If you want your company to survive, you need to know how much money you need to keep it running. As operating expenses increase, your profitability goes down. So, you must be proactive in mitigating operational costs.
In this post, we’re going to share everything you need to know about operating expenses to improve your company’s financial health.
What Are Operating Expenses?
Operating expenses are the costs that a business incurs that are not related to manufacturing a product. They are also referred to as selling, general, and administrative (SG&A) expenses.
The profitability of a company is dependent on various factors, but operating expenses can play a crucial role in it. To help you understand its impact, let’s take a look at the basic formula of the profit and loss statement:
Revenues – Cost of Goods (COGS) = Gross Profit
Gross Profit – Operating Expenses = Operating Income
Operating Income +/- Non-Operating Income/Expenses = Net Income
The formula above shows that you subtract operating expenses from your gross profit. Once you do that, you’ll get your business’s operating income. Here are other important details you need to know about operating expenses:
Operating vs. Non-Operating Expenses
Sometimes referred to as OpEx, an organization’s operating expenses are reflected in its income statement. As we’ve mentioned, operating and non-operating expenses determine a company’s profitability.
Now, investing or financing activities indirectly result in expenditures or non-operating expenses. Some examples of non-OpEx are interest payments on loans.
Non-operating and operating expenses can be fixed or variable. Changes in service delivery or production volume do not have to affect them. If they’re variable, they fluctuate according to the changes in delivery or production volume. Some examples of fixed operational expenditures are salaries and rent. Meanwhile, variable ones can include sales commissions and fuel expenses.
Operating Expenses vs. COGS
Cost of goods sold or COGS is different from operating expenses. COGS includes direct expenses for purchasing or manufacturing products. The complexity of the business and its products will determine the level of difficulty in calculating COGS.
To put things simply, COGS includes your beginning inventory and inventory purchases. However, you need to subtract the ending inventory from the amount. The formula will also include the cost of buying the items, manufacturing (including labor), inbound freight, packaging, and modifications.
Operating Expenses vs. Capital Expenses
Unlike operating expenses and cost of goods sold, capital expenses do not appear on the income statement of a business. Also referred to as CapEx, capital expenses are one-time expenditures of intangible and tangible assets. These expenses are reflected on the balance sheet of a company. Usually, these assets have at least a year-long lifespan. Even so, they bring long-term value to a business.
While capital expenditures are indeed deductible, it doesn’t occur immediately. Instead, the deduction happens over time through processes called amortization and depreciation. It’s also worth noting that it’s possible to have a 100% first-year depreciation for certain asset categories.
The Importance of Operating Expenses
As a business owner, it should be your goal to improve the bottom line of your operations. There are several methods you can use, but optimizing costs or reducing operating expenses can be the best solution.
There are many reasons behind this. For one, if you try to increase your product or service fees to boost revenue, you may lose customers who aren’t willing to pay more. Of course, you can use cheaper materials or labor to decrease your COGS. However, the quality of your service or product may suffer. Consequently, you will lose loyal clients and not gain new ones.
What Should Be Included in Operating Expenses?
Operating expenses include a wide array of cost categories. Here are 11 cost expenses examples:
- Office supplies – These are items that office staff consistently use. These can include replenishable things like invoice and sales receipts, printer paper, pens, staplers, flash drives, and janitorial cleaning supplies.
- Depreciation – This includes fixed assets that a company bought. These items have depreciated in value over time. They can include furniture, warehouse machinery and equipment, computer equipment, store displays, and delivery vehicles.
- Advertising –This category includes expenses for marketing the business. Advertising expenditure can include money spent on social media, business cards, websites, and print, TV, and digital campaigns.
- Property tax – This includes the taxes you pay for real estate, and the amount can vary depending on the assessed value of your property.
- Inventory – This category included anything related to storing and ordering inventory in preparation for sale. For instance, this can include costs for raw materials, transportation and delivery, manufacturing overhead, storage, and labor.
- Rent – This includes expenses for using a property or location that is not owned by the business. It can include office, storage, factory, or retail spaces. The real estate industry uses the operating expense ratio to compare the costs of running properties with the revenue they generate. Ideally, a lower operating expense ratio would mean higher profitability. After all, it is an indicator that less of the income of the property is going toward operational expenses.
- Payroll – Operating expenses also include administrative spending on employee wages, benefits, and payroll taxes.
- Maintenance and repairs – This category includes unavoidable and necessary upkeep costs to ensure that things are in working order. Anything spent on replacing or fixing broken items will also fall under this category. It can also include expenses for painting, cleaning, and inspecting business structures.
- Utilities – Operating expenses can include money spent on public services like electricity, water, telephone, internet, sewage, waste disposal, and heating.
- Insurance – This is the money you spent on purchasing insurance coverage. It also includes the monthly unpaid premium cost.
- Travel – OpEx can also include the cost of reimbursing travels related to business affairs.
How Do You Calculate Operating Expenses?
When you understand your operating expenses, you can compute the operating expense ratio of your business. The operating expense ratio provides you with a direct comparison of your business costs and income. This way, you can determine how your company fares against others in your industry.
Here’s the formula:
(Cost of Goods Sold + Operating Expenses) / Revenues = Operating Expense Ratio
As an example, let’s look at the 2021 financial statements for Lolita Moon Dresses:
|Income Statement Item||Amount|
|Cost of Goods Sold||$40,000|
Kristine, the owner of Lolita Moon Dresses, wants to determine how her business is faring against other companies in her industry. So, she computes here operating expense ratio:
($40,000 + $60,000) / $180,000 = 0.56
So, in this example, Kristine is spending 56 cents of every dollar she earns on the daily costs of operating her business. The result can be judged as good or bad depending on the standards in her industry.
When you’re calculating the operating expense ratio for your company, you must compare it with the benchmarks in your industry. Usually, trade organizations, industry associations, and your chamber of commerce will provide this information.
You should also monitor an operating expense ratio that increases over time. When this figure rises, it can indicate a decline in the operating efficiency of your business from year to year. So, you must review your processes to determine what’s causing the increase in the operating expense ratio.
How Do You Compute Your Operating Expenses on Your Income Statement?
Perhaps, you don’t have an income statement for your business. What if you do have one, but you don’t separate the amounts for operating expenses, non-operating expenses, and the cost of goods sold? Well, you can still get an idea of how much it costs to run your company.
You can go through your expense report or general ledger. Then, you need to identify recurring costs that do not go to labor or raw materials used for manufacturing a product.
You can compute the operating expenses of your business by adding up those costs. Once you’ve determined the figures, you can consider improving your bottom line by reducing your operating costs.
How Do You Reduce Operating Expenses?
Capgemini research reports that decreasing operating costs even by 1% can increase profitability. It can go up to ten times higher than how boosting revenue can. So, if you have a clear view of your operating expenses, you can identify areas and processes that are too costly. You can break them down and evaluate opportunities for saving costs.
Here are some of the ways you can lower operating expenses:
Assess the trends in your utility bills and check if they keep on going up over time. Search for energy-efficient solutions like HVAC upgrades and motion-sensor lights.
Evaluate your insurance coverages and your options for internet providers. Look for vendors that can offer more competitive rates.
Use a time tracker to determine productivity. Wages are also included in your operating expenses. Now, if employees are not doing productive work during paid time, you’re losing money.
Increase Profitability with Traqq
If you want to maximize labor costs, you need to ensure that your employees are doing productive work and not cyberslacking. One of the best ways to monitor your workers is by using a reliable time tracker like Traqq.
With Traqq, you can get comprehensive reports about employee productivity. For instance, it shows you how active your workers are. On the dashboard, you will see their activity levels based on their keyboard movements and mouse clicks and scrolls.
What’s more, Traqq comes with a URL and app monitoring feature. You can generate reports on the top apps that your employees use and the websites they frequently visit. This way, you can identify what’s wasting their time at work. You can block distracting apps and websites that prevent them from becoming productive.
It’s essential to identify your operating expenses if you want to determine the profitability of your business. Once you’ve calculated the figures, make sure you find ways to cut down your operating costs. Also, don’t forget to integrate Traqq into your cost optimization strategy. After all, labor expenses can quickly take up a huge chunk of your operational costs.