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What are Operating Expenses?

Operating expenses are the costs associated with the core activities of a business. Many items are categorized as operating but all contribute towards the delivery of the final goods or services to customers. Operating expenses can be further subdivided into COGS, which represents the costs directly related to the manufacturing of goods and SG&A, which reflect overhead costs a company incurs to sell its products. These expenses are always reported in the company’s income statement which provides further detail on the changes in retained earnings for two accounting periods.

Operating expenses often represent a large proportion of the total expenses reflected in a company’s income statement. The revenue less all operating expenses for the same period provides a company’s operating profit. This is an important measure of financial performance for many analysts as it represents the earnings generated from the main activities of the business.

Key Learning Points

  • Expenses are decreases in economic benefits for a company and arise from the depletion of assets or incurrences of liabilities
  • Operating expenses are those associated with the production or distribution of goods and services
  • Operating expenses can be divided into cost of goods sold (COGS) and selling, general and administrative (SG&A) expenses
  • Operating profit is the income a company has generated after the deduction of all operating expenses and before financing and government costs

Common Operating Expense Items

  • Cost Of Goods Sold (COGS)
  • Compensation-related expenses such as sales commission and pension plan contributions
  • Office-related expenses such as property rental and insurance costs
  • Sales and marketing costs such as advertising and travelling

Examples

Below is an extract from Coca Cola’s Consolidated Financial Statements and Notes for 10-Q September 2019:

The Coca Cola Company – Extract from the Income Statement

The Coca Cola Company – Extract from Footnote

Selling, Marketing and Administrative

Selling, marketing and administrative (“SM&A”) expenses increased $27.4 million or 6.0% in the third quarter of 2019. Total advertising and related consumer marketing expenses increased 10.5%, driven by advertising increases in North America. Selling, marketing and administrative expenses, excluding advertising and related consumer marketing, increased approximately 3.5% in the third quarter due to increased spending related to personnel-related costs.

Key Ratio

Operating expenses enables a company to calculate its operating expense ratio (OER), which provides a comparison of expenses incurred to income earned. OER is expressed as a percentage and allows businesses to compare themselves to businesses in the same industry.

Ratio

[(Cost of goods sold + Operating expenses) / Revenue] x 100

Below is an extract of the income statements of Coca Cola from their three months end quarterly 10-Q report 2019:

The Coca Cola Company – Extract from the Income Statement

Points to Note

  • Numbers reported in the income statement are in millions
  • Coca Cola’s operating expense ratio is 73.7% [(3,116+125+3,767) / 9,507] x 100
  • Coke’s OER states that the company spends $0.73 on daily operations for every $1.00 earned

Operating vs. Non-Operating Expenses

Operating expenses are costs that a company incurs in the day-to-day running of its operations, whereas non-operating expenses are costs unrelated to the business’s core operations.

These expenses relate to financing and investing activities. Typically, these are expenses such as interest income and expense, and dividend income.

Other expenses also categorized under non-operating expenses are one-off or unusual costs. Examples of one-off and unusual costs would be when a business gets sued and needs to pay a reimbursement or incurs reorganization expenditure.