Operating Expense – Defined and Some Examples
In running a business, there are day-to-day costs that are necessary to keep it afloat such as rent, utilities, salaries, etc.
These costs are not directly attributable to the sales of goods and services but are still related to the operating activities of a business.
For example, let’s look at a small pastry shop that employs four people (one admin staff, two service staff, and one baker).
The shop owner rents the place where the pastry shop is located and pays for utilities.
In the above example, while the salaries of the employees, rent, and utilities expenses are necessary to keep the pastry shop running, only the salary of the baker can be considered that directly contributes to the cost of the product (pastries in this case).
These costs that are necessary for operating a business are referred to as operating expenses.
What is an operating expense?
Any expense made by a business that is incurred through operating activities and is not directly related to the production of goods or delivery of services is an operating expense.
To make it shorter, any expense that does not directly contribute to the cost of sales or services is an operating expense.
For example, in a factory setting, the salaries of wages of the employees who are directly involved in the manufacturing process are considered as part of the cost of sales, while those of office and admin staff are considered as operating expenses.
Likewise, the cost of materials used for the production of a product is a part of the cost of sales, while the cost of office supplies such as paper, pens, and paper clips is an operating expense.
Most operating expenses are necessary and unavoidable.
For example, if you don’t pay for the salaries of your employees, they will quit on you and may even sue you.
If you don’t pay rent for the space that you’re renting, then you might get evicted.
If you don’t pay for business taxes and licenses, you might lose the privilege of running a business.
While it is enticing to minimize operating expenses as much as possible, it isn’t easy to do.
Some companies even hire people who are dedicated to the minimization of costs.
It is a delicate process as not doing it right may result in the deterioration of the quality of operations.
If you’re planning to reduce operating expenses, do so with proper care and planning.
It is important to keep track of your business’ operating expenses.
Not only will doing so help you in knowing how much your business is spending, but it can also help you in understanding how your business is utilizing its assets.
Is the amount you pay for rent worth it for the level of income you’re generating?
Is your cost of utilities at an expected level?
Would it be cheaper if I outsource these processes?
Are there any expenses that I can cut? These are just some of the questions that good monitoring of operating expenses can answer.
Operating vs Non-Operating Expenses
Aside from the cost of sales and operating expenses, there are other expenses that a business can incur, the most common of which is the interest expense.
These expenses that cannot be considered as a cost of goods sold or an operating expense are referred to as non-operating expenses.
Unlike operating expenses, non-operating expenses are not related to the operating activities of a business.
These are often incurred by one-time transactions (loss from disposal of a long-term asset, loss due to fire, etc.) and as such, are not expected to be incurred every operating cycle.
It is still important to keep track of these expenses as they still affect the overall income of your business.
It’s good practice to separate operating expenses from non-operating expenses.
Operating Expenses vs Capital Expenses
When a business acquires a long-term asset, the cost of the asset is considered a capital expense.
Another instance of a business incurring a capital expense is when a business upgrades or repairs a long-term asset to increase its useful life.
Capital expenses are capitalized as assets rather than recognized as expenses outright.
While operating expenses are recognized as expenses when they are incurred, capital expenses are capitalized as assets and only recognized as expenses via depreciation (for tangible assets) or amortization (for intangible assets).
The amount of the expense does not necessarily matter when treating an expense as an operating or capital expense.
Rather, what matters is the nature of the expense.
For example, company AX spends $25,000 to upgrade a piece of equipment which increases its useful life.
The $25,000 that company AX spent on the upgrade is treated as a capital expense.
But if the $25,000 is instead spent on general repairs just to bring the piece of equipment to an acceptable operating level, it is treated as an operating expense.
Examples of Operating Expenses
Some of the commonly known examples of operating expenses are:
Salaries and Wages
The payment you make to your business’s employees in exchange for their services is referred to as salaries and wages.
The primary difference between the two is that wages are based on hourly labor while salaries are not.
Do note however that the salaries and wages of personnel directly attributable to the cost of sales are not included in this operating expense account.
For example, the pay of a baker who makes the bread in a bakery is a cost of sales, while the pay of the cashier manning the same bakery is an operating expense.
Businesses will use things that consume electricity such as computers, lights, air conditioners, or that neon sign that says ‘welcome’ that you often see in cafes.
The cost of electricity, along with other utilities such as water, heating, and even janitorial services is referred to as utilities expense.
The payment you make in exchange for utilizing a property or space that you don’t own is referred to as rent expense.
Rent expense is usually related to the renting of office space, a warehouse, a piece of equipment, or a whole building.
Rent expense can be treated as either cost of sales or operating expenses depending on how it is utilized.
For example, the cost of renting equipment used for the manufacturing of a product is a part of factory overhead, which is a part of the cost of sale.
The cost of renting an office space for your admin staff is an operating expense.
Travel expense refers to the costs of necessary travels required by some business activities.
This could include the cost of fare, vehicle rentals, airfare, etc.
However, travel expense is not exclusive to the cost of transportation.
Any necessary expenses incurred during the duration of the travel are also included.
Examples are the cost of lodging, meals, rental of computers and other communications devices during the travel, etc.
For example, you sent Melvin, one of your employees, to meet a client that is in a state away from your place of business.
Over the course of Melvin’s travel, he stayed in a hotel, ate meals, and paid for wi-fi. All of these plus the cost of fares are included in the travel expense account.
In the course of running a business, certain supplies will be consumed.
The cost of these supplies is referred to as supplies expense.
The common examples of a supply consumed by businesses are paper, pens, printer ink, paper clips, etc.
The cost of these supplies is relatively low and not enough to be capitalized as assets.
Some businesses record unused supplies as an asset account (supplies on hand) and recognize it as an expense when the supplies are consumed.
However, the effort required to maintain such practice is usually not worth it so most businesses just outright record supplies as expenses whether used or unused.
Businesses advertise themselves or their products to garner a customer base.
These advertisements could come in the form of TV ads, radio broadcasts, newspaper publications, billboards, or even social media campaigns.
The cost of these advertisements is referred to as advertising expense.
Knowing which type of advertisement is effective for your business will help in minimizing your advertising expense.
Training and Development
As a business owner, you would want to have competent employees.
This can be achieved in two ways: hiring experienced employees, though they usually come with a premium -or- training and developing your employees.
The cost of going with the second option -training and developing employees- is referred to as training and development.
While not always necessary for the ongoing operation of your business, training and developing your employees can help you in producing competent employees.
Having competent employees can lead to more efficient operations, and might ultimately result in the growth of your business.
Repairs and Maintenance
As a capital asset age, repairs and maintenance will have to be performed on it.
It could be simply replacing the bolts and nuts, or changing the oil of a piece of equipment, or it could be replacing a major part so that it can be used for a longer time.
The cost of these repairs and maintenance is referred to as repairs and maintenance expense.
Depending on the nature of the expense, repairs and maintenance can be treated as an operating expense or a capital expense.
If it is for the purpose of bringing an asset to an acceptable operating level, it is treated as an operating expense.
If it is a replacement of a significant part of an asset or an upgrade to extend its useful life, it is a capital expense.
Depreciation Expense and Amortization Expense
When a business acquires a capital asset (or long-term asset), the cost of such asset isn’t recognized as an expense outright.
Rather, it is capitalized and then recognized as an expense throughout its useful life.
This expense is referred to as depreciation expense for tangible long-term assets such as equipment, machinery, furniture and fixtures, and building.
For intangible long-term assets such as software license, trademark, copyright, etc., it is referred to as amortization expense.
For example, your business acquired a piece of equipment for $50,000 and is expected to be usable for five years.
The $50,000 isn’t expensed outright but rather spread over the useful life of the equipment, which is five years.
There are several methods of calculating for depreciation, but for now, we will go with the straight-line depreciation method which divides the cost of an asset by its useful life.
In this case, you will be recognizing $10,000 depreciation expenses annually over five years.
Do note though that while Land is a capital asset, it cannot be depreciated.
Bad Debts Expense
Sometimes, a receivable can become noncollectable.
In such a case, an expense should be recognized to represent the noncollectable account.
This expense is referred to as bad debts expense.
Businesses that only do cash sales won’t encounter bad debts expense.
However, businesses that do both cash and credit sales will eventually encounter an noncollectable account.
There are two ways to record a bad debts expense: the direct write-off method, and the allowance method.
Under the direct write-off method, bad debts expense would only be recognized when there is an actual write-off of a receivable.
Under the allowance method, a portion of a receivable is recognized as bad debts expense in the period that they are earned.
The amount to be recognized will depend on the policy of the business.
A corresponding contra asset account (allowance for bad debts) is recorded. Whenever a receivable is written-off, the contra asset account is debited instead of bad debts expense.
License Fees and Taxes
Aside from federal taxes, a state may impose taxes and fees for the privilege of doing business in their jurisdiction. These are referred to as license fees and taxes. They are necessary expenses that ensure that your business is authorized to operate in the state.
Be noted that Income taxes are not included in the License Fees and Taxes account but are instead included in a separate expense account
Managing Your Operating Expenses
While the main purpose is to generate as much revenue as possible, it is also important to manage costs.
That includes managing operating expenses. A business can have a good figure for its gross profit, but if it does not manage its operating expenses well, it can still result in an overall loss.
Say for example, company AB had a gross profit of $150,000, but due to incurring $170,000 in operating expenses that were caused by wasteful usage of supplies, overpayment of new hires, and penalties due to late payment of state taxes, it had a net loss of $20,000.
Having an understanding of your business’s operating expenses is important as most of these expenses are unavoidable and necessary for the continued existence of your business.
Not only that, it can help you in knowing which areas of the business you can cost-cut.
For example, if you deem that the office space you’re renting is too much for the number of employees you’re employing, you may decide to transfer to a smaller one that has cheaper rent.
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