Operating expenses refer to expenses that a business incurs through its normal operations, such as rent, office supplies, insurance, and advertising costs. These expenses don't include capital expenditures or the cost of goods sold (COGS), such as materials, wages for production workers, or manufacturing overhead. Big and small businesses alike should keep track of their operating expenses on their financial statements because it affects their bottom line.

Generally, as a business owner who wants to increase profits, you have three ways of doing so:

  • Raising prices for your products or services
  • Employing cheaper labor or materials for your products or services
  • Reducing your operating services

Although raising prices and using cheaper materials may increase revenue, most business owners consider those options only after reducing operating expenses first. This is because allocating a smaller budget for operating expenses doesn't adversely affect the price or quality of the product or service. This is why it's essential to keep track of your business's operating expenses.

This article will review what operating expenses are, how to calculate them, and where they're used to gauge how your business is doing.

What Is Included in the Operating Expenses?

Operating expenses (OPEX) are the costs of running a business that are incurred daily, monthly, or yearly. Some examples are:

  • Rent
  • Office supplies
  • Salaries, wages, and commissions for non-production employees
  • Insurance
  • Professional fees
  • Advertising and marketing
  • Subscription fees
  • Legal fees
  • License fees
  • Accounting fees
  • Utilities
  • Property taxes
  • Travel expenses
  • Maintenance and repairs
  • Vehicle expenses

Compensation-Related Operating Expenses

This type of operating expense refers to any costs a business incurs to pay employee salaries or benefits packages. Compensation-related expenses also include commissions and bonuses paid to contractors. Some examples are:

  • Employee salaries
  • Benefits contributions
  • Commissions and bonuses to employees or contractors
  • Retirement plan contributions for employees
  • Payroll processing costs and payroll taxes
  • Accounting fees
  • Insurance costs
  • Subscription fees
  • Professional and license fees
  • Legal fees
  • Office supplies
  • Property taxes
  • Office space utility costs
  • Rent for office space

Office-Related Operating Expenses

Office-related operating expenses are administrative costs that a business incurs to run its offices. These are not direct costs to create a product or provide a service but are still important to ensure the business runs smoothly. This category includes:

Sales and Marketing-Related Operating Expenses

Sales and marketing-related operating expenses are costs incurred to promote the business's products or services to its target market. Some examples include:

  • Digital marketing costs
  • Advertising costs (brochures, newsletters, business cards)
  • Website development and maintenance costs
  • Travel and vehicle maintenance costs

What Is Not Included in Operating Expenses?

Non-operating expenses include manufacturing costs that the company incurs infrequently and expenses not related to its daily business operations. Examples may include:

  • Depreciation of fixed assets
  • Bank charges and interest expense
  • Losses from sale of capital assets (machineries)
  • Losses from obsolete inventory (expired products)

How Do You Calculate Operating Expenses?

You will find a summary of your operating expenses in your income statement. Separate your operating expenses from your cost of goods sold (COGS) and capital expenses, such as machinery, buildings, and vehicles. Add up the amount for each like so:

Accounting fees
+ Office Supplies
+ Insurance
+ Licensing Fees
+ Legal Fees
+ Marketing and Advertising
+ Payroll and Wages
+ Repairs and Equipment Maintenance
+ Taxes
+ Travel Costs
+ Utilities
= Operating expenses

Operating Expense Ratio

You can gain several benefits from knowing how much your operating expenses cost your small business. For instance, you can compare your operating expense ratio (OER) to industry benchmarks. Your income statement results can also help you understand how your costs affect your net profit.

The operating expense ratio is a metric generally used to calculate the profitability of real estate properties. However, more and more businesses are using it to measure their cost efficiency from year to year. To calculate your operating expense ratio, use the following formula:

Operating Expense Ratio
(Operating Expenses + Cost of Goods Sold)
Gross Income

The operating expense ratio will help you measure and understand if you have your business costs under control and are keeping more of your profits. If you want to compare your OER to industry benchmarks, you can usually find this information from industry associations, trade organizations, or your chamber of commerce.

Let's calculate the operating expense ratio for Wendy, a fictitious small business owner who sells crafts and customized cards on Shopify. She has the following yearly figures for her business:

Operating Expenses
Rent and utilities 8,760
Office supplies 650
Subscription fees 1,140
Licenses 520
Website 550
Marketing 420
Accounting 360
Insurance 600
Total Operating Expenses $13,000
Cost of Goods Sold
Materials 10,500
Direct Labor 13,800
Overhead (rent of equipments, utilities, etc.)1,700
Total COGS $26,000
Gross Income $65,000
Operating Expense Ratio
(13,000 + 26,000)
= 0.6
Multiply by 100 to convert to percentage and you get 60%.

From the example, Wendy learned that 60% of her revenue is going to operating expenses and production. Essentially, she is spending 60 cents for every dollar she earns on the day-to-day operations of her business. If Wendy wants to retain more profits, she can look at her expenses and figure out where to reduce.

Operating Expenses on Net Profit

Net profit is the amount of money left over after your business expenses have been deducted from your gross income. Your income statement summarizes your revenues and expenses to calculate your net profit. To determine your net profit, you account for interests, taxes, and amortization or depreciation expenses, along with the cost of goods sold and operating expenses. Depending on the size of your operation, you may want a monthly, quarterly, or yearly income statement report.

Net profit - also called net income, bottom line, or net earnings - measures the overall success of your business. Having a high net profit margin means your products or services are priced right and your operating expenses are well-managed. Knowing your net profit is also helpful when you're pricing out your products or services.

To calculate the net profit for Wendy's business, we can use the following formula:

− Operating Expenses
− Depreciation
− Taxes
= Net Profit

Net Profit = Revenue - (COGS + Operating Expenses + Depreciation + Taxes)

Let's use the following amounts:

Revenue 65,000
Less: Cost of Goods Sold − 26,000
Less: Operating Expenses − 13,000
Less: Depreciation − 800
= Operating Income 25,200
Less: Taxes −5,040
= Net Profit/Net Income $20,160

From this calculation, we can determine Wendy's net profit margin, a measure used by businesses to express how many cents of profit is earned for each dollar of sale.

Net Profit Margin
Net Income
= 0.31
Multiply by 100 to convert to percentage and you get 31%.

So, Wendy learned that she's taking home at least 30 cents for every dollar of sale. She can use the information to compare how her business is doing with others in her industry. Wendy can also use this profit margin to reexamine her operating expenses and the prices of her products.

Let Skynova Help You Manage Your Small Business Income Statements

As a small business owner, knowing how much your day-to-day operations cost your business is important - not only so you're aware of how your business is doing but also so you can have it under control. Business owners often make the mistake of going too big too soon instead of keeping operating expenses low.

Speak to your financial adviser or accountant if you're planning to scale your operations to ensure you're ready. However, in the meantime, here are some tips to help you cut operating costs:

  • Look into office sharing, relocating into a cheaper location, or working out of your home to lower your rent and utilities cost.
  • Learn to manage your own website or online marketing.
  • Shop around for lower insurance rates.
  • Cancel subscriptions that don't add value to your business.
  • Negotiate or take advantage of discounts from suppliers for paying early.
  • Look into automating some of the administrative tasks that take up your time, like invoicing, bookkeeping, or payroll.

Try Skynova's all-in-one invoicing and accounting software for small business owners. This accounting software will help you keep accurate records of your income, expenses, sales tax, and payments. You're sure to stay organized because it will sort your expense reports by vendor, category, or date.

You can also easily create reports like income statements, balance sheets, and cash flow statements any time you need them. Making better-informed decisions for your business's future just got easier. Explore Skynova's software products for all your business needs. You'll also find free templates to help you run and grow your business.