What Are Operating Expenses?

Operating Expenses on the Income Statement Explained

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

Operating expenses are one of the main entries that appear on an income statement for a business. These are the normal costs that it takes to run that business.

The nature of these costs will depend on the type of business. They can include a wide range of things. For example, 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 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 service (also known as the cost of goods sold), it counts as an operating expense. Think what it takes to keep things running smoothly, but do not include supplies it takes to make products.

There are many 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%-80% of their gross revenue. This can vary 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 to profit 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 it. This might look like a retail store with high mark-up value that relies on high-end service to charge more for their product. They may 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 picked up
  • Solving problems before they happen
  • Having 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 give 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 holidays. The types of costs that count as operating expenses are many, 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. This allows them to charge higher prices and make a bigger profit that way.

The Low Cost, No Frills Model

Other businesses follow the model to make profit by 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 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.

Sample Operating Costs for a Custom Business Model

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, or other types of outreach.

The bank might not pay for things like a lavish holiday party each year. Instead they 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 standard. But the hope is that it will all be worth it, 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 is felt. For each line item cost, you should have a good concept of how much return it creates, and whether it is worth it.

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 or product or service it offers (or aims to offer), and where they might be spending more or less than their 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. 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 costs 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 have a sense of 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 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 create 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%-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.