04 May What is an Operating Expense?
It doesn’t matter what word you put in front, nobody likes an expense.
Well, I take that back a little bit I guess.
Some expenses are non-cash expenses and help your bottom line without wasting cash. So, you probably don’t mind those expenses.
Anyway, the point here is that there are a lot of different expense accounts.
In today’s article, we’re going to discuss daily expenses of a company…
An Operating Expense is an expense that occurs in the daily operations of a company.
Taking this one step further, it’s also important to realize that operating expenses can be divided into fixed and variable expenses.
Fixed expenses are the expenses that don’t change; they’re simply a set amount. Common examples of fixed expenses include Rent Expense, Insurance Expense, and the Phone bill.
Variable expenses are the exact opposite, they’re expenses that will vary month-by-month.
These are the type of expenses that companies try to minimize. Common examples include Employee Wages and Advertising. If a company can lower these expenses without hurting operations, it’s usually a good idea to do so.
It’s also important to recognize the difference of Operating Expenses and COGS. Operating expenses are the daily expenses for operations, COGS is the cost of sales. Two different accounts, but they do the same thing – they lower net profits.
Examples of an Operating Expense
I already spoiled this in the section above, but operating expenses included daily expenses.
Once again, it’s important to remember the difference between operating expense and other expenses.
Technically speaking, there are seven different categories of expenses:
- General and Administrative
- Depreciation and Amortization
- Other Operating Expenses
- Interest Expense
- Income Tax Expense
Simplifying this – it’s important to separate COGS, Interest Expense, and Income Tax Expense. All other categories are commonly classified as operating expenses.
Operating Expense’s Role in Accounting
Type of Accounting
Believe it or not, operating expense is an expense account.
Operating expense covers a wide array of expenses, and essentially, it’s any expense that’s not COGS, Interest Expense, or Tax Expense.
As with every expense, operating expense is an income statement account.
Proper accounting takes place using the Multiple-Step Income Statement.
In a multiple-step income statement, operating revenues and expenses are separated from nonoperating expenses and gains or losses.
With this said, operating expenses immediately follow gross profit.
This places operating expenses in the middle of the income statement, generally the largest section.
The following example provides a visual of operating expenses on an income statement:
Operating Expenses on an Income Statement
The example above shows where are operating expenses are located, and a good example of some of the expenses that are included.
As mentioned, this class should only show expenses that aren’t COGS, Interest Expense, or Income Tax.
COGS is located above operating expenses, interest expense and income tax are below – generally referred to as “other” items.
Operating expense is a term for a category of expenses.
With this said, the actual term of operating expense will never have a journal entry.
However, to provide an example of a journal entry, we’ll provide an example of the journal entry for a common operating expense. Today, we will focus on the rent expense.
For this example, let’s assume you rent your office building for $3,000/month.
This $3,000 is paid in cash, and the journal entry would be recorded as follows.
The first area of impact is our rent expense account. Expense accounts increase with debit transactions. After this transaction, rent expense is $3,000 higher.
Other Areas of Impact
Operating expenses are the daily expenses a business incurs.
These expenses are also the expenses that most companies will try and streamline. Some of the expenses are important and you never want to cut expenses if it causes harm to your company.
An example of this would be reducing your workforce. If you cut employee expense by $80,000 but lose $140,000 of gross profit because you can’t operate like you used to – then that’s probably not a good idea.
Another use for operating expenses is operating margin. Investors and creditors like to see the percentage of revenues that your operating expenses consume. If they’re higher than the industry average, it’s a good sign that some expenses can be streamlined to improve your bottom line.
It’s always important to measure expenses from a percentage of revenues standpoint and not a numerical standpoint. If your revenues increase, so will your expenses. Don’t think a numerical expense increase is a bad thing, but always consider a percentage of increase to be a red flag.
Operating Expense Recap
- Lists all expenses that aren’t COGS, Interest Expense, or Income Tax Expense
- Located after gross profit
- Likely the largest section on an income statement
- Section that many owners try to reduce in an order to increase net profit
- Includes both fixed and variable expenses