Operating Expense on the Income Statement

Investing Lesson 4 - Analyzing an Income Statement

Operating expenses on the income statement consists of costs not directly required in the manufacturing or sale of goods or service. Common operating expenses include advertising, marketing, payroll, office supplies, accountants, lawyers, etc.
Operating expenses on the income statement consists of costs not directly required in the manufacturing or sale of goods or service. Common operating expenses include advertising, marketing, payroll, office supplies, accountants, lawyers, etc. DNY59/Getty Images

The next section of the income statement focuses on the operating expenses that arise during the ordinary course of running a business. Operating expenses include everything from employee salaries to the toilet paper in the office restrooms; research and development to electricity bills; copy paper to corporate phone lines and high-speed Internet.

The general rule of thumb: If an expense doesn't qualify as a cost of goods sold, meaning it isn't directly related to producing or manufacturing a good or service, it goes under the operating expense section of the income statement.

There are several categories, the biggest of which is known as Selling, General, and Administrative Expense, but we'll get to that later in this article.

Whether you are a new investor trying to study a company's annual report and 10K, a business owner examining your operations, or an entrepreneur considering buying or starting a new undertaking, understanding the role of operating expenses is vital to your success. This includes developing a firm grasp on the company's business model and how that plays into its competitive strengths.  

For example, some businesses have a high-touch, top-shelf customer service model that relies upon making the customer experience extraordinary. This means never having the phone ring more than twice before it's answered, proactively solving problems or making suggestions, befriending clients on a more personal level, as well as doing whatever is necessary to bring a smile to the client's face.

This typically results in higher operating expenses on the income statement but, in exchange, you often get much higher customer retention rates and pricing power. Other businesses focus on a bare-bones, do-it-yourself, rock-bottom cost model that results in operating expenses being a mere fraction of those found at competitors when measured as a percentage of revenue.

Both can be the pathway to success, just as you can build a fortune running a luxury hotel such as a Ritz Carlton or by operating a Super 8, which is more modest in its accommodation. One of the largest banks in America is famous for purposely running operating expenses about 10% to 15% higher than competitors because its executives and shareholders believe that shorter lines combined with a face-to-face presence in the community results in "stickier" deposits; that people will want to use them rather than the folks online or across the street. The results speak for themselves because this particular financial institution is the envy of the commercial banking sector and funds most of its balance sheet at a cost of a few dozen basis points.

In general, you want to work with managements that strive to keep operating expense as low as possible within the business model they are following, without going so low they begin to damage the underlying business by effectively putting the company into liquidation. Again, it's important to understand the business model in order to gauge whether or not its operating expenses are too low or too high. To go back to the bank I just used as an illustration, the former CEO famously wouldn't buy the employees at headquarters a Christmas tree, telling them it wasn't the stockholders' job to pay for their decorations.

On the other hand, the branch offices were always well-maintained, well-lit, and well-staffed. It's about prioritizing expenditures that lead to higher returns on equity.

Agency Cost and Operating Expenses

One of the biggest challenges to controlling operating expenses is a risk known as agency cost. The short version: Agency cost is the inherent conflict between owners and managers. Those who work in the business are almost always going to want nicer offices, more secretaries, better facilities, faster computers, free lunches, or whatever else they can imagine. These are easier to control if you have a small business but your options are limited if you own shares in a large corporation. You have to trust that the board of directors has selected a management that is looking out for your best interest.

This page is part of Investing Lesson 4 - How to Read an Income Statement. To go back to the beginning, see the Table of Contents.