A Beginner’s Guide to Operating Expenses for Small Businesses

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Operating expenses are the expenses your business incurs on a daily basis. Typical operating expenses include rent, payroll, utilities, printing, postage, and property taxes. Many, if not all, of these expense categories have a separate expense account in the general ledger.

Operating expenses are not directly related to the production of products or services, but instead reflect what it truly costs to open your doors each day.


Overview: What are operating expenses?

Operating expenses reflect the cost of keeping your business running. For example, Jessica owns a small bakery that employs 11 full- and part-time employees, including four bakers and seven sales and counter people.

Excluding the bakers, who are considered part of the manufacturing process, all of the other employees’ payroll expenses, including wages, payroll taxes, and benefits, are considered operating expenses and are part of the cost of doing business.

In the meantime, remember that the bakers need gas and electricity in order to use the ovens to produce baked goods. In addition, the bakery needs to turn on the lights to display the baked goods properly, the Open sign in the window needs to be plugged in, and the computer needs to be running in order to use the point-of-sale system.

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The bakery owner also needs to ensure her employees and their customers are comfortable, so she makes sure the bakery is heated in the winter and cooled in the summer. Jessica also needs to pay her landlord rent in the amount of $1,000 each month. All of these things are considered operating expenses.


Example of operating expenses

Operating expenses are typically divided into several categories such as payroll-related expenses, administrative or overhead expenses, and sales and marketing expenses. Examples of operating expenses include:


Operating expenses on an income statement

While operating expenses are typically reflected on your business income statement, they also play a role in both your profit and loss statement as well as your cash flow statement, since each statement is designed to reflect expenses in order to arrive at current profit or loss or current cash flow levels.

However, on the income statement, operating expenses play a more prominent role, with total revenue and total expenses detailed. Net income before taxes, or pretax income, is then calculated by subtracting operating expenses from revenue.

This total gives you and any potential investors or financial institutions a good look at the financial health of your business, as well as detailed information on how your money is being spent. Here’s an example of what an income statement might look like:

INCOME STATEMENT

For the year ending December 31, 2020

Revenue

Sales Revenue

$150,000

Other Revenue

$75,000

Total Revenue

$225,000

Cost of Goods Sold

$105,000

GROSS PROFIT

$120,000

Operating Expenses

Accounting Fees

$1,500

Advertising Expenses

$750

Depreciation

$1,250

Employee Payroll

$40,000

Employee Payroll Taxes

$5,500

Insurance

$3,000

Rent

$10,000

Utilities

$4,100

Vehicle Expense

$750

TOTAL EXPENSES

$66,850

NET INCOME BEFORE TAXES

$53,150

Tax Expense

$17,540

NET INCOME

$35,610


What do operating expenses tell you about your business?

Imagine trying to create a budget or financial projections without knowing what your operating expenses are. Detailing your operating expenses can provide you with a wealth of information about your business, such as utility costs, wage details, and advertising and marketing costs.

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In addition, reviewing your operating expenses can provide you with the following information.

The true profitability of your business

While your business may initially appear to be profitable when subtracting cost of goods sold from revenue, the true test of business profitability comes when factoring in operating expenses.

After all, in Jessica’s case, if her baked goods are profitable only before operating expenses are considered, she will end up losing money and ultimately closing the business if her operating expenses are too high.

Whether you need to decrease expenses

This is one of the factors business owners look at when considering staff cuts. If products and services are not profitable enough, business owners may need to look at areas where they can cut expenses.

Unfortunately, in many cases, the first cuts are usually made in staffing totals, particularly since fixed costs such as rent are non-negotiable in most cases.

Whether you’re overspending

In Jessica’s case, it’s doubtful that travel expenses play a large role in her operating expenses. However, there are likely other areas that Jessica can review in order to determine whether she’s overspending. For instance, Jessica currently pays two accounting clerks as well as a CPA firm to oversee her business finances.

It’s likely that she could eliminate one of the accounting clerks if operating expenses become an issue. Jessica has also determined that the majority of her new customers have found her through social media, so she may want to consider cutting print advertising, as it isn’t an effective advertising tool for her business.


Operating expenses frequently asked questions

What’s the difference between operating expenses and cost of goods sold?

Operating expenses are the cost of doing business, such as employee wages, utilities, insurance, and rent, while the cost of goods sold directly relates to the products that are sold.

For instance, if you sell jewelry, your cost of goods sold will include the items you purchase from a manufacturer to resell, or the gems and precious metals that are purchased in order to manufacture the jewelry.

What financial statements do operating expenses appear on?

Though operating expenses have an indirect impact on most financial statements, operating expenses details are typically found on an income statement.

Are sales and marketing expenses considered operating expenses?

Yes. Advertising and public relations costs, such as flyers, brochures, print, radio, and TV ads, are all considered operating expenses.

Is operating expense analysis important?

Yes. Looking at operating expenses is an important part of determining how profitable your business is. It’s also one of the best ways to spot trends and address potential problems before they impact your business.


Know your operating expenses, know your business

Whether you’re buying a car, buying a house, or looking for a new pair of shoes, you always determine the cost of that item before purchasing. That cost, or expense, often determines whether you purchase that item or walk away. The same principle holds true when looking at operating costs for a business.

There’s no way to successfully manage a business in a sustainable fashion without knowing and understanding what your operating expenses are. One of the best ways to determine current and future business success is by regularly examining your operating expenses and making adjustments when needed.

You can easily manage your operating expenses using accounting software. If you’re ready to move on from handwritten journals and ledgers or are looking for software more suitable for your business needs, be sure to check out The Blueprint’s accounting software reviews.

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