Definition of Operating Expenses
An expense incurred by the business to run its daily business operations like rent, salary, insurance, office expenses, repair and maintenance, marketing expense, cost of research and development, cost of insurance, etc. is known as operating expense, abbreviated as OPEX and it is the responsibility of the management to reduce these expenses in such a way that it does not affect the competitiveness of the business in the market.
Expenses are the mandatory expenses incurred by businesses to run their regular operations. In other words, this is the amount the business spends to convert its inventory into throughput. Management tries to reduce these expenses so that the business can gain a competitive advantage and increase its earnings, but sometimes it will affect the quality of operations of the business. Expenses are shown in the Income Statement of the business, and these expenses are written off in the year in which they are incurred.
What is Included in Operating Expenses?
Expenses are the necessary expenses incurred by the company which is not associated directly with the manufacturing of goods. Some of the items included in Expenses comprise of following-
- Administrative Expenses: Expenses incurred by the business for administrative or office purposes like accounting expenditures, legal charges, cost of insurance, repair & maintenance, rental expense, property taxes, office supplies (like letterhead, writing paper, etc.), etc.
- Sales related Expenses: Expenses incurred by the business to promote its sales, like marketing expenses, travel expenses, etc.
- Expenses related to compensation: This includes payroll expenses (for the employees not engaged in the production of goods), sales commission, etc.
Examples of Operating Expenses
Following are examples as given below:
Suppose, the income statement of the company contains the following information:
|Revenue From Sales of goods||$500,000|
|Cost of goods sold||$350,000|
|Expenses related to research and Development||$100,000|
|Administrative and selling Expenses||$20,000|
|Earning After interest and Tax||$28,000|
Based on the above information, compute the Expenses of the company.
Solution: The Expenses of the company can be computed by using two Approaches:
Operating Expense = Expenses related to Research and Development + Administrative & Selling Expenses
- Operating Expense = $100,000 + $20,000
- Operating Expense = $120,000
First of all, we have to compute income.
For the computation of income, interest and tax expenses are ignored.
Income is calculated as –
Operating Income = Earning after Interest and tax + Tax + Interest Expense
- Operating Income = $28,000 + $1,500 + $500
- Operating Income = $30,000
Operating Expenses is calculated as –
Operating Expenses = Revenue from Sales Operation – Operating Income – Cost of Goods Sold
- Op Expenses = $500,000 – $30,000 – $350,000
- Op Expenses = $120,000
How to Find Operating Expenses?
The following steps should be followed to find expenses:
- Step 1: Firstly, we have to calculate the cost of goods sold. Cost of goods sold means cost of production which is directly attributable to the process of production. It includes the cost of raw materials, the cost of direct labor, and production overhead.
- Step 2: Calculate Earnings before interest and Taxes or income from the income statement of the company.
- Step 3: Determine the revenue earned by the company from sales operations which is shown in the Income statement of the company.
- Step 4: Then apply the formula to calculate Expenses:
Operating Expenses =Revenue from Sales Operation – Earning before Interest and Taxes -COGS
Alternatively, expenses are calculated as follows:
Operating Expenses = Administration Related Operating Expenses + Operating Expenses Related to Sales and Marketing + Operating Expenses Related to Compensation.
Importance of Operating Expenses
The importance of expenses is provided and discussed below:
- Expenses are very important for the company as it helps the company to measure the cost incurred by the company for running its regular operations. It shows how much cost the company has to incur to generate the revenue.
- If a company incurs more expenses in comparison with its competitors, this may be an indication of poor stock management by the company and the company may face overstock or oversupply problems in the future.
- Expenses are very important in calculating the profitability of the company.
- Expenses are influenced by pricing strategy or other managerial activities of the company. Thus, the study of these expenses gives a fair idea about the flexibility and competitiveness of the company.
Advantages of expenses are provided and discussed below-
- Operation expense means the cost incurred by the company to generate revenue for the company. It helps management to plan or reduce its day-to-day expenses so that the company does not get trapped in a financial ditch.
- Some company trims their expenses to increase the profitability or earnings of the company. But fixed expenses like salary and wages are not trimmed by the company unless the company reduces its staff. So it helps management to manage its current expenses.
- The income (total profit of the company associated with its operations) of the company can be computed by using expenses. The formula for the determination of operating income is as follows:
Operating Income = Revenue from Sales Operation- Operating Expenses
- The Expense ratio can be computed by using operating expenses. Most companies compute the operating expense ratio to track their efficiency. The expense ratio is computed as follows:
Operating Expense Ratio = Cost from Operating Business/Revenue from The Operation
Thus, there are two types of expenses incurred by the company. One is Capital Expenses and the other is Expenses. Capital expenses include expenses related to investments by the company or costs related to the acquisition of tangible (computers, furniture, buildings, etc.) and intangible (patent, copyrights, etc.) assets. Operating expenses mean expenses incurred by the company in its day-to-day business. Expenses are shown in the income statement of the company and used in the computation of the profitability of the company. Management tries to reduce its operating expenses, the results of which, the earnings or profitability of the company are increased. It helps the company to manage and plan its current expenses.
This is a guide to Operating Expenses. Here we also discuss the definition and what is included in operating expenses? along with importance and advantage. You may also have a look at the following articles to learn more –