This is Part 4 of a short series discussing the basics of the income statement. See part 1 for a general overview, part 2 for more info regarding revenue, and, part 3 for costs of goods sold.
Operating expenses are expenses needed to run the company that does not directly correlate to generating revenue, or at least not as directly as the expenses we show in costs of goods sold. Common expenses in this category are:
- Office rent
- Office supplies
- Professional fees
- Employee benefits
Operating Expenses vs. Costs of Goods Sold
Before we go further, let’s clarify the “directly correlated to generating revenue” bit. I’ve worked with owners who sometimes struggle with classifying expenses, especially if they’re creating an income statement layout for the first time. After all, at the end of the day all expenses are needed to generate revenue.
If you don’t rent office space, pay office staff, turn on the electricity for their computers, pay lawyers and attorneys to stay in compliance, etc., the business cannot go on. Directly correlated to sales should be looked at more narrowly. If I sell one more unit of something, none of the expenses I mentioned as examples should change at all. What does change are things like raw materials, freight, warehouse labor, and none of these are operating expenses.
When speaking about revenue and costs of goods sold, we talked about how sometimes less is more, and we don’t want to bog down those sections with trivial information. While that holds true in operating expenses, you will find you need many more accounts here than anywhere else. Here are some things to lookout for when choosing operating expenses:
- In general, try not to create an account for something that will have only a handful of small transactions in an entire year, especially if those transactions are low dollar amounts. If something smaller and unusual pops up, just find an account that best fits, even if not perfect, and wait to create a new account until this type of transaction becomes more common.
- Try not to have redundant accounts that don’t add meaning. Things like “Lunches”, “Employee Lunches”, “Office Lunches” all on the same income statement are things I see relatively commonly. It spreads the value thin and makes it hard to quantify what was actually spent on the general category.
- Don’t just throw everything in “Office Supplies”. This is a little contrary to the first two points, but you’ll want to avoid the temptation of just putting everything in office supplies because it’s quick and easy. If your office expense is a huge amount bloated with all kinds of transactions, then that account loses meaning when reading the financial statements.
- Another exception to #1 above are accounts that need to exist separately to make other parts of your life easier. For example, subcontractors is usually a good account to keep separate if for no other reason than it makes 1099s a lot easier to calculate at the end of the year.
- Whatever you do, try to fit your income statement to one page unless you have a really compelling reason to stretch it further. If you can’t look at this at a glance and see things popping out at you, then what purpose is this report serving you? You can always dig into details later; you don’t need all the detail to be present right on the face of the income statement.
Reducing Operating Expenses
Operating expenses tend to be generally “fixed” and a much lower dollar amount when compared to costs of goods sold. For this reason, operating expenses are often a trap where business owners may spend a lot of time trying to fix something, when the upside is actually a small amount of money, and the savings won’t scale with growth. How much money can you save on pens? How much can you save on hotels when travelling?
What if you improved your costs of goods sold or increased revenue by even 1% instead, how much of a dollar difference is that increase vs. saving on an operating expense? My general recommendation for budgeting for and management of operating expenses is to review them to be sure they’re within reason, and then task your office manager with creating a plan for improvement in certain areas if necessary. As the business owner your time is often going to be more valuable somewhere else.
Now that we have a basic understanding of operating expenses, you are ready to tackle 99% of the income statement. Our last section will be other income/expense, and there we will discuss the real outliers or the handful of accounts that don’t really belong anywhere else on the income statement.
If you missed the previous installments of this series, you can find them here:
If you have any questions about income statements or need assistance with your income statements, please contact us.