What is Operating Expense?
Operating expenses are costs associated with keeping a business operating at full capacity. Operating expenses are not correlated to the product of a product or service, but rather the costs not associated with direct materials and labor such as:
- Rent
- Office supplies
- Accounting fees
- Insurance
- Storage costs
- Marketing
- Payroll
- Legal Fees
As you can see, the list can go on and on. Operating expenses are one of the larger sections of a detailed company ledger due to the broad criteria for transactions to fit under operating expenses.
Operating Expense Ratio
Once a firm calculates their operating expenses, they can use their findings to determine their operating expense ratio. The operating expense ratio compares a company’s expenses to their generated income within an accounting period and can be used to compare with other companies within the industry as a way of benchmarking performance. The formula to calculate the operating expense ratio is shown below:
Operating Expense Ratio = (COGS + Operating Expenses) / Revenues
Operating Expenses in Business
Calculating and monitoring operating expenses is vital for a business. Due to the vast amount of items that can be classified as an operating expense, businesses may not realize the amount of expenses that are associated with coming into work every day. As operating expenses increase, gross profit decreases and makes a company less profitable. In order to reduce operating expenses, company’s will have to reduce some aspects of operating expenses such as marketing or payroll and this will increase gross profit. The problem with this is that if a company reduces operating expenses drastically, overall performance and sales revenue might decrease. It is the accountants’ and analysts’ jobs to determine what the right course of action is to remain profitable and not have high expenses.
