Operating Expenses

What is an Operating Expense?

Operating expense is defined as the expense incurred by a business for its normal operational activities. Also referred to as OpEx, these costs are attributed to the various operational activities of a business.

OpEx is attributed to business activities in a given period that are taken as normal company operations and are found on the company's income statement. These expenses are difficult to pin down, and the most common underscoring denominator as a definition of what OpEx is has been outlined above. 

Because OpEx involves defining what “normal operational activities” are for a company and the costs involved, different companies/industries have different definitions of OpEx.

Some define OpEx as all-encompassing of both Cost Of Goods Sold (COGS) and sales general and administrative (SG&A) expenses. 

COGS are defined as the costs involved in the production of the goods that are sold. COGS might be attached to OpEx due to the matching principle, which states that the cost of goods/services matches revenues from selling the goods.

The matching principle is when the company reports an expense in the income statement in the period its respective related revenue is earned. This results in a liability appearing on the balance sheet at the end of the accounting period.

SG&A is defined as the costs of operating the main business (not involved with producing the goods) during the accounting period. They encompass the operating expenses required to promote, sell, and deliver a company’s product or service and to manage the company.

These costs are expensive as they may expire, be used up, or not have a certain measurable future value.

However, OpEx might also be defined as only encompassing SG&A. Hence, reading the 10K/10Q footnotes is key to identifying what the company defines and whether the record properly measures OpEx.

OpEx vs. Operating costs

As described above, there are differing definitions of what OpEx comprises. If the company describes OpEx as both SG&A and COGS, then OpEx will be the same definition (and account) as Operating costs. 

However, if the company defines OpEx as only encompassing SG&A, then Operating Costs will have to be calculated as 

Operating Expenditure + Cost Of Goods Sold = Operating Costs

If we take OpEx as SG&A, then it makes sense to show how operating costs are a build-up from OpEx and COGS. More specifically, operating costs are a build-up from OpEx and COGS, with OpEx being a part of Operating costs.

SG&A usually encompasses a list of line items, such as:

Meanwhile, COGS would include:

As the two terms might mean different things in different firms’ sheets, proper research and reading into the footnotes are required before making any calculations for the firm.

Since COGS is usually the largest expense record found in the income statement, identifying whether OpEx accounts for COGS as well can be done by seeing if COGS is larger than OpEx, in which case OpEx only considers SG&A.

Is Depreciation an OpEx?

Depreciation can be taken as part of OpEx if the depreciated asset is used in the organization’s main operating activities. 

Certain companies take depreciation as part of OpEx if it is involved with the related asset’s function. For instance, depreciation of a manufacturer's factory or production equipment as part of inventory costs, and therefore, will be counted as depreciation under COGS recording. 

If the company treats COGS as OpEx, then this will also be encompassed in OpEx.

However, other functions, such as the depreciation of corporate headquarters, are recorded as part of SG&A expense, resulting in the depreciation being incorporated into the SG&A expense.

Only if the company treats OpEx as both COGS and SG&A, then depreciation will be fully covered in OpEx. However, if the company takes OpEx as SG&A only, then depreciation will not be fully covered.

At times, companies will also remove depreciation and amortization as a separate line item in the statement of operations and will not include these fees under SG&A or COGS. In those cases (with a separate line for depreciation), it is not considered OpEx.

Operating Expense Vs. Operating Income 

Operating income is a company’s profits after deduction from operating expenses or profit after core business activities. 

Operating Income = Gross profits - OpEx(SG&A) - Depreciation - Amortization

Or

Operating Income = Net Income - Non-Operating Income +Interest + Taxes

Operating income is a key metric that reveals a company's profitability from its core business activities alone; since it does not include non-operating activities, it sees the inherent business prospects of just the business the company runs alone. 

In calculating this, operating expenses are deducted from gross profits.

Operating expenses, which can also be referred to as the accounts for SG&A (Selling, General, and Administrative Expenses), are dependent on the definition by which the business runs.

SG&A encompasses all costs incurred to run the business's day-to-day operations not directly involved with the cost of making the service/good. 

These included expenses comprise:

Other overhead costs can also be included. However, these are directly related to the business operations but not to the direct production of these goods. 

By subtracting these operating expenses from gross profits, a company can determine how well its primary business activities (not non-operating business such as investments) are generating profits.

The formula for calculating operating income:

Gross profits - SG&A - D&A = Operating income

It involves subtracting operating expenses (SG&A) and depreciation and amortization from gross profits, which fully accounts for total earnings, excluding interest and taxes. 

Alternatively, operating income can be derived by adding non-operating income to net income and then adjusting for interest and taxes by deducting these accounts, or bluntly, net income + non-operating income - interests - taxes.

On the other hand, operating expenses are crucial in evaluating the company's ability to function and deliver its products or services to the market with all these operational costs in place.

Operating Expenses Vs. Capital Expenditures

CapEx, or Capital expenditure, is defined as money invested in purchasing, maintaining, or upgrading both physical and intangible assets. 

Some characteristics used to define CapEx include:

• Long-term benefits
• Substantial monetary investment
• Enable growth and sustainability 

CapEx is costs that enable long-term benefits for companies, although these assets have a shelf-life of (often) more than a year.

OpEx refers to costs involved with assets with less than a year’s worth of benefits and ties directly to the expense incurred for a business for normal operating activities.

CapEx is money the business devotes to assets the company will use for years, including office equipment or production machinery.

These overheads are usually required for production but do not require replacement often. An example of CapEx is PPE (property plant equipment)

Since CapEx is useful for more than one working financial year, they are required by IRS (Internal Revenue Services) standards to be capitalized. This means the asset’s cost will spread over its useful years or lifespan.

Some examples of CapEx include:

CapEx = PPE (Current) - PPE (previous) + Depreciation (current)

While OpEx shows up in the income statement, CapEx rears its head in the balance sheet, and these two terms will usually not conflict with each other in the accounting statement.

Typically, operating expenses are expensed in the same year they are incurred. This stands in contrast to CAPEX, where the costs are allocated over the asset's useful life through methods like depreciation or amortization.

Operating Ratio

The operating ratio helps assess the efficiency of the company's management by comparing OpEx (and COGS) to net revenue. This is important as it covers how efficiently the company keeps costs low while generating revenue. 

The smaller this ratio, the more efficient the company.

Operating ratio = Total OpEx/ Net revenue or COGS + OpEx (SG&A)/ Net revenue

Depending on the company’s definition.

This is important in standards such as comparable analysis as this is a ratio that only highlights the company's efficiency in a like-to-like comparison in a comparable universe, whereas other companies might be selling more in industries that specific firms dominate.

The increase in the operating ratio means operating expenses are rising relative to net revenue or COGS, which is seen as a negative sign as it indicates reduced efficiency.

The decrease in the operating ratio is usually seen as a positive development as it shows the firm getting more efficient in the net sales against its production costs and the general administrative costs of the main business, improving efficiency.

Conclusion

Operating expenses (OpEx) play a pivotal role in shaping the financial landscape of businesses, determining their ability to remain competitive and sustainable. 

These expenses encompass day-to-day costs incurred in running core business activities against the revenues earned by these core business products. They are a vital component of the income statement.

The variance in OpEx definitions across different companies and industries underscores the need for a comprehensive understanding of how each organization classifies and manages its operating costs.

Distinguishing OpEx from Capital Expenditure (CapEx) is essential in accurately gauging a company's financial health. 

CapEx involves strategic investments in assets that yield long-term benefits, contrasting with OpEx, which reflects ongoing expenses incurred in the ordinary course of business. 

This distinction is instrumental in prudent financial planning, guiding companies to allocate resources efficiently and optimize returns.

The operating ratio serves as a strong measure by which a company's operational efficiency is accessed. By measuring OpEx and COGS against net revenue, this ratio provides valuable insights into cost management and revenue generation. 

A decreasing operating ratio indicates improved efficiency, as costs are minimized relative to revenue, resulting in higher profitability.

A well-informed approach to managing operating expenses, capital expenditures, and revenue generation is critical for businesses to successfully navigate the complexities of the market. 

The appropriate balance between cost control and strategic investments can empower companies to thrive and achieve sustained growth in an ever-evolving business landscape, best measured through understanding operating expenses and revenue numbers in calculating the operating ratio.

This is critical as technology pushes boundaries and lowers costs while increasing overheads, and business might transform from the conventional.

By embracing sound financial practices and optimizing their operations, companies can position themselves for long-term success and deliver value to their stakeholders.

Researched and Authored by Jo Vial | LinkedIn

Reviewed and edited by Alexander Bellucci | LinkedIn

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