Understanding Business Operating Expenses: What to Include and Impact

Operating expenses are the ongoing costs a business incurs to run its day-to-day operations. They include everything from rent and payroll to marketing and office supplies but exclude the direct costs of producing goods, which fall under cost of goods sold (COGS). Operating expenses appear on the income statement and directly reduce a company's operating profit.

Understanding what counts as an operating expense, and what does not, helps business owners control spending, improve margins, and produce accurate financial reports that lenders and investors trust.

What Are Operating Expenses?

Operating expenses (often abbreviated as OPEX) are the costs required to keep a business functioning outside of production. The IRS defines a deductible business expense as one that is both ordinary (common in your industry) and necessary (helpful and appropriate for your trade).

On the income statement, operating expenses sit below gross profit and above operating income:

Revenue - COGS = Gross Profit
Gross Profit - Operating Expenses = Operating Income

This structure makes it easy to see how much of your gross profit is consumed by the cost of running the business.

Categories of Operating Expenses

Operating expenses span a wide range. Below are the most common categories:

Payroll and Benefits

• Salaries and hourly wages for non-production staff
• Payroll taxes (employer share of Social Security, Medicare, unemployment)
• Health insurance, retirement contributions, and other benefits

Facilities

• Rent or lease payments for office, retail, or warehouse space
• Utilities: electricity, water, internet, phone
• Property taxes and building maintenance

Sales and Marketing

• Advertising (digital ads, print, sponsorships)
• Marketing software and agency fees
• Trade show and event costs

Administrative

• Office supplies and equipment
• Accounting and legal fees
• Software subscriptions (CRM, project management, communication tools)

Insurance and Licensing

• General liability, professional liability, and workers' compensation insurance
• Business licenses and permits

Travel and Vehicles

• Mileage reimbursement and fuel
• Airfare, lodging, and meals for business travel
• Vehicle insurance and maintenance

Tracking these categories consistently helps you spot trends when you review your expenses each month.

Operating Expenses vs. Cost of Goods Sold

Operating expenses and COGS both appear on the income statement, but they measure different things:

	COGS	Operating Expenses
What it covers	Direct costs of producing goods or services	Costs of running the business
Examples	Raw materials, direct labor, manufacturing overhead	Rent, marketing, admin salaries
Relationship to output	Scales with production volume	Relatively fixed regardless of output
Location on income statement	Deducted from revenue to get gross profit	Deducted from gross profit to get operating income

A freelance designer's cost of a stock photo license used in a client deliverable is COGS. The designer's monthly subscription to project management software is an operating expense.

How Operating Expenses Affect Profitability

Every dollar of operating expense reduces operating income. Two businesses with identical revenue and COGS can have very different profitability if one has higher operating expenses.

Example

	Company A	Company B
Revenue	$500,000	$500,000
COGS	$200,000	$200,000
Gross Profit	$300,000	$300,000
Operating Expenses	$180,000	$240,000
Operating Income	$120,000	$60,000

Company A retains twice the operating income because it spends $60,000 less on overhead. This difference flows straight to the bottom line.

The Operating Expense Ratio

The operating expense ratio (OER) measures how efficiently a business converts revenue into profit after covering operating costs:

OER = Operating Expenses / Revenue

A lower ratio is better. If your OER is 0.45, you spend 45 cents of every revenue dollar on operating expenses. Comparing your OER against industry benchmarks highlights whether your cost structure is competitive.

The ratio is especially useful in real estate, where property managers compare the operating costs of similar buildings to identify inefficiencies.

Non-Operating Expenses

Some costs fall outside normal operations and are classified separately on the income statement:

• Interest expense on loans and bonds
• Loss on sale of assets
• Restructuring charges such as severance for layoffs
• Foreign currency losses

Non-operating expenses are reported below operating income so they do not distort the picture of core business performance. Keeping them separate helps when you analyze trends in your financial reports.

Strategies to Reduce Operating Expenses

Thoughtful optimization improves margins without sacrificing quality:

1. Audit subscriptions quarterly. Cancel unused tools and consolidate overlapping software.
2. Negotiate vendor contracts. Annual renewals are opportunities for volume discounts or competitive bids.
3. Adopt remote or hybrid work. Less office space directly lowers rent and utilities.
4. Automate repetitive tasks. Invoicing software and expense tools eliminate manual data entry.
5. Review staffing models. Contractors handle variable workloads without the fixed cost of full-time hires.

The AICPA recommends regular financial reviews to maintain healthy expense ratios.

Fixed vs. Variable Operating Expenses

Type	Behavior	Examples
Fixed	Stay the same regardless of sales volume	Rent, insurance premiums, salaried wages
Variable	Fluctuate with business activity	Sales commissions, shipping, credit card processing fees
Semi-variable	Have a fixed base plus a variable component	Utilities (base charge + usage), phone plans with overage fees

Understanding this breakdown helps with budgeting and forecasting. Fixed costs are predictable but harder to cut; variable costs flex naturally but can spike during busy periods.

Key Takeaways

• Operating expenses are the day-to-day costs of running a business, excluding COGS and non-operating items.
• They directly reduce operating income and are a primary lever for improving profitability.
• Tracking expenses by category and monitoring the operating expense ratio helps you spot inefficiencies early.
• Regular audits of subscriptions, vendor contracts, and staffing models keep costs in check.

Related Articles:

• How to Track Your Small Business Expenses
• How to Categorize Expenses for a Small Business
• What Are Non-Cash Expenses?
• Cost of Goods Sold (COGS) Explained