What are operating expenses?

Definition and Examples of Operating Expenses

Operating expenses on the income statement are the costs that arise during the normal course of business operations.

Operating expenses on the income statement are the costs that arise in the context of conducting business. For most companies, these costs should be between 60% and 80% of total revenue. Different business models and industries require different operating expenses. The return on investment in these costs is what indicates the financial health of the company.

How Operating Expenses Work

Ensuring that expenses do not escalate is a fundamental part of having a company that is profitable. However, this is not the only path to profitability that a company may take.

High-Cost, High-Price Model

Some companies can spend more on back-end costs if they are able to bring in more income to cover them. For example, there might be a retail store with high sales value, relying on high-level service to generate more money from its product. It may have a model based on excellence and ensuring that every customer receives the best service possible. This can mean:

• The phone does not ring more than twice before answering
• Problem prevention
• Maintaining friendly relationships with customers
• Constantly trying to bring a smile to the customer’s face

This level of service requires higher operating expenses on the income statement. It costs more to maintain high service standards, as you may need to invest in training your staff, or you may need more people in the store. You may subscribe to a music streaming service to provide a certain atmosphere in your retail store, or you may offer free gift wrapping during the holidays. There are many types of operating expenses, and they can add up. In contrast, this type of business typically has very loyal customers who stay for a long time.

Low-Cost, Basic Service Model

Other companies try to keep their costs low. They lack frills or embellishments, making their operating expenses small compared to other companies in their industry.

Both models can be a pathway to success. For example, a luxury hotel like the Ritz-Carlton will have a high-level service model with higher operating costs. In contrast, a Super 8 hotel has a more modest business model that keeps costs low for the company and guests.

Both approaches can work and generate profit. You just need to know what type of business you are in and what type of customer you will attract.

Operating Expenses for a Customized Business Model

Imagine a local bank that wants to compete with cheap online banks. To do this, it operates with higher costs. It may hire more tellers to keep lines and wait times shorter, or it may sponsor local sports teams so residents see the bank’s name in town.

The bank may not spend on things like a lavish holiday party every year. Instead, it may make an effort to always keep the branch office extra clean, well-lit, and well-staffed. This approach focuses on costs that lead to higher returns and more loyal customers.

Investing money in these types of costs may mean that the operating expenses are higher than the industry average. The hope is that everything will be worthwhile when the high costs are met with high deposits on the balance sheet.

Operating expenses require balance. You want to keep costs low, based on your business model, but you do not want to drop to a level that drives customers away or makes them feel a significant lack of quality. For each cost item, you should have a good idea of how much return it generates and whether it is worth it.

What

This means for the individual investor

If you are thinking about investing in a company, you will want to look at its budget and assess how it has performed over time, based on a number of metrics. Operating costs can tell you a lot about a company, such as the level of product or service it provides (or aims to provide) and where it may be spending more or less than its competitors. You may also uncover red flags. One of the biggest challenges in keeping operating expenses under control is a risk known as “agency cost,” which is the conflict that can occur between owners and managers.

People working in the company may always want better offices, more supportive employees, better buildings, faster computers, free lunches, and other perks. It’s easier to control these costs in small businesses.

In a large company, the board must choose managers who are looking out for the best interests of the shareholders. The management team should understand agency costs and the reasons why operating expenses cannot exceed what the business model requires.

You cannot rely on operating costs alone to make decisions about where to invest. Instead, look at where those costs go and whether the money is being put into areas that lead to good returns.

Using spending wisely and strategically is an important metric for company value.

Source: https://www.thebalancemoney.com/operating-expense-on-the-income-statement-357586