Operating Expenses: What They Are, How to Calculate, and How to Reduce Them
Every dollar your business spends on rent, salaries, software subscriptions, and office supplies chips away at your profit margin—yet many business owners can't clearly distinguish their operating expenses from other costs. Understanding this distinction isn't just an accounting exercise. It's the foundation for making smarter spending decisions, improving profitability, and preparing accurate financial statements.
In this guide, we'll break down what operating expenses are, how to calculate your operating expense ratio, and practical strategies to bring those costs under control.
What Are Operating Expenses?
Operating expenses (often abbreviated as OpEx) are the ongoing costs a business incurs to run its day-to-day operations. Think of them as the price of keeping the lights on—literally and figuratively. These are the expenses required to maintain normal business activities but are not directly tied to producing goods or delivering services.
You may also hear operating expenses referred to as Selling, General, and Administrative (SG&A) expenses, though some companies break SG&A into a separate line item on the income statement.
Operating Expenses vs. Cost of Goods Sold (COGS)
One of the most common points of confusion is the difference between operating expenses and COGS. Here's the distinction:
- COGS includes costs directly tied to producing your product or service—raw materials, manufacturing labor, and shipping costs for finished goods.
- Operating expenses cover everything else needed to run the business—rent, administrative salaries, marketing, and office supplies.
If you run a bakery, the flour and butter are COGS. The rent for your storefront and the salary you pay your bookkeeper are operating expenses.
Operating Expenses vs. Capital Expenditures (CapEx)
Another important distinction is between OpEx and CapEx:
- Operating expenses are fully deductible in the year they're incurred. They have short-term benefits (less than one year).
- Capital expenditures are long-term investments in assets like equipment, vehicles, or property. They appear on the balance sheet and are depreciated over their useful life.
Buying a laptop for your office is a capital expenditure. The monthly internet bill you pay to use that laptop is an operating expense. Understanding this difference matters for both financial reporting and tax planning.
Common Categories of Operating Expenses
Operating expenses generally fall into three broad categories:
Office and Facilities
- Rent or mortgage payments
- Utilities (electricity, water, gas, internet)
- Office supplies and equipment maintenance
- Property taxes and insurance
- Cleaning and janitorial services
Compensation and Benefits
- Administrative and management salaries
- Employee benefits (health insurance, retirement contributions)
- Payroll taxes
- Sales commissions
- Training and professional development
Sales, Marketing, and Administration
- Advertising and marketing campaigns
- Software subscriptions and SaaS tools
- Travel and entertainment
- Legal and accounting fees
- Licensing and permit fees
- Bank fees and payment processing costs
Most operating expenses are either fixed (staying consistent month to month, like rent) or variable (fluctuating with business activity, like shipping supplies or sales commissions). Knowing which of your expenses are fixed versus variable helps you forecast and budget more accurately.
How to Calculate Your Operating Expense Ratio (OER)
The operating expense ratio tells you how many cents of every revenue dollar go toward running your business. It's one of the most useful benchmarks for measuring operational efficiency.
The Formula
Operating Expense Ratio = (COGS + Operating Expenses) / Total Revenue
Example Calculation
Suppose your small business had the following numbers last quarter:
| Item | Amount |
|---|---|
| Total Revenue | $250,000 |
| Cost of Goods Sold | $75,000 |
| Operating Expenses | $100,000 |
OER = ($75,000 + $100,000) / $250,000 = 0.70
This means 70 cents of every dollar you earn goes toward operational costs, leaving 30 cents for debt payments, taxes, and profit.
What's a Good Operating Expense Ratio?
Benchmarks vary by industry, but here are general guidelines:
| OER Range | Assessment |
|---|---|
| Below 50% | Excellent cost management |
| 51%–60% | Good—room for optimization |
| Above 60% | Needs review—profitability at risk |
Industry-specific examples:
- Retail: Average OER around 20%, though discount retailers tend to be lower and high-end retailers higher.
- SaaS companies: Healthy OER below 40%, though early-stage startups often run 50%–80% as they invest in growth.
- Professional services: Typically 60%–75%, reflecting high labor costs.
The key is to track your OER over time and compare it against your own historical performance and industry peers.
Where Operating Expenses Appear on Financial Statements
Operating expenses show up on your income statement (also called a profit and loss statement). Here's how they fit into the bigger picture:
Revenue
- Cost of Goods Sold
= Gross Profit
- Operating Expenses
= Operating Income (EBIT)
- Interest and Taxes
= Net Income
Operating income—sometimes called EBIT (Earnings Before Interest and Taxes)—is one of the most watched metrics by investors and lenders because it shows how profitable your core business operations are, independent of financing decisions and tax situations.
Tax Implications of Operating Expenses
Most operating expenses are tax-deductible in the year they're incurred, as long as they meet the IRS standard of being "ordinary and necessary" for your business. This is one of the advantages OpEx has over CapEx, which must be depreciated over multiple years.
Key tax considerations for 2025–2026:
- Qualified Business Income (QBI) deduction: 20% for 2025, increasing to 23% for tax years beginning after December 31, 2025.
- Section 179: Allows you to deduct up to $2.5 million in qualifying equipment purchases in the year of purchase (2025).
- Documentation: The IRS requires records for all deductions. For expenses under $75, a bank statement showing the amount, date, and vendor may suffice. For larger expenses, keep itemized receipts.
Properly categorizing your expenses as operating vs. capital can save you significant money at tax time, since operating expenses provide an immediate deduction rather than a multi-year depreciation schedule.
8 Practical Ways to Reduce Operating Expenses
Cutting operating expenses doesn't mean slashing quality or morale. Here are strategies that target waste without undermining your business:
1. Audit Your Subscriptions and Software
The average small business uses over 100 SaaS tools, and many go unused or underutilized. Review every recurring subscription quarterly. Cancel what you don't need and consolidate overlapping tools.
2. Renegotiate Vendor Contracts
Most vendors would rather keep a customer at a lower rate than lose them entirely. Renegotiate leases, insurance policies, and service agreements annually. Even a 5% reduction on your largest contracts can add up quickly.
3. Embrace Remote or Hybrid Work
Office space is often one of the largest operating expenses. If your team can work remotely, even partially, consider downsizing to a smaller office or switching to a coworking space, where desk fees average around $300 per month with flexible terms.
4. Automate Repetitive Tasks
Accounting, invoicing, payroll, and customer communications can all be automated. The upfront investment in automation tools typically pays for itself within months by reducing labor hours and human error.
5. Optimize Energy Usage
Utility costs can account for 10% or more of operating expenses. Simple changes—LED lighting, programmable thermostats, and energy-efficient equipment—can reduce energy usage by 20% or more.
6. Review Staffing Strategically
Labor is typically the largest operating expense. This doesn't mean layoffs—it means smart scheduling. Staff up on busy days, scale back on slow ones. Cross-train employees so you can operate efficiently without hiring specialists for every function.
7. Take Advantage of Early Payment Discounts
Many suppliers offer discounts (typically 1%–2%) for paying invoices early. If your cash flow allows it, these discounts compound significantly over a year.
8. Track and Benchmark Continuously
Reducing operating expenses isn't a one-time project. Set up monthly reviews of your OER, compare against industry benchmarks, and flag any categories that are trending upward. Small leaks sink big ships.
Common Mistakes When Managing Operating Expenses
Avoid these pitfalls that can distort your financial picture or lead to poor decisions:
- Misclassifying CapEx as OpEx (or vice versa): This affects your income statement, balance sheet, and tax liability. A new roof for your office is CapEx; the monthly cleaning service is OpEx.
- Ignoring variable costs: Fixed expenses get most of the attention, but variable costs can quietly balloon as your business grows. Monitor them per unit of revenue.
- Cutting too aggressively: Eliminating training budgets or marketing spend might save money this quarter but hurt growth next year. Cut waste, not investment.
- Not separating personal and business expenses: This creates accounting headaches and potential tax problems. Always use a dedicated business account.
Keep Your Finances Organized from Day One
Whether you're tracking operating expenses for a startup or optimizing costs for a growing business, clear and accurate financial records make everything easier—from budgeting and tax prep to securing a loan or investment.
Beancount.io provides plain-text accounting that gives you complete transparency and control over your financial data—no black boxes, no vendor lock-in. Every transaction is version-controlled, auditable, and ready for the AI-powered tools that are transforming how businesses manage their finances. Get started for free and see why developers and finance professionals are switching to plain-text accounting.
