Operating Expenses

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What are operating expenses?

These are general and administrative expenses that a business incurs to keep operating, for example office rent and internet connectivity.

The key distinction between operating expenses and direct costs is that direct costs are specifically tied to the production of goods or services, while operating expenses are just general in nature. 

Factors to consider

1. Split between fixed and variable expenses.

Some expenses are fixed, that is, they do not vary depending on usage or the level of activity, for example, office rent. For rent, regardless of the level of sales a business makes, it must pay the same amount of rent.

Other expenses are variable, that is, they change depending on usage, for example, software subscriptions. For software, the more users signed onto a platform, the more a business must pay.

The higher the level of fixed costs in a business, the greater the operating leverage. Higher operating leverage basically means a business must make higher sales to cover its fixed costs and then make a profit.

 Practical Example.

Consider two businesses, A & B:

Company A has a higher fixed costs structure than Company B. Company B’s cost structure is more variable.

The gross profit from each unit of sales helps a business meet its operating costs. This is defined as the contribution margin.

Company A’s contribution margin is $8 (I.e. Sales price of $10 less the variable cost of $2), while Company B’s contribution margin is $4.

This means that to breakeven (i.e. to cover the fixed operating costs so that no profit or loss is made), Company A will have to sell more units than Company B, since there is a greater level of fixed costs to be covered.

We can calculate the required sales units by dividing the fixed costs by the contribution margin:

Company A: $500,000 /8 = 62,500

Company B: $150,000 /4 = 37,500

Company A must sell 25,000 more units than Company B just to breakeven.

The overall incentive is to keep the level of fixed costs as low as possible.

Business nature considerations:

However, some businesses necessarily have a high level of fixed costs, for example software companies that must necessarily incur a high level of upfront development costs that will (hopefully) be recouped by having a high subscriber base in future.  

2. Categorising expenses

Operating expenses should be split into reasonable categories and sub-categories, to make it easier to forecast, measure against forecasts and understand where money is being spent.

For example, marketing would be major cost bucket. Under marketing we could have other sub-categories as below.

 Marketing:

a. Billboards

b. Social media marketing

c. TV & Radio advertising

3. Inflation

Costs are ever increasing, with the purchasing power of a single unit of money constantly declining, due to inflation.

It is thus prudent to adjust expense forecasts upwards (or indeed downwards in extremely rare cases) with expectations of inflation. This way, expense forecasts remain up to date.

A $100,000 current rent expense would be $127,628 in 5 years after applying a 5% annual inflationary adjustment.

4. Cash flow

Majority of businesses fail because they run out of money.

One of the ways of ensuring that this doesn’t happen to your business is having accurate forecasts.

For operating expenses, the forecast should show when expenses are actually paid for (i.e. cash basis) rather than when they are incurred (i.e. accruals basis).

Consider a business with a $10,000 monthly rent expense, but that is paid quarterly in advance (i.e. $30,000 at the start of the quarter)

To generate an accurate cash flow forecast, the rental payment should be shown in month 1, rather than spread over the 3-month period. Spreading the expense over the period creates an illusion of the business having more cash than is available.

Conclusion

A deep understanding of a business’ operating expenses helps keeps those costs under control and avoid the difficult work of having to cut them in the future when they are already out of control. The business will also generate more accurate forecasts.

Access an easily customisable financial model here.