How Do Operating Expenses Affect Profit?

Operating expenses are ongoing costs incurred from running a business that are not related to production. Basically, the day-to-day costs to operate. Any cost not related to the direct production of a good or service gets filed under operating expense. Operating expenses included in running a business are rent, utilities, wages, office supplies, and business travel. Operating expenses differ by industry and within an industry by how a company decides to operate based on its business model.

As a general rule, an increase in any type of business expense lowers profit. Operating expenses are only one type of expense that reduces net sales to reach net profit. An income statement has three levels of profit, however, and the relationship between operating expenses and profit can be seen most directly when looking at operating profit, also known as profit before interest and taxes.

Businesses often look at operating expenses under a microscopic eye, as it is an area that is easier to cut costs, as opposed to costs related to manufacturing or fixed costs. Companies can reduce operating expenses by outsourcing certain divisions of the business, allowing employees to work from home, a reduction in starting salaries, or automating parts of the business.

Operating Expenses and Profit on the Income Statement

On an income statement, profit calculated by deducting the cost of goods sold (COGS) from total net sales is called gross profit. The COGS includes both fixed costs and variable production costs. Both types of production costs reduce gross profits. However, fixed production costs, such as buildings and equipment, are unaffected by production levels, whereas variable costs, such as the wages paid to factory workers and the cost of raw materials, increase when production levels rise.

At the second level of profit, operating profit is calculated by subtracting operating expenses from gross profit. Sales, general, and administrative expenses (SG&A) are also included in operating expenses but sometimes marked separately on an income statement. SG&A are overhead expenses not directly related to production. SG&A typically include the cost of administrative buildings, as opposed to production plants, the salaries of salespeople and executives, and expenditures for office supplies, legal expenses, and marketing costs, for example. Net profit is then calculated by deducting non-operating expenses such as taxes and interest from operating profit.

The Bottom Line

Net profit is equal to revenue minus the cost of goods sold (COGS), operating expenses, and taxes and interest. Cutting back on operating expenses or the COGS can increase net profit, at least in the short term, but a business must be careful not to cut back so much that the sales are adversely impacted by shoddy production quality or a failure to meet customer demand.

On the other hand, some business expenses, such as purchases of new information technology innovations, can lower net income over the short term but raise income potential over the long term. Capital expenses on equipment and other fixed assets can be depreciated over several years, lowering the immediate impact on profits.