Expenses, if controlled and used efficiently, can grow your business and, if left unchecked, can squeeze your business dry of every last penny. Business expenses can be broadly classified into capital, operating, non-operating expenses, and cost of goods sold (COGS).

Capital expense is when you spend on assets – equipment or vehicles – which will not directly earn you revenue but will be used to earn revenue for multiple years. Non-operating expenses do not impact your daily business operations and are one-time in nature. They include legal fees incurred to file or defend against the lawsuit, as well as costs associated with selling the equipment or taking out a loan.  

Importance of Operating Expenses

Operating expenses and the cost of goods sold are essential for keeping the business running and require consistent monitoring. Overspending in these areas can leave your business in a spiral of losses. Failing to pay these expenses can halt your business operations. Imagine losing your power supply due to non-payment of the electricity bill.

In this article, we will explore the key aspects of reporting operating expenses and utilizing them to enhance business efficiency and profitability.

How Are Operating Expenses Reported

Your business undergoes various transactions daily. The bookkeeper records these transactions as journal entries. At the end of the accounting period, the accountant transfers the journal entries to the income statement by categorizing them according to their respective categories.

Capital expenditure is reported in the Balance Sheet, and COGS and operating expenses are in the Income Statement. The COGS is deducted from the revenue to determine gross profit, and the operating expense is then deducted from gross profit to arrive at operating profit.

When operating expenses increase significantly, operating profits tend to decrease. The sole purpose of a business is to earn profits. While a company may make an operating loss in the initial years, it should report a profit at some point. Otherwise, it may raise the Canada Revenue Agency’s (CRA) suspicion that the business is inflating expenses or categorizing personal expenses as business expenses to avoid paying taxes on profits.

Which Expenses Are Categorized as Operating Expenses

Every business has different operating expenses. For instance, the cost incurred to sell a vehicle (advertising, paperwork) is an operating expense for a car dealer but a non-operating expense for a baker.  

Suppose John runs a bakery and buys an oven.

• The purchasing cost of the oven is capital expenditure.
• The electricity consumed to run the oven and the servicing and maintenance to keep the oven running smoothly are operating expenses.
• After five years, John sells the oven, and the cost incurred to sell it is a non-operating expense.

Some generic operating expenses include:

• Utility: Water, gas, heating, broadband
• Salaries and wages of employees 
• Leases and rentals
• Research expenses to create a new product or add a new feature to your software platform
• Marketing and advertising expenses, such as flyers, internet ads, and reward points
• Travelling expenses to meet a client or vendor, attend a conference or meeting, deliver products
• Other expenses such as subscriptions, cybersecurity, maintenance and repairs, insurance premiums, bank fees, bookkeeping, and accounting fees.

How Businesses Can Use Operating Expenses

As a business owner, you should know how to read the income statement and derive insights from it. Operating expenses play a vital role in helping your business navigate the ups and downs, expansion, and stagnation.

Fixed Costs

Fixed costs, such as leases or rentals, employee salaries, insurance, utilities, and property taxes, will stay constant whether or not you earn revenue.

Business owners can use the fixed cost to determine how many units they should sell to break even. For instance, an e-commerce site opens a warehouse and allocates a $2 fixed cost for every order. The fixed cost of the warehouse is $10,000 a month, which means it will have to process 5,000 orders a month to break even. This insight can help you determine if this expansion is feasible or not.

Fixed costs have cost schedules, contract agreements, or other policies, making them easy to predict. They grow significantly during business expansion. However, you can consider cutting fixed costs if you are downsizing your business or restructuring to optimize operations. Cutting fixed costs doesn’t directly affect the quality of your goods and services.

Variable Costs

Variable costs, such as utility costs, direct labour, sales, commission, packaging, and logistics, depend on sales volume. A retail store or a restaurant may hire contract workers during the holiday season, and farmers may lease equipment during harvest season. You can optimize your variable cost, but do so carefully, as it could affect the quality of your offerings.

Business owners can use the variable cost and divide it by the number of units sold to determine the pricing for their products. Returning to our previous example of an e-commerce warehouse, the company calculates the fuel, logistics, and other variable expenses incurred to deliver an order, which amount to $5 per order. It will add the fixed cost of $2 and the variable cost of $5, and charge the customer $7 or more to break even. 

If the e-commerce warehouse processes 10,000 orders, its profits will increase as the fixed cost will remain stable. It will earn $70,000 from 10,000 orders instead of $35,000 from 5,000 orders. The business owner can look for alternatives to reduce variable costs, such as using a bigger vehicle and planning routes efficiently to deliver maximum orders in one rotation.

Budgeting and Forecasting

Business owners can utilize historical operating expenses to analyze trends, forecast future expenses, and create a budget. Forecasting fixed costs is easy, as contracts bind them and don’t increase suddenly. The risk is in variable costs; fuel costs can increase, and supply shortages can spike commodity prices. When forecasting, you can have a bigger buffer for variable costs amid high inflation or supply shortages.

Analyzing the cost can help you forecast the operating expenses for a branch and allocate a more practical budget for business expansion. 

Compare Your Business with Competitors

Business owners can use the operating expense ratio to compare their expenses with those of their competitors.

Operating expense ratio = Operating Expense / Revenue

You can also create a ratio for a single expense, such as salaries and wages/revenue or lease/revenue.

For instance, the lease is the single most significant operating expense in the retail sector. The industry benchmark may be 20% of revenue goes into a lease, while retailers in your area may be spending 18% of revenue on a lease. You can compare your expenses and keep scouting for better deals as your business grows.

Operating expenses can be helpful in strategic planning if you know how to control and optimize them.  

Contact Glenn Graydon Wright LLP in Oakville to Help You Prepare Financial Statements

A professional accountant can help you prepare financial statements, analyze trends, identify gaps, and suggest measures to optimize your operating expenses. To learn more about how Glenn Graydon Wright LLP can provide you with the best accounting expertise, call today at 905-845-6633 or connect with us online to schedule an initial consultation.