What are Operating Expenses?
Operating expenses, operating expenditures, or “opex,” refers to the expenses incurred regarding a business’s 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. Principally, they can build up an understanding of the company’s cost and sales management efficiency.
- Operating expense reflects the operational activities, not the investing or financing activities of a company.
- Operational activities are a company’s key commercial activities in generating revenue.
- When it comes to physical assets, it is vital to distinguish between operating expenses and capital expenditures.
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 difference between operating expenses and capital expenditures.
The counterpart of operating expense is capital expenditure, which is the cost of developing or improving the system in which a company performs its operational activities. Purchasing machinery, for example, is considered a capital expenditure. On the contrary, repair and maintenance of the machinery is considered an operating expense.
Fixed Costs and Variable Costs
When it comes to analyzing operating expenses, classify the expenses as either fixed cost or variable cost. In such a way, a manager can better understand the nature of the expense. Fixed cost is the cost that remains the same in the short-term, while variable cost is the cost associated with the number of products or services that a company produces.
In other words, fixed cost can only change in the long term, while variable cost depends on the company’s operational decisions. For example, expenses such as rent and employee wages are fixed costs, while purchased supplies 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 employee is a fixed cost to the company, while the wage for a temporary or contract employee should 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 exclusively important because they help measure a company’s cost and stock management efficiency. It highlights the cost and needs that a company needs to make to generate revenue, which is the main goal of a company.
If a company incurs relatively higher opex compared to its competitors, that may indicate that the company faces poor stock management and may experience an overstock problem in the near future.
The disadvantage of looking at a company’s opex is that it is an absolute number, not a ratio. It means that the expenses cannot reflect the size of a company, making it unreasonable to be used as an indication 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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