What it means
Every business has costs beyond the materials and labour that go straight into the product. Those that keep the organisation running, such as office rent, management salaries, insurance and advertising, are called operating expenses, often abbreviated to opex.
They appear on the income statement below gross profit. The split between operating expenses and cost of goods sold matters for analysis.
Cost of goods sold, or COGS, covers the direct cost of producing what was sold, and it tends to rise and fall with sales volume. Operating expenses are generally less closely tied to volume, so they can weigh heavily on profit when sales fall.
Managers watch operating expenses because they are the main lever for improving profitability without changing the product. Common groupings include selling expenses, general and administrative expenses (often called SG&A) and research and development.
Depreciation, which spreads the cost of equipment over its useful life, is usually included as well. Comparing operating expenses with revenue gives a quick view of efficiency.
A business whose costs grow faster than its sales is losing operating leverage, meaning each extra dollar of sales is producing less profit than before. A growing business may deliberately accept higher spending for a period if it is building future revenue.
Cost behaviour shapes how managers respond. Fixed operating expenses, such as rent and salaried staff, do not shrink when sales dip, whereas variable ones, such as sales commissions and delivery costs, fall away automatically.
Knowing the mix tells a manager how quickly profit will drop in a weak month. There are boundaries to watch.
Interest on debt and income taxes are normally reported separately from operating expenses, and one-off items such as restructuring costs are often shown on their own line. Classification choices can change the picture, so analysts compare figures only when the definitions match.
In practice
Real-world examples.
Example
A software company pays developers, support staff and rent for its offices. These costs are operating expenses, and the finance team tracks them monthly against budget. Rising salaries cut into operating income unless revenue grows too. The finance lead builds a monthly report that shows each category as a percentage of revenue.
Example
A restaurant records food and kitchen wages as cost of goods sold, but treats the manager's salary, utilities and advertising as operating expenses. The owner compares the ratio to sales each month to spot overspending. A sudden jump in utilities or marketing prompts a quick conversation with the manager.
Example
A retailer opens a second store, and operating expenses rise sharply because of new rent and staff. The finance director models how many extra sales are needed to cover the extra costs before the store adds to profit. The answer shapes the decision on whether to open a third location.
Formula
Calculation
Operating income = gross profit - operating expenses
Operating expense ratio = operating expenses / revenue x 100
A company has revenue of $2,000,000 and cost of goods sold of $1,100,000, so gross profit = 2,000,000 - 1,100,000 = $900,000. Operating expenses are $600,000, covering salaries, rent and marketing. Operating income = 900,000 - 600,000 = $300,000. The operating expense ratio = 600,000 / 2,000,000 x 100 = 30%. Every $1 of revenue therefore leaves 45 cents of gross profit, of which 30 cents goes on operating expenses and 15 cents remains as operating income.Case study
Seen in the real world.
Cedar Lane Printing is a fictional commercial printer whose sales were steady at $4,000,000 a year, yet profit was shrinking. The owner could not see why until the accountant separated operating expenses from the cost of paper and ink.
Operating expenses had climbed from $1,000,000 to $1,300,000 over two years, rising from 25% to 32.5% of revenue. Most of the growth came from software subscriptions, an enlarged marketing budget and higher office costs. None of these were individually large, which is why they went unnoticed.
In this illustrative story the owner cancelled unused subscriptions and renegotiated the lease. Operating expenses fell by $200,000, which added the same amount directly to operating income, and she began reviewing the ratio every quarter. The company's operating margin improved from 8% to 13% within a year.
Watch out
Common mistakes.
- Mixing up operating expenses with the cost of goods sold, which distorts gross profit and margins.
- Cutting operating expenses that drive future revenue, such as marketing or training, without considering the effect on sales and on the business a year or two later.
- Including interest and income tax in operating expenses, when they are normally reported separately.
Questions
People also ask.
Is depreciation an operating expense?
Usually yes, because it spreads the cost of equipment used in the business over its life, although some presentations show it on a separate line.
What is the difference between fixed and variable operating expenses?
Fixed ones, such as rent, stay the same whatever the sales volume, whereas variable ones, such as sales commissions, move with activity.
How do operating expenses differ from capital expenditure?
Operating expenses are charged to the income statement in the period, whereas capital expenditure buys assets that are recorded on the balance sheet and written off over time.
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