Operating expenses are one of the entries that appear on an income statement for a business. These are the normal costs that it takes to run that business.
What these costs will be depends on the type of business. They can include a lot of things.
Paying a worker is an operating expense. So is buying toilet paper for a bathroom. Any cost that it takes to keep a business running for a normal day, week, or month is an operating expense.
Learn more about the many types of operating expenses, as well as what they mean on an income statement.
What Are Operating Expenses?
There is a good rule of thumb to decide what is and is not an operating expense. If an expense isn't directly related to producing or making a good or service (also known as the cost of goods sold), it counts as an operating expense.
There are several types of operating expenses. Most often, the biggest is known as Selling, General, and Administrative Expense (SGA).
Operating expenses include many kinds of costs and spending. These might be:
- Office supplies
- Research and development
- Utility bills, such as internet or electricity
- Phone lines
Most businesses will try to keep their operating expenses between 60% and 80% of their gross revenue. This varies quite a bit, though, based on the business model and industry.
How Operating Expenses Work
Making sure that these expenses don't run too high is a key part of having a business that makes a profit. However, it's not the only route a company might take.
Some businesses have a model that relies on going above and beyond to ensure that each customer gets the best service possible. This could mean:
- Never having the phone ring more than twice before it's answered
- Solving problems before they happen
- Having friendly relationships with clients
- Always trying to bring a smile to the client's face
This kind of service often needs higher operating expenses on the income statement. In return, though, a business often has very loyal customers who stick around for a long time. This allows them to charge higher prices and make a bigger profit that way.
Other businesses keep their costs low. They don't have perks or frills, which keeps operating expenses small compared to other businesses in their industry.
Both models can be a pathway to success. For example, a luxury hotel such as the Ritz-Carlton would be a high-touch customer service model with larger operating costs. A Super 8 motel, by contrast, has a more modest business model that keeps costs low for the business and the guests.
Both choices can work and make a profit. You just have to know what type of business you're running and what sort of customer you will bring in.
The Business Model and Operating Expenses
Picture a local bank that wants to compete with cheaper, online banks. To do this, it operates with higher costs. It might hire more tellers to keep lines and waits shorter, or support local sports teams so that locals often see the bank's name around town.
The bank doesn't pay for things like a Christmas party at company headquarters. But the branch offices are always extra clean, well-lit, and well-staffed. It keeps the focus on the costs that lead to higher returns and more clients staying loyal.
Putting money into these costs could mean 10% to 15% higher operating expenses than the industry standard. But being able to keep those deposits on the balance sheet means that the cost of the higher operating expenses is worth it.
Operating expenses require a balance. You want to keep costs as low as possible within the business model a company is following. But you don't want to go so low that it harms the business or drives away clients. For every cost, you should have an idea of what return you will get and whether it is worth it.
What It Means for the Individual Investor
One of the biggest challenges in controlling operating expenses is a risk known as agency cost. Agency cost is the conflict that can happen between owners and managers.
The people who work in the business may always want nicer offices, more support staff, better buildings, faster computers, free lunches, and other perks or updates. These expenses are easier to control in a small business.
At a bigger company, the board of directors must choose managers that are looking out for the best interest of a shareholder. The management team must understand agency costs and why they can't drive up operating expenses beyond what the business model needs.
If you are an investor, you can't look only at the operating expenses when making choices about where to invest. Instead, look at where those costs are going and whether money is put in places that create good returns.
Careful, strategic use of spending 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.
- For most businesses, these costs should be between is 60% to 80% of gross revenue.
- Different business models and industries require different operating expenses.
- The return on investment of these costs is what defines a company's health.