Are you going to calculate the operating costs of your business or do you want to invest in a company? Whatever the reason may be, you must understand the concept of operating expenses and why they are important for the growth of a company. Operating expenses are crucial to the smooth working of business operations. However, there are some costs that are part of these types of expenses while others are excluded from it. The importance of operating costs and operating expenses are as much important as the revenues generated during a year.
So, the basic understanding of the different types of operating costs is also significant. In this blog, we will walk you through operating expenses, their different categories, their significance in a business, and how to calculate them. Moreover, we will provide you with a distinction between operating expenses and other non-operating expenses. So, let’s explore operating expenses in more detail!
What are Operating Expenses?
Operating expenses, also known as OPEX, are the expenses incurred during the core business activities. A business requires some expenses to produce goods and services, and deliver them to the end-user. Moreover, they hire the services of some professionals and use machinery and other equipment. Moreover, the expenses for research and development are also a part of operating. All these expenses are called operating expenses or Selling, general & administrative (SG&A) costs.
In other words, the business expenses are related to the primary business activities directly contributing to the execution of the business.
For example, expenses on raw materials, payroll, machinery, equipment, inventory costs, rent and insurance. While studying a company’s income statement, you can find the financial strength by looking at the operating costs of that company.
In other words, an income statement consists of six types of operating expenses. Cost of goods sold, selling, general & administrative costs, depreciation & amortization cost, and other operating expenses.
What are the Different Types of Operating Expenses?
Basically, there are three different types of operating expenses. These three categories let you segregate the different types of costs and you can calculate and prepare an income statement conveniently and accurately.
- Compensation-related expenses
- Office-related expenses
- Sales-and-marketing expenses
All of the above categories comprise all those expenses directly incurred in carrying out the business operations.
Why Are the Operating Expenses Important?
Operating expenses are crucial to estimating the financial position and financial health of a company. If a company fails to cut back its operating expenses, it would not earn any profits as a result. As operating costs are part of the income statement, the borrowing or investor’s funds cannot be obtained if the expenses are more than the revenues. So, a business can catch investors and borrow money from the lenders only if it has a reasonable amount of operating costs on its income statement.
How to Calculate Operating Costs and Operating Expenses?
Calculating operating expenses is not as complex as it may seem. You can calculate it from the income statement of a company. Moreover, the investor interested in a company can calculate the operating expenses as:
Operating Expenses = Payroll/Wages + Sales Commission + Marketing/Advertising + Costs + Utilities + Rent + Insurance + Taxes
The calculation and its elements can vary from industry to industry and organisation to organisation due to the varying nature of products and services.
On the other hand, the operating expense ratio is used to analyse and measure the efficiency of a company. This efficiency is related to how well a company is managing its operating expenses. Whether a company is optimally managing its costs or making extravagant expenditures.
Operating Expense Ration = Operating Expense/ Total Revenue
So, it is essential to measure the expense ratio of an organisation to grasp the financial management and financial health.
Operating Cost is different from the Operating expenses in that operating cost covers the cost of producing goods and the administrative costs.
Operating Cost = Cost of Goods Sold (COGS) + Operating expenses.
Operating Expenses vs. Capital Expenses vs. COGS vs. Non-Operating Expenses
Operating expenses are the expenses incurred to execute a business and these costs do not contribute directly to the production of goods. These expenses are also called Selling, general & Administrative Costs (SG&A).
On the other hand, capital expenses are the expenses incurred on the investment or purchase of new equipment, machinery and intellectual property rights, patents and copyrights.
Cost of Goods Sold (COGS) is the cost directly incurred for the production of goods sold. The expenditures on the production of goods to be sold are known as the COGS in finance.
Non-operating expenses are expenses other than the operating expenses. For example, financing activities and paying off the interest on the loans. These expenditures are not as important as other expenditures in a business.
In sum, operating expenses are a part of the operating costs. When a financial manager adds operating expenses to the cost of goods sold (COGS), the operating costs can be calculated. Operating costs do not directly contribute to the production of goods and services. Instead, they support the activities involved or used indirectly in the manufacturing of goods.
Calculating operating expenses is not difficult as you can analyse it from the income statement of an organisation also. Moreover, you can use these expenses to measure the overall financial efficiency of a firm using the operating expense ratio.
Lastly, operating expenses help a business grow its sales at the minimum cost. The financial managers can reduce the operating cost by lowering the operating expenses.
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Disclaimer: The information about Operating Costs provided in this article is general in nature. It does not intend to disregard any professional advice.