What are Operating Expenses?
Operating expenses, operating expenditures, or “opex,” refers to the costs incurred by a business for its operational activities. In other words, operating expenses are the costs that a company must make to perform its operational activities.
Operating expenses are essential for analyzing a company’s operational performance. It is therefore important for both internal and external analysts to identify a company’s opex, to understand its primary cost drivers, and assess management efficiency.
- Operating expenses reflect the operational activities, not the investing or financing activities of a company.
- Operational activities are a company’s key commercial activities in generating revenue.
- It is important to distinguish between operating expenses and capital expenditures as the two are treated differently for accounting purposes.
What are Operational Activities?
Before calculating a company’s operational expenses, it is essential to identify the operational activities or the primary revenue-producing activities of the business and other activities that are not financing or investing activities.
The operating activities primarily cover the commercial activities of the company. For example, the main operating activity for a manufacturing company is to produce the product from raw materials, while for a trading company, it is to buy products from the supplier and sell them to the end-users.
It is critical to note that operational activities differ greatly among industries. A business activity can be classified as operational in one industry, but financing or investing in another. For instance, buying a building is typically an investing activity in most industries. However, it is an operational activity for real-estate companies, given that the purchased building is intended for resale.
An example of Amazon.com‘s income statement is shown below. Encompassed by a red border, Amazon’s operating expenses include the cost of sales, fulfillment, marketing, general and administrative, technology and content, and other operating expenses.
Operating Expenses and Capital Expenditures
For businesses, operating expenses may typically include supplies, advertising expenses, administration fees, wages, rent, and utility costs. When it comes to capital or physical asset-related costs, however, it is important to make a distinction between operating expenses and capital expenditures as the two are treated differently for accounting purposes.
Capital expenditures are assets that are purchased and have a multiyear life, and are used in the operations of the business.. Purchasing machinery, for example, is considered a capital expenditure, whereas, repair and maintenance of the machinery is considered an operating expense.
Fixed Costs and Variable Costs
When it comes to analyzing operating expenses, managers classify the expenses as either fixed or variable. In such a way, a manager can better understand the nature of the expense. A fixed cost remains the same no matter what the production level is, while variable cost does vary with the number of products or services that a company produces.
For example, fixed costs are things such as rent, lease payments and insurance expense, and labour, raw materials and sales commissions are variable costs.
It is noteworthy that the same category of an operating expense can be either a fixed cost or a variable cost, depending on the situation. For example, the wage for a full-time office employee is a fixed cost to the company, while the wage for an assembly line factory worker can be identified as a variable cost. Understanding the distinction can help managers to better control the operating expenses while considering the timeframe.
Importance of Operating Expenses
Operating expenses are important because they can help assess a company’s cost and stock management efficiency. It highlights the level of cost that a company needs to make to generate revenue, which is the main goal of a company.
If a company incurs relatively higher opex as a percentage of sales compared to its competitors, that may indicate they are less efficient at generating those sales.
The disadvantage of looking at a company’s opex is that it is an absolute number, not a ratio. Therefore it is unreasonable to be used as a metric to compare between firms even if they are in the same industry. However, they can be highly instrumental in the horizontal analysis since it can reflect the company’s current performance in the past.
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