What is an 'Operating Expense'
An operating expense is an expense a business incurs through its normal business operations. Often abbreviated as OPEX, operating expenses include rent, equipment, inventory costs, marketing, payroll, insurance and funds allocated toward research and development. One of the typical responsibilities that management must contend with is determining how low operating expenses can be reduced without significantly affecting a firm's ability to compete with its competitors.
BREAKING DOWN 'Operating Expense'In the absence of raising prices or finding new markets or product channels to raise profits, some businesses attempt to increase their bottom line purely by cutting operating expenses. While laying off employees and reducing product quality can initially boost earnings and may even be necessary in cases where a company has lost its competitiveness, there are only so many operating expenses that management can cut before the quality of business operations is damaged.
The Internal Revenue Service allows businesses to deduct their operating expenses from their business income on their tax returns. However, the IRS and most accounting principles distinguish between operating expenses and capital expenditures.
Abbreviated as CAPEX, capital expenditures include costs related to acquiring or upgrading capital assets. Capital assets can be tangible or intangible. Tangible business assets include real estate, factory equipment, computers, office furniture and a range of other tangible items. Intangible assets include intellectual property, copyrights, patents and similar items.
Capital Expenses vs. Operating Expenses
The IRS treats capital expenses differently than operating expenses. In general, businesses are allowed to write off operating expenses the year they are incurred, but they must deduct capital expenses slowly over time. For example, if a business spends $100,000 on payroll, it can write off the entirety of that expense the year it is incurred, but if a business spends $100,000 buying a large piece of factory equipment or a vehicle, it has to capitalize the expense or write it off slowly over time. The IRS has guidelines related to how businesses must capitalize assets, and there are different classes for different types of assets.
Operating Expenses on Income Statements
An income statement tracks the income and expenses of a company over a certain period of time to create a picture of its profitability. Income statements typically categorize expenses into six groups: cost of goods sold; selling, general and administrative costs; depreciation and amortization; other operating expenses; interest expenses; and income taxes. All of these expenses can be considered operating expenses, but when determining operating income using an income statement, accountants exclude interest expenses and income taxes.