What is an Operating Expense?
Please note that this article is intended for educational purposes only and should not be deemed to be or used as legal, employment, or health & safety advice. For guidance or advice specific to your business, consult with a qualified professional.
An operating expense is an expense that is related to a business’s core operations. Operating expenses (OPEX) are the first expenses shown on a company’s profit and loss statement. The amount left over after operating expenses have been deducted from gross revenue is known as operating income.
Examples of operating expenses
Operating expenses can generally be split into four broad categories.
- Overhead costs
- Cost of goods sold (products)
- Cost of revenue (services)
- Selling, general and administrative expenses
The term overhead costs refers to the fixed operating costs businesses must pay regardless of their output. These are generally much the same for all companies. They include:
- Certain types of insurance
- Core labour costs (contracted, permanent employees)
The terms cost of goods sold and cost of revenue refer to the operating costs that are directly connected to the production of goods or services.
These would typically include:
- Equipment and supplies
- Non-core labour (such as fixed-term employees and freelancers and/or overtime pay for employees)
- Additional insurance (to cover increased production)
- Selling, general and administrative expenses
This can include anything from sales, advertising and marketing to distribution costs to research and development. Many selling, general & administrative expenses are also overhead costs.
Operating expenses vs non-operating expenses
Non-operating expenses are expenses that do not relate directly to the business’s core operations. The most common examples of non-operating expenses are interest, taxes, depreciation and amortisation. Less common non-operating expenses can also include inventory write-offs, restructuring costs and even settlements for lawsuits.
Operating expenses in accounting
In accounting, a company’s gross profit is shown as the first line item on the profit and loss statement. Its operating expenses are shown immediately after this. Deducting the operating expenses from the gross income gives the operating income.
Non-operating expenses are shown next. Once these costs have been deducted, from the company’s operating income the money left over is the company’s net income or net profit.
The net profit can be used to calculate the net profit margin. The calculation for this is:
Net Profit/Total Revenue = Net Profit Margin
The significance of operating expenses
In the real world, there are two important facets to managing operating expenses successfully. The first is knowing when to spend and when to save. The second is knowing how to spend.
Spending vs saving
Businesses that compete purely on price may benefit from paring back costs to an absolute minimum. Most businesses, however, compete on value for money. This means they need to keep their costs as low as they reasonably can without compromising on quality.
There are two main strategies businesses commonly use to achieve this.
Firstly, they look to get maximum value out of every purchase they make. This means thinking carefully about what they need and want and looking for the most cost-effective way to get it.
Businesses will generally try to make themselves valuable customers to their suppliers. For example, they will usually try to make fewer, larger orders to benefit from volume pricing. They may order well in advance and possibly make a down payment to secure their goods (or services).
Secondly, they always look for more efficient ways to do what they do. For example, businesses are increasingly using technology to reduce their payroll costs without compromising performance.
Knowing how to spend
For many businesses, the desire to achieve maximum value for money on each purchase has to be balanced against the need to maintain reliable cash flow. This can mean that companies make smaller purchases even though they know that buying in volume would be more economical.
Alternatively, they may avoid buying items and lease or rent them instead. This can work out more expensive in the long run. The additional expense can, however, often be justified by the extra flexibility, improved cash flow and ability to keep cash in hand on the balance sheet.
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