What is an Operating Expense?

An operating expense is like paying for parking when you drive to work...

If you drive a car to work, you need to park your car before you can head to the office and get work done. Paying for parking is a necessary cost so you can earn money. Likewise, a company needs to pay essential expenses, such as salaries and wages, rent, and licenses, to be able to carry on daily activities.

Operating expenses are the mandatory and required costs associated with running regular business activities. A company incurs operating expenses to generate revenue and maintain competitiveness. Examples of operating expenses include rent, insurance, office supplies, repair and maintenance, salary and wages, utilities, sales and marketing, and depreciation. Typically, companies refer to operating expenses as OPEX.

One of the main roles of management is to strike the appropriate balance between a low total operating expense and a high ability to make revenue. A common technique is to identify operating expenses that are fixed costs (expenses like rent that doesn't change based on the increase or decrease in a company’s daily activities) and variable costs (expenses like hourly wages that change with the level of company activity). By minimizing fixed costs, management enables the company with a lower break-even goal to start making a profit.

Some operating expenses don’t involve cash outflows. For example, company assets lose value through use and time, so a company needs to account for that loss of value. A company’s accountant uses depreciation to quantify a decline in the value of physical fixed assets, and amortization to reduce the book value of intangible assets. Both depreciation and amortization are non-cash operating expenses.

Any expenses not related to a business core operations are non-operating expenses. Examples include interest payments, losses on the sale of undeveloped land, and lawsuit settlement expenses.

The principal difference between operating expenses (OPEX) and capital expenses (CAPEX) is the timing of the expense. For example, a manufacturer needs to purchase upfront equipment that she plans to use for years to generate revenue, but she also incurs recurring daily expenses to operate that equipment. CAPEX is the upfront investment to purchase the long-term asset, and OPEX is the necessary, repeated expenses to use the asset.

CAPEX involves purchases of fixed assets — company resources that have a useful life longer than 12 months. Fixed assets may be tangible or intangible assets — items that can’t be touched, felt, or seen because they don’t have a physical form. Examples of tangible fixed assets include land, buildings (including significant upgrades or improvements), and equipment. Examples of intangible fixed assets include patents, copyrights, and trademarks.

Another difference between OPEX and CAPEX is the accounting treatment of the expenses. CAPEX depreciates over time, but OPEX is fully deductible in the same year. A company deducts CAPEX over many years after the initial expense and OPEX in the current year. The IRS lays out guidelines on how companies may capitalize different types of assets.

In summary, CAPEX provides a long-term benefit to the company, while OPEX provides immediate benefit.

The difference between operating expenses and non-operating expenses is that non-operating expenses aren’t necessary costs for a company to perform its regular daily activities. A company is still capable of running its day-to-day operations without having to incur non-operating expenses.

Examples of non-operating costs include payments for outstanding loans, lawsuit settlement costs, and write-offs of obsolete inventories.

Operating expenses are influenced by the company’s industry, business model, and other factors — and vary from company to company.

Typically, a company classifies operating expenses into:

General and administrative expenses: Typically, expenses unrelated to selling products and services. Examples include:

• Payments of salaries, wages, and benefits to administrative staff and managers
• Payments of salaries, wages, and benefits to finance, legal, risk operations, and human resources staff
• Utilities
• Insurance
• Rent
• Fees for third-party professional providers of accounting, legal, and tax services
• Depreciation
• Repair and maintenance
• Mandatory license fees and permit fees

Marketing and sales expenses: Costs directly related to the sale and promotion of goods and services. Examples include:

• Advertising and promotion expenses (e.g., direct mail, online display, mobile advertising, magazine, and newspaper ads)
• Payments of salaries, wages, and benefits to employees involved in sales, marketing, customer service, and business development efforts
• Sales commissions to sales staff
• Payments to marketing partners

Research and development expenses: Also referred to as R&D, research & development expenses to improve products or processes. Examples include:

• Pharmaceutical research expenses
• New software development costs
• Expenses for improving manufacturing processes
• Expenses in hardware and software related to research and development
• Payments of salaries, wages, and benefits to engineering, data science, and design personnel
• Payments to contractors and third-party providers of services related to research and development

Companies don’t include items that aren’t related to the core business activities as part of their operating expenses. Typically, these excluded expenses can be broadly classified as non-operating expenses and capital expenses.

• Non-operating expenses are cash outflows unrelated to business core operations. Lawsuit settlements, interest payments, and losses on the sale of long-term investments are examples of non-operating expenses.
• Capital expenses are investments to acquire a new asset or implement significant upgrades to an existing asset. Capital expenses are also referred to as capital expenditures. The purchase of a building for new company headquarters or the upgrade of a cold storage facility are examples of capital expenses.

The main difference between a non-operating expense and capital expense is its accounting treatment. Capital expenses depreciate over time, generally over more than one year. For example, a $10,000 piece of production equipment can be expensed over a five-year period or $2,000 per year. Alternatively, non-operating expenses are fully deductible in the same year that they take place. For example, a $10,000 court settlement is expensed in the same year that payment was issued.

Typically, salaries are operating expenses. Salaries, wages, and benefits for administrative staff, management, and sales & marketing staff are considered operating expenses.

The exception is the salaries involved in the production or manufacture of goods or services for sale. Salaries, wages, and benefits paid directly related to the production of goods or services aren’t operating expenses, and instead, are tracked under the cost of goods sold (COGS) — the amount a company directly spends to create a product or service.

The treatment of operating expenses on an income statement varies per company. Some companies may provide a total line item for operating expenses, while others don’t.

If the financial statement provides a total for operating expenses, then you can refer to that line item. If a total for operating expenses isn’t available, then you would use the formula for operating expenses.

The formula for operating expenses is:

Operating Expenses = Research and Development + Sales and Marketing + General and Administrative

Let’s take a look at Microsoft's operating expenses on its income statement for the quarter that ended March 31, 2022 (all values below are in millions):

Research and development $6,306M Sales and marketing $5,595M General and administrative $1,480M

(Source: Microsoft Quarterly Reports)

While the income statement doesn’t state the total for operating expenses, you can use the operating expense formula to find the total operating expense for Microsoft on that quarter (all values in millions):

Operating Expenses = Research and Development + Sales and Marketing + General and Administrative = $6,306 + $5,595 + $1,480 = $13,381M

Microsoft recorded over $13.3B in total operating expenses for that quarter.