Operating Expense Definition
Operating Expense (OPEX) is the cost incurred in the normal course of business. It does not include expenses such as the cost of goods sold directly related to product manufacturing or service delivery. They are easily available in the income statement and other costs subtracted from the operating income to determine net profit.
Following are some of the common Operating Expenses –
- Selling General and Admin Expenses (SG&A) – 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 other expensesOther ExpensesOther expenses comprise all the non-operating costs incurred for the supporting business operations. Such payments like rent, insurance and taxes have no direct connection with the mainstream business activities. that do not belong in COGS. This expense category is recognized as an 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 referred to as COGS (cost of goods sold)COGS (cost Of Goods Sold)The Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. , and the category comprises of inventory cost, freight expense, labor cost, factory overhead, etc.
However, it is to be noted there are a few other expenses that are not included in the calculation of OPEX as it is considered unrelated to a company’s core operations. This category of expenses includes costs such as interest expenseInterest ExpenseInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense. or other costs of borrowing, one-time settlement, accounting adjustments, taxes paid, etc.
Table of contents
Let us take an example of an income statement of a company named XYZ Ltd to illustrate how OPEX is deducted from net sales in determining operating profit and the net profit. All the amounts shown in the table below are in millions.
|Particulars||Amount (in millions)|
|Raw Material Cost||$50|
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 salesNet SalesNet sales is the revenue earned by a company from the sale of its goods or services, and it is calculated by deducting returns, allowances, and other discounts from the company's gross 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 essential to understand the concept of this expense as it is a crucial 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 a company’s financial performance. The thumb rule states that the lower a company’s OPEX, the more profitable the company is.
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 costLabor CostCost of labor is the remuneration paid in the form of wages and salaries to the employees. The allowances are sub-divided broadly into two categories- direct labor involved in the manufacturing process and indirect labor pertaining to all other processes.,
etc. However, these expenses are part of daily decisions, and such financial performance based on OPEX can be regarded as a measure of managerial flexibility and competency, especially during a difficult economic scenario.
Although it is seen as a measure of financial performance, it is essential to note that it varies across industries, i.e., some industries tend to have higher operating expenses than others. Consequently, comparing this expense among companies within the same industry is more meaningful, 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 successfully reduced the OPEX to gain a competitive advantage, which has eventually resulted in increased earningsResulted In Increased EarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments.. Nevertheless, it is to be taken into cognizance that the reduction of these expenses can also compromise product integrity or quality of operations, which may lead to the 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 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, then used to compare 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 captures the amount of profit generated from operating the business. It is computed by deducting OPEX, such as salaries, depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. , and COGS, from net sales or revenue. The operating income can also be calculated from a company’s gross profitGross ProfitGross Profit shows the earnings of the business entity from its core business activity i.e. the profit of the company that is arrived after deducting all the direct expenses like raw material cost, labor cost, etc. from the direct income generated from the sale of its goods and services. 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 article has been a guide to what is Operating Expenses (OPEX). Here we discuss how to calculate Operating expenses using its formula and practical examples and uses. You may also have a look at the following accounting articles –