What Are Operating Expenses?

Woman working in modern business office
••• MoMo Productions / Getty Images
DEFINITION

Operating expenses on an income statement are the costs that arise during the ordinary course of running a business.

Definition and Examples of Operating Expenses

There is a good rule of thumb to help you decide what is and is what is not an operating expense. If an expense isn't directly related to producing or making a good or providing a service (also known as the "cost of goods sold"), it counts as an operating expense. Think about what it takes to keep things running smoothly, but do not include its supplies to make products. Operating expenses are located on the income statement.

There are many types of operating expenses, and most fall under selling, general, and administrative expense (SGA).

Examples of operating expenses include:

  • Phone lines
  • Office supplies
  • Research and development
  • Utility bills, such as internet or electricity
  • Rent and repair costs for non-production buildings
  • Compensation, payroll tax expenses, and benefits for non-production employees
  • Contributions to pension plans for non-production employees
  • Marketing costs such as advertising, direct mail, and sales material

Most businesses will try to keep their operating expenses between 60% and 80% of their gross revenue. This range can vary quite a bit, though, based on the business model and industry.

How Operating Expenses Work

Making sure that 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 to profit that a company might take.

The High-Cost, High-Price Model

Some businesses can spend more on behind-the-scenes costs if they can pull in more income to cover them. One example would be a retail store with a high mark-up value, that relies on high-end service to charge more for their product. It may have a model that relies on going above and beyond to ensure that each customer gets the best service possible. That could mean:

  • Never having the phone ring more than twice before it's picked up
  • Preventing problems
  • Maintaining friendly relationships with clients
  • Always trying to bring a smile to the client's face

This level of service often calls for higher operating expenses on the income statement. It costs more to uphold high standards of service, because you may need to invest in training your employees, or you may need more people on the floor. You may subscribe to a music-streaming service to set a certain ambiance in your retail store, or you may offer free gift wrapping during the holiday season. There are many types of operating expenses, and they can add up. In return, though, a business of this type often has very loyal customers who stick around for a long time.

The Low-Cost, No-Frills Model

Other businesses try keeping their costs low. They don't have perks or frills, which keeps operating expenses small, compared to others 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 approaches 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.

Sample Operating Costs for a Custom Business Model

Picture a local bank that wants to compete with cheaper, online banks. To do that, it operates with higher costs. It might hire more tellers to keep lines and waits shorter, or support local sports teams so that locals will often see the bank's name around town.

The bank might not pay for things like a lavish holiday party each year. Instead, it might make an effort to always keep the branch office extra-clean, well-lit, and well-staffed. This approach keeps the focus on the costs that lead to higher returns and more clients staying loyal.

Putting money into these types of costs could mean that operating expenses are higher than the industry average. The hope is that it will all be worthwhile when the high costs are met with high deposits on the balance sheet.

Operating expenses require a balance. You want to keep costs as low, based on the model your company follows, but you don't want to go so low that it drives away clients, or that a major lack of quality is felt. For each line item cost, you should have a good idea of how much return it generates, and whether it is worthwhile.

What It Means for the Individual Investor

If you are thinking about investing in a company, you'll want to look at its balance sheet and assess how well it might perform over time, based on a number of metrics. Operating costs can tell you a lot about a business, such as the level of product or service it offers (or aims to offer) and where it might be spending more or less than its competitors. You can also spot red flags. One of the biggest challenges in keeping operating expenses under control is a risk known as "agency cost," which 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 costs are easier to control in a small business.

At a bigger company, the board of directors must choose managers who are looking out for the best interests of the shareholdes. The management team must have a sense of agency costs and why they can't drive up operating expenses beyond what the business model requires.

You can't look at operating costs alone to make choices about where to invest. Instead, look at where those costs are going and whether money is put in places that lead to good returns.

Careful, strategic use of spending is an important measure of a company's value.

Key Takeaways

  • Operating expenses on an income statement are costs that arise in the normal course of doing business.
  • For most businesses, these costs should be between 60% and 80% of gross revenue.
  • Different business models and industries require different operating expenses.
  • The return on investment of these costs is what indicates a company's financial health.

Article Sources