There are two main categories of expenses that a business can incur: overhead and operating expenses. Operating expenses are those that a business incurs as a result of its normal operations. Overhead expenses, on the other hand, are what it costs to run the business.

Expenses can be divided into several different types, including equipment costs, inventory, and facilities costs. These business expenses can be further divided into overhead or operating costs, each of which depends on the nature of the business being run.

Key Takeaways

  • Operating expenses are the result of a business's normal operations, such as materials, labor, and machinery involved in production.
  • Overhead expenses are what it costs to run the business, including rent, insurance, and utilities.
  • Operating expenses are required to run the business and cannot be avoided.
  • Overhead expenses should be reviewed regularly in order to increase profitability.

Operating Expenses

Operating expenses are incurred by a company through its normal business operations. That means these expenses are required and cannot be avoided because they help the business continue running. Operating expenses are also referred to as opex.

These expenses are found on the income statement and are components of operating income. Most income statements exclude interest expenses and income taxes from operating expenses.

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.

Reducing operating expenses can give companies a competitive advantage. It can also increase their earnings, which can be a boon to investors. But reductions in opex can have a downside, which may hurt the company's profitability. Cutbacks in staff (and therefore, salaries) can help reduce a company's operating expenses. But by cutting personnel, the company may be hurting its productivity and, therefore, its profitability.

One 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, even though production for the soda bottler in the example above may shut down, it still has to pay the lease payments on the facility.

Overhead Expenses

Overhead expenses are other costs not related to labor, direct materials, or production. They represent more static costs and pertain to general business functions, such as paying accounting personnel and facility costs.

These costs are generally ongoing regardless of whether a business makes any revenue. Unlike operating expenses, these costs are fixed, meaning they can be the same amount over time.

In the scenario with the soda bottler above, 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 company still incurs other business expenses, such as insurance payments and administrative and management salaries.

They may also be semi-variable, so the amounts that need to be paid may change slightly over time. Utilities are one example. The cost of power can change based on usage. If the soda company increases production, it will have to pay more for electricity.

Overhead expenses also include marketing and other expenses incurred to sell the product. For the soda bottler, this includes commercial ads, signage in retail aisles, and promotional costs. These costs still remain if production is shut down for a short period of time.

These expenses can be categorized based on where they fit into the business. They can include:

  • Administrative overhead
  • General business overhead
  • Research overhead
  • Transportation overhead
  • Manufacturing overhead
  • Step costs

Companies must account for overhead expenses in order to determine their net profit.

Companies should review these costs regularly to determine how to increase profitability. 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 costs less because benefits aren't required when hiring independent contractors.

The Bottom Line

Overhead and operating expenses are two types of costs that businesses must incur to run their business. The difference between the two is the types of costs that are classified under them. Overhead costs are related to the general business, fairly fixed, and can be reviewed often to make adjustments. Operating costs are the direct costs required to produce a product or service and are difficult to avoid.