Operating Expense Definition

Operating Expense (OPEX) is the cost that is incurred in the normal course of business and does not include expenses such as the cost of goods sold which are directly related to product manufacturing or service delivery. They are easily available in the income statement along with other costs which are subtracted from the operating income to determine net profit.

Following are some of the common Operating Expenses –

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For eg:
Source: Operating Expense (OPEX) (wallstreetmojo.com)

However, it is to be noted there are few other expenses that are not be included in the calculation of OPEX as it is considered unrelated to a company’s core operations. This category of expenses includes costs such as interest expense or other costs of borrowing, one-time settlement, accounting adjustments, taxes paid, etc.

Examples

Let us take an example of an income statement of a company named XYZ Ltd to illustrate how OPEX is deducted from net sales in the determination of operating profit and the net profit. All the amounts shown in the table below are in millions.

ParticularsAmount (in millions)
Net Sales$125
Raw Material Cost$50
Labour Cost$20
Sales Commission$10
Rent$5
Utilities$5
Depreciation$8
Interest Expense$6
Tax Paid$2

For the calculation of Net Profit first, we will calculate the following values.

COGS

Operating
  • COGS = ($50 + $20) million
  • COGS = $70 million

Operating Expense

Example

Operating Expense Formula = Sales commission + Rent + Utilities + Depreciation

  •  = ($10 + $5 + $5 + $8) million
  • = $28 million

Operating Income

Example

Now, Operating income = Net salesNet sales is the revenue earned by a company from the sale of its goods or services, and it is calculated by deducting returns, allowances, and other discounts from the companys gross sales.read more – COGS – Opex

Net Profit

Example

Finally, Net profit = Operating income – Interest expense – Tax Paid

  • Net profit = ($27 – $6 – $2) million
  • Net profit = $19 million

Relevance and Uses of OPEX

It is essential to understand the concept of this expense as it is a crucial component in the calculation of operating profit, which is then used to calculate net profit, which is again a critical factor in the assessment of the financial performance of a company. The thumb rule states that lower a company’s OPEX, the more profitable the company is.

The formula for calculation of net profit (as per popular practice) is given below,

Net profit = Operating profit – Taxes paid – Interest expense

where,

Operating profit = Net sales – COGS – Opex

It is to be noted that several factors can impact this expense, which includes (not exhaustive) pricing strategy, raw materials price, labor costCost of labor is the remuneration paid in the form of wages and salaries to the employees. The allowances are sub-divided broadly into two categories- direct labor involved in the manufacturing process and indirect labor pertaining to all other processes.read more, etc. However, these expenses are part of the day to day decisions that a manager makes, and as such financial performance based on OPEX can be regarded as a measure of managerial flexibility and competency, especially during the difficult economic scenario.

Although it is seen as a measure of financial performance, it is essential to note that it varies across industries, i.e., some industries tend to have higher operating expenses than others. Consequently, it is more meaningful to compare this expense among companies within the same industry, such that the designation of “high” or “low” expenses should be made within that context.

Another interesting thing about controlling it is to find the right balance, which can be difficult, but once achieved, it can yield significant returns. There are several examples where the company has been successful in reducing the OPEX to gain a competitive advantage, which has eventually resulted in increased earningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments.read more. Nevertheless, it is to be taken into cognizance that the reduction of these expenses can also result in the compromise of product integrity or quality of operations, which may lead to deterioration of the company’s reputation in the long run.

Given below are some of the terms related to this expense.

#1 – Operating expense ratio

It is a measure that is used to assess what portion of the income is consumed in performing a normal course of the business. It is calculated by dividing the company’s OPEX by its total revenue or net sales, which is then used for comparison among companies in the same industry. Mathematically, it is represented as,

#2 – Operating Profit

The operating profit is a measure of the financial performance of a company and captures the amount of profit generated from operating the business. It is computed by deducting OPEX, such as salaries, depreciation, and COGS, from net sales or revenue. The operating income can also be calculated from a company’s gross profitGross Profit shows the earnings of the business entity from its core business activity i.e. the profit of the company that is arrived after deducting all the direct expenses like raw material cost, labor cost, etc. from the direct income generated from the sale of its goods and services.read more by subtracting all the OPEX. Gross profit is equivalent to net sales minus COGS. Mathematically, it is represented either as,

Operating Profit = Net Sales – COGS – Opex

or

Operating profit = Gross profit – OPEX

Where,

Gross profit = Net sales – COGS

This article has been a guide to what is Operating Expenses (OPEX). Here we discuss how to calculate Operating Expense using its formula along with practical examples and uses. You may also have a look at the following accounting articles –

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