What Are Operating Expenses on the Income Statement?

How Your Business Model Dictates Them

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

Why Operating Expenses Matter

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).

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.

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 business, understanding the role of operating expenses is vital to your success. Controlling operating expenses is a key component in creating a profitable business.

Expenses Can Make You More Competitive

Slashing operating expense budgets is not the only route to profitability. 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, 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 fortune running a luxury hotel such as a The Ritz-Carlton or by operating a Super 8, with its more modest accommodations. 

The Business Model Dictates Operating Expenses

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 result in "stickier" deposits—that people will want to use its services 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.

Still, the company 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 are always well-maintained, well-lit, and well-staffed. It's about prioritizing expenditures that lead to higher returns on equity.

In general, you want to work with management that ​strives to keep operating expenses 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. The real question is, what return are you getting on those expenses?

Agency Cost and Operating Expenses

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 will almost always want nicer offices, more secretaries, better facilities, faster computers, free lunches, or whatever else they can imagine. These expenses are easier to control if you have a small business, but your options are limited if you own shares in a large corporation. You must trust that the board of directors has selected management that is looking out for your best interest as a shareholder. At the least, you want a management team that understands agency costs and their potential role in driving up operating expenses beyond what's warranted by the business model.

The Bottom Line

Operating expenses represent an important part of a company's income statement and a crucial piece of its overall financial picture. To really understand what they mean, though, you have to understand the company as a whole—and what those expenses mean for its bottom line.

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