What is an operating expense?

Operating expense (definition)

Operating expenses (often shortened to OpEx) are the costs of doing business. They’re recorded on the profit and loss statement.

Operating expenses are commonly divided into six categories.

1. Cost of goods sold (COGS) / cost of sales (COS) – money spent providing your goods or services to customers. This typically includes things like inventory and freight. Some businesses include wages under COGS or even rent for dedicated production facilities.

2. Sales general and administration (SG&A) – these are expenses that aren’t tied up in the product or service itself. They may include things like business travel, sales commissions, salaries for managers, and general admin.

3. Depreciation (and amortisation) – records the diminishing value of assets that the business owns. The loss of value is recorded as a cost. Depreciation refers to physical things that wear out, like work tools. Amortisation refers to non-physical assets like a patent that becomes less valuable as it gets closer to expiry.

4. Interest – only the interest portion of loan repayments are counted as an expense. The principal is not an operating expense. Principal repayments are recorded as a finance expense.

5. Income taxes – taxes that are applied to business profits are recorded as an expense. But sales tax may not be counted as an expense because the money never belonged to the business.

6. Miscellaneous – things that don’t fit into the above categories are captured under miscellaneous.

Some categories, such as depreciation, are governed by strict rules. Others are more discretionary. For example, one business might record an employee’s wages or even rent in COGS, while another might record them in SG&A. The main thing is to be consistent once you’ve set a rule.

Why operating expenses matter

Operating expenses are important for three main reasons:

1. Operating expenses are money going out of your business. The higher they are, the less profit you get to keep. Monitoring and managing them can improve business performance.

2. Because they lower profits, operating expenses also lower the taxes a business has to pay. If a business fails to record them correctly it may end up paying more tax than it needs to.

3. Because operating expenses affect taxes, the tax office has a strong interest in how they are reported. There are rules to follow.

Avoid calling expenses overheads

You will hear people talk about ‘overheads’ as a type of operating expense. Overheads are often thought of as things like rent, insurance, and utilities. However some people think of overheads as fixed costs while others think of them as indirect costs, and there are subtle differences between the two. Because of this inconsistency, it’s a good idea to avoid using the term. Try to stick to the six categories of operating expenses listed here.

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Disclaimer: This glossary is for small business owners. The definitions are written with their requirements in mind. More detailed definitions can be found in accounting textbooks or from an accounting professional. Xero does not provide accounting, tax, business or legal advice.