expenses

$20,000

Operating income

$30,000

Non-operating expenses

$10,000

Net income

$20,000

 

 

Here, as per this income statement, the OER of the company can be calculated as:

$(50,000+20,000)/100,000= 0.70

 

So, the company is spending the 70 cents of every dollar earned by it in running its day-to-day activity. If it is profitable or not, that depends on the norms of the company.

 

Importance of Operating Expenses

 

Operating expenses don't directly affect the quality of the products. But indirectly plays its role in the business. The operating expenses are important for a business because of the following reasons:

 

  1. Operating expenses help in identifying the operating expense ratio for the business.

 

  1. Reducing operating expenses help in gaining the competitive advantage for the business.

 

  1. Operating expenses help in identifying the recurring expenses which may not be essential for the businesses.

 

  1. Operating expenses prove effective horizontal analysis of the business.

 

  1. Operating expenses reflect the current performance of the businesses.

 

(Also Read - Ratio Analysis)

 

 

Difference between Operating expenses and Capital Expenses

 

People sometimes confuse capital expenses as operating expenses. But there is a difference between the two. Even the accounting principles also define the boundaries between the two terms. But the basic differences between the two terms are listed below:

 

  1. Operating expenses are abbreviated as OPEX and Capital expenses are abbreviated as CAPEX.

 

  1. Operating expenses are defined as money done on operational activities while capital expenses include the costs related to acquiring or upgrading tangible and intangible assets. 

 

  1. Operating expenses include spent like accounting expenses, license fees, maintenance and repairs, advertising, office expenses, and attorney fees and legal fees. 

 

On the other hand, Capital expenses include the cost of estate, factory equipment, IPR expenses, patents, furniture, computers and other physical assets.

 

  1. Even the IRS treats operating expenses and capital expenses as two different terms. According to the IRS , operating expenses must be ordinary and necessary. While capital expenses are money required for the capitalization of the assets.

 

  1. An operating expenses shows the day-to-day incurrence amount of the company. While capital expenses is an investment made to the future.

 

  1. The operating expenses of the company are recorded in the income chart of the company, while capital expenses are maintained in the balance sheet of the company.

 

  1. Companies can deduct their operating expenses, but the same doesn’t apply to the capital expenses.

 

  1. Both OPEX and CAPEX are treated as different for the accounting and tax purposes.

 

(Also Read - Market Capitalization)

 

Despite so many differences, both capital expenses and operating expenses are important aspects of the business. Operating expenses are essential to run the day-to-day functions of the company and capital expenses help in maintaining the plant, property and equipment of the company.

 

If analysts, accountants and business leaders are able to understand the operating expenses by its core. They can follow cost-cutting measures, plan schemes to reduce the operating expenses and increase the efficiency of the market quota for the company.

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