The Basics
- Operating expenses (also called OPEX or overhead) are the amount of money a company spends on business operations.
- Operating expenses include rent and other fixed costs, as well as variable costs for office supplies, or operating activities such as research and development expenses.
- OPEX does not include the cost of goods sold (COGS) or capital expenditures.
What are operating expenses (OPEX)?
Operating expenses are the costs associated with running a business that are not direct ingredients or raw materials needed to make the products or services sold. Operating expenses are abbreviated “OPEX” and sometimes referred to simply as “overhead.”
Operating expenses include (but aren’t limited to):
- Compensation: Payroll expenses for employees not directly related to production of goods or providing services to customers. This includes salaries for executives and departments such as Human Resources (HR). It also includes benefits like employer contributions to employee 401k plans.
- Research and development (R&D): This includes all cost and spending for things like designing and improving existing products, or inventing new products. Salaries of employees working on new products are included in Research and Development expenses.
- Office expenses: This includes costs associated with running an office, such as rent and office supplies.
- Sales and marketing: These are exactly what they sound like—costs associated with promoting the business and its products. This includes advertising costs like media buying, sales commissions, as well as entertainment and travel expenses when sales reps visit clients.
Operating expenses are paid for with gross margin dollars. You can calculate operating profit (also referred to as operating income) by deducting operating expenses from gross margin.
OPEX are tax-deductible in the United States (for businesses that earn a profit).
Operating expenses on an income statement
Operating expenses appear below the line on a company’s income statement. They are sometimes represented as a single line item, or they may be broken out into multiple line items for different types of expenses.
Note: Because Apple spends a lot on R&D, they choose to itemize and break out that line separately here. They also bucket Selling, General, and Administrative Expenses (often abbreviated SG&A) together. These costs are generally fixed, meaning they don’t vary directly with sales volume.
Operating expenses vs. capital expenditures
Whereas operating expenses are business expenses incurred by day-to-day operations of a business, capital expenditures are costs associated with major purchases—that is, purchases of assets a business will use for more than a year. So while rent on an office space is considered an operating expense, if a business were to purchase a new production plant to manufacture goods, that would be considered a capital expenditure.
Other examples of capital expenses include:
- Hardware, such as computers
- Business vehicles
- Production equipment
- Property purchases or upgrades and expansions to existing property
Capital expenditures have several key differences from operating expenses:
- They come out of a different budget.
- They are not fully tax-deductible in the year they are purchased; rather, they are deductible over time.
- They appear on a company’s balance sheet, rather than on the income statement.
Operating expenses vs. non-operating expenses
Non-operating expenses are costs not associated with the core business operations. Examples include interest on financing, or other borrowing costs.
Operating ratio
Operating ratio is a financial ratio that measures operational efficiency of a company. It’s calculated using the following formula:
Operating ratio = (Operating expenses + Cost of goods sold) / Revenue
The result is a percentage, which represents the portion of revenue that is spent on core operation of the business. Analysts want to see operating ratio decrease over time, as that suggests that a company is becoming more efficient and retaining a higher percentage of every dollar of revenue.
What operating ratio doesn’t reflect is debt. That’s why it’s important to look at debt ratio as an additional metric when evaluating a company’s performance.
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