In business, the term operating expense (OPEX) appears in budgeting and spending, but also as an Income statement term in financial accounting.
In brief, operating expenses include most expenditures for operating the firm's normal line of business, which are not capital spending. Operating expenses do not result in capital assets. Instead, they serve entirely for operating the business. On the Income statement, they are subtracted from revenues in the accounting period they are incurred.
Explaining Operating Expense in Context
This article further defines and explains operating expense as a term in budgeting and planning, and also as an Income statement category. Note especially that the term appears in context with related terms and concepts, including:
- What are operating expenses (OPEX)?
- Define your terms! What does "operating expense" mean?
- Operating expense role in budgeting and spending.
- Operating expense role on the Income statement.
- How do operating expenses bring tax savings?
- Example Income statement with operating expenses.
In everyday usage, most people make little or no distinction between the terms cost, expenditure, and expense. Outside of the business setting, these terms simply refer to spending—money used to purchase something. And, outside of business, people use these terms more or less interchangeably
In business, however, these terms have different meanings, especially in accounting, finance, budgeting, and business planning. As a result, businesspeople working in these areas need to understand precisely the meaning of each. And, it is not easy to define operating expense properly without this understanding.
The Meaning of Expense-Related Terms
Start with the most inclusive of these terms, cost. All of the events Exhibit 1 below (blue cells) are in fact costs. Business people sometimes define Cost simply as the amount of money required to pay for something. A better and more useful alternative defines cost as "an outcome that works against meeting business objectives." As a result, the latter meaning of cost extends to include non financial costs. (See the article Business Benefit for more on the meaning of cost.)
Exhibit 1. In accounting, finance, and budgeting, the term operating expense refers to one kind of expenditure.
- Firstly, to purchase an asset.
- Secondly, to reduce a liability (e.g., payoff a loan).
- Thirdly, to distribute funds to shareholder owners (e.g., dividends).
- Fourthly, as a cash expense (e.g., to pay employee wages).
Formal Definition: Expenses Use Up Assets
Accountants and financial specialists define expense as follows:
An expense is decrease in owner’s equity due to using up assets.
Notice especially that the formal definition of "expense" refers to two Balance sheet categories: (1) Owner's equity and (2) Assets. And, every expense involves using up one kind of asset or another. It is the depletion, or using up of assets that distinguishes expenses from other kinds cost events.
- An expense for office supplies, for instance, uses up cash assets. Spending for office supplies is an operating expense.
- Purchasing a capital asset (such as a factory machine) results in an asset that decreases book value over time through depreciation expense. Depreciation is non cash expense and usually an operating expense as well.
- A prepaid expense, such as prepaid floor space rent, is an asset that turns into an ordinary cash operating expense as the occupancy period passes.
Operating Expenses and Non Cash Expenses.
Sections below show how to classify expenses in two different ways.
- Firstly, expenses are either operating expenses or non-operating expenses.
- Expenses incurred in operating the firm's core line of business are operating expenses. Employee wages, inventory handling costs, and expenditures for office supplies are operating expenses.
- Expenses incurred outside the core line of business are called, not surprisingly, non-operating expenses. For instance, when a retail merchant paying interest on a bank loan is paying a non operating expense.
- Secondly, expenses are either cash expenses or non-cash expenses.
- Depreciation, for instance, is an expense because it uses up an asset: It reduces book value of a Balance sheet asset.
- Because it does not involve cash payment, depreciation is a non-cash expense. Non cash expenses use up assets other than cash.
- When depreciation and other non cash expenses occur in the core business, they are also operating expenses.
Sections below further explain the role of these distinctions for budgeting and financial reporting.
In brief, most routine expenditures a firm makes in normal business operations are operating expenses, except for the few cases named above (e.g., asset purchase). Operating expenses typically represent spending for such things as:
- Employee salaries/wages and overhead.
- Contract labor.
- Office space rental or lease and utilities costs).
- Employee travel and training expenses.
- Computer maintenance expenses.
- Marketing communication and advertising.
- Telephone, Internet services, heating, electricity, and other utilities.
- Insurance costs.
- Outside consultant fees.
- Office supplies.
The Operating Expense (OPEX) budget in the budget hierarchy
Budget planning begins with high level budgets, primarily the entity-wide capital and operating budgets.
- Many firms plan the capital budget on an entity-wide basis, choosing not to further divide it into individual department budgets. Individual items for the high level capital budget may nevertheless appear in categories. And, these may represent major components of the firm's asset structure, such as"Inventory purchase".
- On the other hand, large firms almost always plan spending and revenues for the operating budget in the framework of a budget hierarchy.
- Individual items in the top level operating budget may carry the names of departments or groups, such as "Marketing." Or, items may name basic roles, such as "General management and administration".
- In the budgeting process, senior managers first set spending levels for higher level categories such as the "Marketing Budget." . Then, Marketing managers further apportion this into lower level budgets for areas such as market research, advertising, and events.
The two top level budgets together cover most all spending for the entire entity. Note, however, that many firms also plan additional small budgets for non-operating expenses, or "emergency contingencies." These latter kinds of budgets normally play a minor role in business budgeting.
Exhibit 2 shows a few of the levels in one firm's budget hierarchy:
Exhibit 2. Part of one firm's budget hierarchy. Funding requests for the next budgeting cycle normally start at the bottom. Requests pass from the bottom up through the hierarchy, where they aggregate at the highest level. Budget Office staff and senior leaders then make spending decisions for the highest levels, and then move downward.
Major categories of expense items may appear on the Income Statement as follows:
- Cost of Goods Sold
The costs of producing goods or services
- Operating Expenses – Selling Expenses
The costs of selling the goods or services
- Operating Expenses – General and Administrative Expenses
Overhead, support, and management costs from across the company.
- Financial Revenues and Expenses
These include revenues from invested funds and costs from financing borrowed funds, for firms that are not themselves in banking or financial services.
- Extraordinary Items
These may include large gains or losses from selling land or major assets, or from major actions restructuring the company (for example, the expenses of laying off part of the workforce).
All of these categories may include "operating expenses" in the budgetary sense.
Note especially that Operating expenses is refers to one or two major Income statement categories: The second and third bullet points above.
- This category normally appears beneath the Gross profit line but above Extraordinary items and above Financial income/expenses.
- The category sometimes appears under the name Selling, General, and Administrative Expenses, or SG&A.
- And, that sometimes divides into two sub-categories: Firstly Selling Expenses and secondly, General and Administrative Expenses.
In any case, Income statement "Operating expenses" (SG&A) do not impact reported Gross profit or Gross margin because they appear below the Gross profit line. However, these operating expenses do impact profits and margins below them: Operating profit, Operating margin, Net profit and Net profit margin.
For an Income Statement example showing entries in the major statement categories, including Operating Expenses, see Exhibit 1, below.
An operating expense does bring some tax savings. The expense lowers reported income and, as a result, that reduces the income tax liability. Specifically:
Tax Savings on Expense = Expense x Tax Rate
For example, consider a firm taking in $100 revenue with a 30% tax rate on operating income.
- As a result, the firm pays taxes of $30 on $100 revenues, if it has no expenses.
- If, however, the firm incurs expenses of $60 to produce the $100 revenues, its income for tax purposes is $100 less $60, that is, $40. As a result, the 30% tax would apply only to $40 for a tax of $12. That is a tax savings of $30 - 12 or $18, or:
Tax Savings on Expense = $60 x 30% = $18
Exhibit 3, below, shows an example Income statement with typical detail for an Annual Report.
|Grande Corporation Figures in $1,000's
Income Statement for Year Ended 31 December 20YY
Gross sales revenues
Less returns & allowances
Net sales revenues
Cost of goods sold
Depreciation, mfr equipment
Other mfr overhead
Net mfr overhead
Net cost of goods sold
Depreciation, Store equip
Other selling expenses
Total selling expenses
General & Admin expenses
Other general & admin expenses
Total general & admin exp
Total operating expenses
Operating Income Before Taxes
|Financial revenue & Expenses
Revenue from investments
Less interest expense
Net financial gain (expense)
Income before tax & ext items
Less income tax on operations
Income before extraordinary items
Sale of land
Less initial cost
Net gain on sale of land
Less income tax on gain
Extraord items after tax
|Net Income (Profit)||2,126|
Exhibit 3. Example Income statement, showing how Revenue and Expense account items and their balances represent the Income statement equation:
Income = Revenues – Expenses.