What Is an Operating Expense?
An operating expense is an expense that a business incurs through its normal business operations. Often abbreviated as OpEx, operating expenses include rent, equipment, inventory costs, marketing, payroll, insurance, step costs, and funds allocated for research and development.
Key Takeaways
- An operating expense is an expense that a business incurs through its normal business operations.
- Operating expenses include rent, equipment, inventory costs, marketing, payroll, insurance, step costs, and funds allocated for research and development.
- The Internal Revenue Service (IRS) allows businesses to deduct operating expenses if the business operates to earn profits.
- By contrast, a non-operating expense is an expense incurred by a business that is unrelated to the business's core operations.
- A capital expense is a different type of expense that relates to acquiring, maintaining, or upgrading an asset.
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Understanding Operating Expenses
Operational Activities
Operating expenses are the costs that a company incurs while performing its normal operational activities. Operational activities are those tasks that must be undertaken from day to day to operate the business and generate revenue. Operating expenses are different from expenses relating to, for example, investing in projects and borrowing.
Operating expenses can differ according to what a company does. In fact, some activities (and expenses) might be considered operational in one industry but not so in another. It's important to understand the distinction due to the tax-deductibility of operating expenses. Some common types of operating expenses include:
- Rent
- Salaries and wages
- Accounting and legal fees
- Bank charges
- Sales and marketing fees
- Office supplies
- Repairs
- Utilities expenses
- Cost of goods sold
Managing Operating Expenses
One of the responsibilities that management must contend with is determining how to reduce operating expenses without significantly affecting a firm's ability to compete with its competitors.
Operating expenses are necessary and unavoidable for most businesses.Some firms successfully reduce operating expenses to gain a competitive advantage and increase earnings.However, reducing operating expenses can also compromise the integrity and quality of operations.Finding the right balance can be difficult but can yield significant rewards.
An income statement tracks the income and expenses of a company over a certain period to provide an image of its profitability. Income statements typically categorize expenses into six groups: cost of goods sold; selling, general, and administrative costs; depreciation and amortization; other operating expenses; interest expenses; and income taxes.
All these expenses can be considered operating expenses, but when determining operating income using an income statement, interest expenses and income taxes are excluded.
Fixed and Variable Costs
Operating expenses can befixed or variable. A fixed cost is set for a fixed period of time; it doesn't change. It typically relates to recurring expenses such as rent, interest payments, insurance payments, and bank fees. It isn't affected by the production levels of goods and services.
A variable cost can change, depending on the production and sales levels of products or services.
A company can better manage its operating expenses when its managers understand the difference between its fixed and variable costs.
Operating vs. Non-Operating Expenses
A non-operating expense is an expense incurred by a business that is unrelated to the business's core operations. The most common types of non-operating expenses are interest charges or other costs of borrowing and losses on the disposal of assets. Accountants sometimes remove non-operating expenses to examine the performance of the business, ignoring the effects of financing and other irrelevant issues.
The Internal Revenue Service (IRS) allows businesses to deduct operating expenses if the business operates to earn profits. However, the IRS and most accounting principles distinguish between operating expenses and capital expenditures.
Example
Here's a look at a simple income statement that shows the operating expenses for a company.
:max_bytes(150000):strip_icc()/SampleIncomeStatement-6c65ce80044e44cea6f20a48e8072f9e.png "Operating Expense Definition and How It Compares to Capital Expenses (2)")
Source: Harvard Business School Online
OpEx vs. CapEx
Abbreviated as CapEx, capital expenditures are purchases that a business makes as an investment.Capital expenditures include costs related to acquiring, maintaining, or upgrading tangible and intangible assets. Tangible business assets include real estate, factory equipment, computers, office furniture, and other physical capital assets. Intangible assets include intellectual property, copyrights, patents, and trademarks.
The IRS treats capital expenses differently than it treats operating expenses. According to the IRS, operating expenses must be ordinary (common and accepted in the business trade) and necessary (helpful and appropriate in the business trade).In general, businesses are allowed to write off operating expenses for the year in which the expenses were incurred. Alternatively, businesses must capitalize capital expenses/costs.
For example, if a business spends $100,000 on payroll, it can write off the entirety of that expense the year it is incurred, but if a business spends $100,000 buying a large piece of factory equipment or a vehicle, it must capitalize the expense or write it off over time. The IRS has guidelines related to how businesses must capitalize assets, and there are different classes for different types of assets.
What Is a Non-Operating Expense?
A non-operating expense is a cost that is unrelated to the business's core operations. The most common types of non-operating expenses are interest charges or other costs of borrowing and losses on the disposal of assets. Accountants sometimes remove non-operating expenses to examine the performance of the business, ignoring the effects of financing and other irrelevant issues.
What Are Capital Expenses?
CapEx includes costs related to acquiring or upgrading capital assets such as property, plant, and equipment. These expenses, unlike operating expenses, can be capitalized for tax purposes. The IRS has guidelines related to how businesses must capitalize assets, and there are different classes for different types of assets.
What Is the Tax Treatment for Operating Expenses?
The Internal Revenue Service (IRS) allows businesses to deduct operating expenses if the business operates to earn profits. According to the IRS, operating expenses must be ordinary (common and accepted in the business trade) and necessary (helpful and appropriate in the business trade). In general, businesses are allowed to write off operating expenses for the year in which the expenses were incurred.
The Bottom Line
Operating expenses are the expenses that arise from daily, core operational activities conducted by a company. They are the costs involved in running a business to generate income. Operating expenses can be fixed or variable. Typically, they're tax deductible as long as a company operates to earn a profit, expenses are commonly known, and necessary.
