What are Operating Expenses?
Operating expenses (OPEX) is an accounting term that refers to the amount a company spends on its general business operations. All payments and income associated with the general running of the business are part of OPEX, such as the cost of inventory, wages, and rent.
They are generally found on the income statement after the revenue/sales section. Two common questions regarding this type of expense are what qualifies as non-operating expenses and how it differs from capital expenditures (CAPEX).
To understand what OPEX is, let's try to first understand what non-operating expenses are. Non-operating expenses are expenses incurred by a business that is unrelated to the business's core operations such as interest expense and restructuring costs. In contrast, OPEX pertains to expenses that are incurred as part of business operations.
Capital expenditures, also called "CAPEX", are costs associated with purchases of fixed assets, i.e. assets a business will use beyond the current accounting period (for over a year).
What is included in operating expenses?
Here are some examples of expenses that are generally included as part of OPEX:
- Rent and utilities
- Wages and salaries
- Research and development (R&D)
- Accounting and legal fees
- Overhead costs such as selling, general, and administrative expenses (SG&A)
- Property taxes
- Business travel
- Interest paid on debt
Other examples include:
- Advertising costs
- Sales materials costs
- Depreciation of fixed assets assigned to non-production areas
- Office supplies
- Repair costs for non-production facilities
What is not included in operating expenses?
While OPEX encompasses a large variety of expenses, it does not include:
- Cost of goods sold (direct labor, manufacturing overhead, and materials)
- Non-operating expenses and capital expenditure (typically larger expenses like buildings and machines)
OPEX: Fixed costs vs. variable costs
While there can be many examples of OPEX, all of them can be broadly classified into two main categories: fixed and variable costs.
A fixed cost is constant, meaning it will remain the same regardless of other factors like the level of production and activity (increased or decreased). On the other hand, a variable cost will change depending on the number of products produced or services provided by a company.
Examples of fixed costs are:
- Rent or mortgage payments
- Property taxes
- Interest expenses
Examples of variable costs include:
- Raw materials
- Cost of goods sold (COGS)
- Some utility expenses like electricity
Operating expense vs. Non-operating expenses
Non-operating expenses, as the name suggests, are the opposite of OPEX. This means non-operating expenses are those expenses that are incurred by activities of companies that are not part of their core operations. Examples of such expenses include:
- Interest charges that commonly arise from any debt taken on by the business
- Restructuring costs
- Currency exchange fees
- Inventory write-downs
Operating expenses (OPEX) vs. Capital expenses (CAPEX)
While OPEX is found on the income statement (as they are regular expenses), CAPEX is presented on the balance sheet as assets because their economic benefit is carried through multiple periods despite the expense being incurred once.
The primary difference between these two types of expenses is that OPEX consists of ongoing costs that are inherent to the operation of an asset while capital expenditures are costs that a company takes on to buy, maintain or improve fixed assets like buildings and equipment. Thus, an expense is recognized as CAPEX when an asset is newly purchased or capital is used to extend the useful life of an existing asset.
Note that CAPEX can also include costs of intangible assets such as patents, and since OPEX refers to ongoing costs, businesses, in general, write off operating expenses for the year in which expenses were incurred. This is in contrast to a CAPEX which would be written off over the useful life of the asset in the form of depreciation or amortization.
An example of the difference between OPEX and CAPEX is the fact that rent expense on a leased office space is considered OPEX as the lease term is generally divided into periods of one year each, while if a business were to purchase an office space of its own, it would be considered a capital expenditure since the benefits of the one-off cost of purchasing the office space carries through multiple accounting periods over its useful life.
In summary, the three key differences between OPEX and CAPEX are:
- OPEX is presented on the income statement while capital expenses are presented on the balance sheet.
- OPEX is incurred during regular business operations, such as administrative expenses, and research and development. Capital expenditure is incurred when a business uses collateral or takes on debt to buy a new asset or add value to an existing asset.
- OPEX occurs in the current accounting period while CAPEX refers to purchases of assets that will be used beyond the current accounting period (over a year).
Here is a short Youtube video explaining the differences between the two types of expenses:
The operating ratio is a financial ratio that measures the operational efficiency of a company (how effective and efficient it is in managing its OPEX). The formula to calculate this ratio is given as:
Operating Ratio = Total OPEX / Net Revenue
A higher ratio indicates higher OPEX incurred compared to the total revenue of a business. Although the absolute level of OPEX can vary across different sizes of companies within the same industry, the operating ratio is a tool that overcomes this issue and provides a more reliable and standard form of measurement to compare between various companies as part of comparable analysis.
Typically, a higher ratio is an indication of inefficiency in managing OPEX and/or generating revenue, though there are other factors that have to be considered to form an accurate analysis of a company, including the cost of sales as well as non-operating expenses.
Financial Statement Modeling Course - Income Statement
To understand how the various expenses and incomes affect the valuation of a company and become a master at Financial Statement modeling, please check out our FSM Modeling Course. Here's a sample video to give you a brief overview of the income statement: