What Are Operating Expenses?
Operating Expenses on the Income Statement Explained
Operating expenses on an income statement are the costs that arise during the ordinary course of running a business.
What Are Operating Expenses?
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 of operating expenses, the biggest of which is known as Selling, General, and Administrative Expense (SGA).
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.
Most businesses will try to keep their operating expenses between 60% and 80% of their gross revenue. However, this varies quite a bit, depending on the business model and industry.
How Operating Expenses Work
Controlling operating expenses is a key component in creating a profitable business. However, it's not the only route to profitability.
Some businesses have a high-touch 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, and doing whatever is necessary to bring a smile to the client's face.
Top-shelf service typically results in higher operating expenses on the income statement but, in exchange, you often get much higher customer retention rates and the freedom to charge higher prices.
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 business running a luxury hotel such as The Ritz-Carlton, or by operating a Super 8, with its more modest accommodations.
The Business Model and Operating Expenses
Let's consider this hypothetical scenario: A bank strategically operates with higher costs because it wants to keep deposits away from online-only banks or the competitor across the street. The cost to invest in shorter lines and a face-to-face presence in its community could mean 10% to 15% higher operating expenses than the industry standard. However, the ability to keep those deposits on the balance sheet outweighs the cost of the higher operating expenses.
While this bank might not pay for holiday decorations at company headquarters, it keeps the branch offices well-maintained, well-lit, and well-staffed. It prioritizes the expenditures that lead to higher returns on equity.
It's a balance to keep operating expenses as low as possible within the business model a company is following, without going so low the underlying business is damaged. The real question is: What return are you getting on the expenses?
What It Means for the Individual Investor
One of the biggest challenges in 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 may always want nicer offices, more support staff, better facilities, faster computers, free lunches, or whatever else they can imagine. These expenses are easier to control in a small business. The board of directors at a larger company must select management that is looking out for the best interest of a shareholder. At the least, the management team must understand agency costs and their potential role in driving up operating expenses beyond what's warranted by the business model.
An investor can't look only at the operating expenses when making investment choices. Just as the hypothetical bank example illustrated, strategic use of spending—investing in places with the most likelihood of direct return—is an important measure of a company's value.
- Operating expenses on an income statement are costs that arise in the normal course of business.
- A benchmark operating margin range for a business is 60% to 80%.
- Different business models and industries require different operating expenses.
- The return on investment of these expenses is what defines a company's health.