The profitability of a company depends on a number of different factors. Ultimately, profit is the revenue a company makes minus the expenses it incurs.
Expenses can be divided into several different types including equipment costs, inventory and facilities costs. These business expenses can be further divided into two main categories — each of which depends on the nature of the business being run. The first is the operating expense, while the second is the overhead expense. Essentially, operating expenses are directly related to production, while overhead expenses are the costs to run the business.
Here is a closer look at each one, along with examples.
Operating expenses are incurred by a company through its normal business operations. That means these expenses are required and cannot be avoided because of their role in helping the business continue running.
Examples of operating expenses include materials, labor and machinery used to make a product or deliver a service. For example, operating expenses for a soda bottler may include the cost of aluminum for cans, machinery costs and labor costs.
An easy way to determine the operating expenses for a particular business is to think about the costs eliminated by shutting down production for a period of time. For example, the soda bottler above still has to pay the facility lease payments, but all costs related to the actual production of the soda may cease to exist.
Reducing operating expenses can be both positive and negative. While it may help in the recovery of cash flow, that reduction may hurt the company's profitability. For example, cut backs in staff (and therefore, salaries) at the soda factory can help reduce a company's operating expenses. But by cutting personnel, the company may be hurting its productivity and therefore, its profitability.
Overhead expenses are other costs not related to labor or direct materials. They represent more static costs and pertain to general business functions such as paying accounting personnel and facility costs. Companies should review these costs regularly in order to determine how to increase profitability.
Unlike operating expenses, these costs can be of a fixed amount — meaning they can be the same amount over time. They can also be semi-variable and may change slightly over time like the cost of utilities, which vary based on usage.
In the scenario above with the soda bottler, the facility lease payments are still owed even if no current production takes place within the facility. Therefore, facility costs are overhead expenses. Likewise, the soda bottler still incurs other business expenses such as insurance payments, administrative and management salaries.
Overhead expenses also include marketing and other expenses incurred to sell the product. For the soda bottler, this includes commercial ads, signage in retailer aisles and promotional costs. These costs still remain if production is shut down for a short period of time.
If business becomes slow, cutting back on overhead usually becomes the easiest way to reduce expenses. Companies may review contracts for electrical consumption, internet and employee phone usage for reductions, or, in some cases, may even turn to contract staff instead of full-time employees, which usually cost more because of benefits.
The Bottom Line
In order to calculate their profitability, companies need to determine their expenses. Operating expenses, which are required to run the business, can reduce costs dramatically, but may lead to a loss in productivity. Overhead expenses, which are relatively static and relate to the day-to-day operations, should be reviewed from time to time to help cut costs and therefore, increase profitability.