Operating Expenses

Operating expenses (abbreviated as OPEX) are costs incurred during normal business operations. It's an income statement item and includes rent, utilities, salaries, advertising, insurance costs, legal fees, and insurance costs.

What are Operating Expenses?

Operating expenses (OPEX) are costs incurred during the normal course of business operations. It’s an expenditure listed on the income statement and includes items such as inventory, payroll, advertising, rent, utilities, travel expenses, and more.
These expenses are also called operating expenditures or overhead costs. OPEX is a fixed cost as opposed to cost of goods sold, which are variable costs and directly linked to revenue levels. Both are reported on the income statement.

Note that operating costs are related, but not the same thing. Operating costs are the sum of two components: cost of goods sold and operating expenses.

By contrast, capital expenses (CAPEX) are large purchases for assets that they will use for more than a year. These expenses are capitalized and recorded on the balance sheet, instead of being expensed on the income statement.

Companies will want to carefully manage their operating expenses as every $1 saved from operating expenses directly translates to an additional $1 of profit. Business owners, executives, and investors will keep a keen eye on whether operating expenses increase or decrease over time relative to revenue.

Operating Expenses Definition

Operating expenses (OPEX) are costs incurred during the normal course of business operations. It’s an expenditure listed on the income statement and includes items such as inventory, payroll, advertising, rent, utilities, travel expenses, and more.

OPEX are referred to as fixed costs or overhead because they are not tied to making revenue. For example, you can pay $100,000 for an advertising campaign or $15,000/month for rent and these expenses do you not guarantee an increase in revenue.

Operating expenses are the overhead required to run the day-to-day operations of a business. Examples include inventory, payroll, wages, advertising, rent, utilities, insurance, and legal fees.

On the other hand, cost of goods sold (COGS) rises and falls proportionally with revenue. If a clothing company makes more revenue by selling more merchandise, their COGS will rise as well.

Here are a list of operating expenses: rent, advertising and marketing costs, salaries and other wages, inventory, utility costs, repair and maintenance costs, office supplies, travel costs, depreciation, and amortization.

Here are two examples of calculating operating expenses.

Company A, Fiscal Year 2021

  • Revenue: $1,200,000
  • COGS: $350,000
  • Gross Profit: $850,000
  • Operating Profit: $175,000

Company B, Fiscal Year 2021

  • Revenue: $2,400,000
  • COGS: $800,000
  • Gross Profit: $1,600,000
  • Operating Profit: $925,000

In this example, we know that gross profit is $850,000 and that operating profit is $175,000. The difference between these numbers is OPEX, so we can solve for it.

Operating Profit = Gross Profit - Operating Expenses

$175,000 = $850,000 - x

-$675,000 = -x

$675,000 = x

Company A had $675,000 of operating expenses. Let’s follow the same steps for Company B.

Operating Profit = Gross Profit - Operating Expenses

$925,000 = $1,600,000 - x

-$675,000 = -x

$675,000 = x

Both Company A and Company B have $675,000 of operating expenses, but they have very different revenue and profit levels. Which company would you prefer to own? Why?

If you answered that Company B was more efficient and more profitable with the same overhead, you were correct.

Capital Expenses vs. Operating Expenses

Capital expenses, also called capital expenditures, are payments that are capitalized and placed on the balance sheet instead of expensed on the income statement. The term is often abbreviated as CAPEX.

For a large purchase, like a building, factory, vehicle, or equipment, it does not make sense to expense that item on the income statement. First, the expense is very large and will seem like the company is not profitable in the current accounting period. Second, the asset has a useful life that extends far beyond the current period.

Instead, these large purchases are capitalized – a process of making them a fixed asset. They are recorded on the balance sheet and slowly depreciated over time.

Cost of Goods Sold vs. Operating Expenses

Cost of goods sold, also called cost of sales or cost of revenue, are variable expenses that are directly attributable to the production of goods or generation of revenue. Examples of cost of goods sold (COGS) include direct labor and direct material costs.

Operating expenses are fixed expenses that relate to the day-to-day operations of the business. For instance, the cost to rent an office for a software company is fixed regardless of how productive you are with that space.

Both cost of goods sold and operating expenses are expenditures that show up on a company’s income statement. Here is an example income statement:

Total Revenue

less Cost of Goods Sold
equals Gross Profit
less Operating Expenses
equals Operating Profit

To increase the bottom line, executives can look to lower COGS, OPEX, or both. A strong exec team will keep careful track of both expense categories as the business looks to scale.

In particular, managers will keep a close eye on their gross margin, contribution margin, and profit margin.

Operating Expenses vs. Non-Operating Expenses

Up to this point, we have been talking about operating income and operating expenses. These are revenues and expenditures that are incurred during the normal course of business.

Imagine a local print shop that sells paper, pamphlets, and brochures to small businesses. Throughout the course of the year, they might have a few customers that pay with a foreign currency and, as a result, the print shop might have a small gain or loss due to currency exchange.

Since this company does not make its business by trading currencies or offering financial services, the currency exchange gain or loss would be a non-operating activity.

Operating expenses are fixed expenditures that relate to the day-to-day operations of the business.

Non-operating expenses are expenditures that are unrelated to the core business. Similarly, non-operating income refers to revenue that is unrelated to the core business.

These items will vary from company to company. For example, what falls under “core business” for a consulting firm, bank, and manufacturing company are all very different.

Here are examples of non-operating expenses:

  • Loss from asset sale
  • Loss from foreign exchange transaction
  • Interest expense
  • Lawsuit settlement expense

Here are examples of non-operating income:

  • Gain from asset sale
  • Gain from foreign exchange transaction
  • Interest income
  • Dividend income

Operating Expense Ratio

The operating expense ratio is the proportion of OPEX to revenue. The formula is:

Operating Expense Ratio = Operating Expenses / Total Revenue

Operating magrin is operating expenses divided by total revenue. It's one of the key profitability ratios.

This ratio is also called operating margin. Here is an example of the operating expense ratio calculation:

Company C, Fiscal Year 2021

  • Revenue: $500,000
  • COGS: $220,000
  • Gross Profit: $280,000
  • OPEX: $260,000
  • Net Income: $20,000

We can use the formula that we learned above.

Operating Margin = Operating Expenses / Revenue

Operating Margin = $260,000 / $500,000

Operating Margin = 52.0%

As a bonus, let’s also calculate the gross margin to get a better sense of how the money is being spent.

Gross Margin = COGS / Revenue

Gross Margin = $220,000 / $500,000

Gross Margin = 44.0%

In 2021, Company C spent 44 cents of every dollar on COGS and 52 cents of every dollar on OPEX. The company was slightly profitable and could increase profit next year by managing its spending.

Final Thoughts

Operating expenses (also called operating expenditures, overhead, or OPEX) are reported on a company’s income statement below total revenue, cost of goods sold, and gross profit.

Here are the key takeaways for OPEX:

  • An important expense category that contains all normal fixed expenses.
  • Examples include rent, marketing, payroll, insurance, office supplies, and more.
  • COGS refers to variable expenses directly tied to generating revenue, OPEX refers to fixed expenses associated with running the business as a whole.
  • OPEX divided by revenue is operating margin, an important financial metric to track.
  • Expenses that are not related to the core business are deemed non-operating expenses.

Executives, managers, and investors will look to operating expenses and operating profit as they show if the business is sustainable. Businesses with high OPEX could be left with large losses if their revenue declines slightly.

These companies have large overhead and need to be managed carefully.

In addition, startups and other high growth companies need to carefully manage OPEX. Hiring more employees and increasing advertising budgets are quick ways to attract new business, but managers need to make sure that these activities are profitable.

Lastly, companies will often invest in OPEX and CAPEX in order to reach economies of scale, which results in lower prices. Companies need to balance these desires to grow with their cash outflows.

For example, it’s difficult for a manufacturing company to double revenue without increasing their employee count, upgrading their factory, purchasing more raw materials, and increasing their sales activities.

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