Operating Expense Definition
Operating Expense (OPEX) is the cost that is incurred in the normal course of business and does not include expenses such as the cost of goods sold which are directly related to product manufacturing or service delivery. They are easily available in the income statement along with other costs which are subtracted from the operating income to determine net profit.
Following are some of the common Operating Expenses –
- Selling General and Admin Expenses (SG&A) – These are usually regarded as “overhead”. The SG&A category includes expenses such as sales commissions, advertising, promotional materials, rent, utilities, telephone, research, and marketing.
- Management Expenses – It also includes costs such as management & staff compensation and various other expenses that do not belong in COGS. This category of expense is recognized as operating expense in the income statement because it is not practically possible to operate the main business without incurring these expenses.
- Labor Cost, Factory Overheads etc – This expense can also include costs which are referred to as COGS (cost of goods sold) and the category comprises of inventory cost, freight expense, labor cost, factory overhead etc.
However, it is to be noted there are few other expenses which are not be included in the calculation of OPEX as it is considered unrelated to a company’s core operations. This category of expenses include costs such as interest expense or other costs of borrowing, one-time settlement, accounting adjustments, taxes paid etc.
Let us take an example of an income statement of a company named XYZ Ltd to illustrate how OPEX are deducted from net sales in the determination of operating profit and the net profit. All the amounts shown in the table below are in millions.
For the calculation of Net Profit first, we will calculate the following values.
- COGS = ($50 + $20) million
- COGS = $70 million
Operating Expense Formula = Sales commission + Rent + Utilities + Depreciation
- = ($10 + $5 + $5 + $8) million
- = $28 million
Now, Operating income = Net sales – COGS – Opex
- Operating income = ($125 – $70 – $28) million
- Operating income = $27 million
Finally, Net profit = Operating income – Interest expense – Tax Paid
- Net profit = ($27 – $6 – $2) million
- Net profit = $19 million
Relevance and Uses of OPEX
It is very essential to understand the concept of this expense as it is a key component in the calculation of operating profit which is then used to calculate net profit, which is again a critical factor in the assessment of financial performance of a company. The thumb rule states that lower a company’s OPEX, the more profitable is the company.
The formula for calculation of net profit (as per popular practice) is given below,
Operating profit = Net sales – COGS – Opex
It is to be noted that several factors can impact this expense which includes (not exhaustive) pricing strategy, raw materials price, labor cost etc. However, these expenses are part of the day to day decisions that a manager makes and as such financial performance based on OPEX can be regarded as a measure of managerial flexibility and competency, especially during the difficult economic scenario.
Although it is seen as a measure of financial performance, it is important to note that it varies across industries i.e. some industries tend to have higher operating expenses than others. Consequently, it is more meaningful to compare this expense among companies within the same industry such that the designation of “high” or “low” expenses should be made within that context.
Another interesting thing about controlling it is to find the right balance which can be difficult, but once achieved it can yield significant returns. There are several examples where the company has been successful in reducing the OPEX to gain a competitive advantage which has eventually resulted in increased earnings. Nevertheless, it is to be taken into cognizance that the reduction of these expenses can also result in compromise of product integrity or quality of operations which may lead to deterioration of the company’s reputation in the long run.
Other Important Terms related to OPEX
Given below are some of the terms related to this expense.
#1 – Operating expense ratio
It is a measure that is used to assess what portion of the income is consumed in performing a normal course of the business. It is calculated by dividing the company’s OPEX by its total revenue or net sales which is then used for comparison among companies in the same industry. Mathematically, it is represented as,
#2 – Operating Profit
The operating profit is a measure of the financial performance of a company and basically captures the amount of profit generated from operating the business. It is computed by deducting OPEX such as salaries, depreciation, and COGS from net sales or revenue. The operating income can also be calculated from a company’s gross profit by subtracting all the OPEX. Gross profit is equivalent to net sales minus COGS. Mathematically, it is represented either as,
Gross profit = Net sales – COGS
This has been a guide to what is Operating Expenses (OPEX). Here we discuss how to calculate Operating Expense using its formula along with practical examples and uses. You may also have a look at the following accounting articles –