You’ve probably heard it said that, in business, “you have to spend money to make money.”
Generally speaking, that’s true. There are certain costs associated with running your company so that you can provide your product (or service) and realize some profit (and, hopefully, lots of it).
The accounting term for the money you spend to run your business is “operating expenses” (OpEx). It is important that you understand how managing your operating expenses well leads to better business sustainability. This post will explain how OpEx works and provide you with strategies for effective expense management.
What Are Operating Expenses?
Operating Expenses (OpEx) are the ongoing costs that are incurred by a business through its normal operations. They could also be referred to as the basic “costs of doing business.”
Examples of Common Operating Expenses
- Rent and utilities
- Salaries and wages
- Office supplies and equipment
- Marketing and advertising costs
- Insurance premiums
- Maintenance and repairs
(Note: OpEx are not the same as capital expenses, which we will explain further in a minute.)
Operating Expenses and Non-Operating Expenses
Non-operating expenses are those which are not directly related to the main functions of the business. For instance, interest payments on loans, inventory write-offs, and losses on the sale of assets are considered non-operating, rather than operating, expenses.
Understanding and managing your operating expenses is a big part of the success (or failure) of your business.
How to Calculate Operating Expenses?
Operating expenses are fairly easy to calculate. How many numbers you’ll be working with depends on the size of your business and the amount of items you’re spending money on. You can do it one of two ways:
- Add together what you have spent on things that are essential to running your business. According to the IRS Tax Guide For Small Business, “a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your field of business. A necessary expense is one that is helpful and appropriate for your business. An expense does not have to be indispensable to be considered necessary.”
Operating Expenses = Advertising/Marketing + Payroll + Rent + Utilities + Insurance + Supplies + (etc.) - Subtract operating income (or earnings before interest and taxes…a.k.a. EBIT) and cost of goods sold (COGS) from your revenue.
Operating Expenses = Revenue – Operating Income – COGS
Once you have a number that lets you know exactly what your operating expenses are, you can use that information to learn other valuable things about the health of your business.
COGS vs Operating Expenses
Before we move on, there are a couple of important distinctions to make. First, the formulas we mentioned earlier referenced Cost of Goods Sold (COGS), and we should point out that those are not the same as Operating Expenses.
COGS is “a sum of all direct costs associated with selling a product or service”, as pointed out in an article on “The Difference Between CapEx, OpEx, and COGS” by the U.S. Chamber of Commerce. The raw materials and labor necessary to produce something are considered COGS rather than OpEx. Expenses that you incur whether you are producing something or not are not COGS.
COGS items are tax deductible if they are associate with items you manufacture or purchase with the intent to resell.
Capital Expenditures vs Operating Expenses
Secondly, capital expenditures (CapEx) are also not considered operating expenses.
Think of CapEx as long-range investments where OpEx is immediate and day-to-day necessities. To be considered a CapEx purchase, it must benefit the company for more than one year. These kinds of items usually include property, equipment, technology, etc.
Since CapEx is seen as an asset (adding value over time), it is listed on the Balance Sheet instead of the Income Statement where OpEx is found. (More on that in a minute.)
Recording and Categorizing Operating Expenses
As any good baker will tell you, a recipe is only as good as how well you follow it and the quality of the ingredients you put in. When it comes to making sure you have good data on your OPEX, you need to start with accurate record-keeping. Sloppy numbers will only lead to inaccurate results.
One way to ensure reliable records is to utilize categories in your accounting software. The more detailed you can be, the better. That way, when a receipt comes in you’ll know exactly where it needs to go. And when you run reports later, you can quickly tell which areas of spending are doing well and which ones need some attention.
The exact OPEX categories (and subcategories) you use will largely depend on the type of business you are in. A product manufacturer will have expenses related to storage, a janitorial service will have more expenses related to supplies, and a software company will spend quite a bit on cloud storage.
If you’re new to this (or just ready to track expenses better), in addition the basic categories we mentioned earlier (rent, utilities, etc.), look back at past bank statements to see your specific spending patterns. Your CPA can be a big help too since they’ve likely had experience working with companies similar to yours.
Read more: “16 Small Business Tax Deductions” that we wrote about may also give you some ideas as well as this list of 36 business expense categories from NetSuite.
Impact of Operating Expenses on Financial Statements
As we referenced above, there are some differences in how OpEx is recorded compared to other expenditures like CapEx.
OpEx is a pure expense representing a cost related to immediate needs rather than long-term investments. Therefore, it shows up on your Income Statement.
Subtracting OpEx and COGS from your gross profit total (as well as any EBIT) gives you your Net Income. So accurately tracking your OpEx costs is essential to really knowing how much money your business is making.
Strategies for Managing Operating Expenses
Since OpEx plays such an important role in determining your company’s Net Income, it stands to reason that the better you control it…the more money you get to keep. So here are some valuable strategies for better managing your Operating Expenses.
- Cost Control Measures
By lowering your costs, you automatically increase your profits. The key is to implement cost-cutting strategies wherever possible without compromising the quality of your product or services. A good place to start is by seeing if you can negotiate better terms with your suppliers and vendors. Also consider ways to reduce “essential expenses” such as energy consumption and other utility costs. - Budgeting and Forecasting
Set realistic budgets for your operating expenses. If you set them too low, you’ll keep getting caught off-guard when bills and invoices come in. Use historical data to better forecast your future expenses. It can take several months to dial things in, so regularly review and adjust your budgets until you get them where you want them. - Leveraging Technology
Use accounting software to track and manage your expenses. (See a previous post we did on “Unlock Success: Why Tracking Annual Business Revenue is Essential for Your Service-Based Business” for more on that.) Also, any routine tasks that you can automate will help reduce labor costs. Netsuite has a good article on “6 Steps to Automate Your Accounting Processes” to give you some ideas. Beyond that, consider investing in technology that will improve the efficiency of your operations such as digital document management, CRM software, inventory management, communications equipment, etc.
Analyzing and Optimizing Operating Expenses
It has been said that you “cannot expect what you do not inspect.” Conduct regular expense audits to identify any unnecessary costs. Benchmark your operating expenses against the standards typical within your particular industry. And commit yourself to implementing continuous improvement processes…since getting better is never a one-time thing.
Best Practices for Managing Operating Expenses
Some of the best practices for managing your operating expenses include:
- Establishing clear policies and procedures for expense management
- Training employees on cost-saving measures
- Encouraging a culture of cost-consciousness within the organization
Trust Experienced Accounting Pros to Help Grow Your Business
Understanding and managing your operating expenses is a big part of the success (or failure) of your business. By implementing the strategies we’ve discussed here and partnering with experienced pros for accounting advice, you can be on your way to better financial health.
Our team of business experts and accountants has been helping small business owners like yourself for over 40 years. Schedule a call today to discover how we can help optimize your operating expenses.