Table of Contents
What Are Operating Expenses? Definition & Examples
- 5 min read
- Authored & Reviewed by: CLFI Team
Operating expenses are the costs a business incurs while generating revenue through its ordinary operations. They are recorded on the income statement in the period they arise and form a central driver of operating profit, EBITDA, and free cash flow forecasts.
Definition:
Operating Expenses (OpEx)
The recurring costs incurred in running a company's ordinary business activities, recorded as expenses in the period in which they arise.
What it represents
OpEx captures the operating cost base required to generate revenue, including production costs, administrative functions, sales activity, research activity, and depreciation charges.
How it is calculated
Operating expenses can be calculated by adding COGS, SG&A, R&D, D&A, and other operating line items, or by subtracting EBIT from revenue.
Fixed and variable costs
Fixed costs such as rent and base salaries remain relatively stable in the short term, while variable costs such as materials and commissions move with revenue.
Why it matters
The mix of operating expenses determines margin resilience, operating leverage, and the reliability of projected cash flows in valuation and lending analysis.
Common limitation
Management adjustments can exclude recurring or economically relevant costs, which means analysts must reconstruct sustainable OpEx before relying on reported profitability.
Table of Contents
What Are Operating Expenses?
Operating expenses are the costs a business incurs in the ordinary course of generating revenue, recorded on the income statement rather than capitalised on the balance sheet. The category can include cost of goods sold, selling, general, and administrative expenses, research and development, and depreciation and amortisation.
Under IFRS and US GAAP, these costs are separated from financing costs such as interest expense, which appear below the operating profit line. Analysts use the term in both a broad and a narrow sense. In the broad sense, OpEx captures all costs deducted before EBIT. In the narrower sense, it refers to costs below gross profit, excluding COGS. That distinction matters because the separation between COGS and the remaining cost base affects gross margin and operating margin comparability across industries.
How Operating Expenses Work
The behaviour of operating expenses shapes how profit responds when revenue changes. Fixed operating expenses such as office rent, base salaries, insurance premiums, and software licences remain broadly stable in the short term. Variable operating expenses such as raw materials, sales commissions, and fulfilment costs move with revenue or units produced.
A cost base weighted toward fixed costs creates operating leverage because each additional pound of revenue can carry a higher incremental margin after the fixed base has been covered. The same structure can compress earnings quickly when revenue falls, which is why analysts look for step costs as well as fixed and variable costs. A new management layer, larger support team, or expanded infrastructure platform can change the margin trajectory at a specific scale threshold.
Operating expenses also connect directly to what EBITDA measures. Depreciation and amortisation reduce EBIT, but they are added back when calculating EBITDA because they are non-cash charges in the period. This makes OpEx composition a primary input to valuation multiples, lending covenants, and management forecasts.
Operating Expenses Formula
Two equivalent ways to calculate OpEx from income statement data
Cost Line Item Approach
Operating Expenses = COGS + SG&A + R&D + D&A + Other Operating Costs
Income Statement Approach
Operating Expenses = Revenue - Operating Profit (EBIT)
| Variable | Meaning |
|---|---|
| COGS | Direct costs of producing the goods or services sold in the period. |
| SG&A | Selling, general, and administrative expenses, including sales teams, management, rent, and back-office functions. |
| R&D | Research and development expenditure linked to product development, engineering, and testing. |
| D&A | Depreciation and amortisation charges for tangible fixed assets and intangible assets. |
| EBIT | Earnings before interest and taxes, also referred to as operating profit. |
Worked Calculation
A manufacturing business reports revenue of £50 million, COGS of £22 million, SG&A of £9 million, R&D of £3 million, and D&A of £4 million. Total operating expenses are £38 million, calculated as £22 million plus £9 million plus £3 million plus £4 million. EBIT is therefore £12 million, while EBITDA is £16 million after adding back the £4 million D&A charge.
Operating Expenses Example
Consider a hypothetical SaaS company, Vertex Analytics, generating £30 million in annual revenue. Its operating expenses include £6 million in hosting and customer support, £8 million in sales and marketing, £5 million in engineering, and £2 million in depreciation of server infrastructure. Total OpEx of £21 million produces EBIT of £9 million and EBITDA of £11 million.
An acquirer examining this cost base would focus less on the total alone and more on how the costs behave under different revenue scenarios. The high fixed proportion in engineering and sales infrastructure means a 20 percent revenue increase could flow through at attractive incremental margins, while a revenue contraction would place immediate pressure on EBITDA. This cost structure analysis becomes a foundation for the unlevered free cash flow model used in a discounted cash flow valuation.
Key Considerations and Limitations
The same OpEx total can represent very different levels of structural efficiency depending on whether the underlying costs are fixed, variable, temporary, or exceptional. Reported OpEx is frequently adjusted by management to exclude restructuring charges, share-based compensation, and one-off provisions. Some exclusions are reasonable, while others remove costs that are economically recurring even if the accounting label suggests otherwise.
The fixed-variable decomposition is also harder than it appears because published accounts usually report costs by function rather than behaviour. An analyst can see sales and marketing, but that line may contain fixed salaries, variable commissions, discretionary campaign spend, and long-term platform costs. The practical test is to trace any reported cost reduction to its source. A temporary freeze on hiring or marketing spend should not be projected as a permanent margin improvement in a discounted cash flow model unless the operating model has genuinely changed.
Operating Expenses vs Capital Expenditure
The boundary between operating expenses and capital expenditure determines where a cost appears in the financial statements and how quickly it reduces reported profit. Operating expenses are recorded in the income statement immediately, while capital expenditure is capitalised on the balance sheet and then charged to profit over time through depreciation or amortisation.
| Area | Operating Expenses | Capital Expenditure |
|---|---|---|
| Financial statement | Income statement | Balance sheet, then income statement through depreciation |
| Timing | Expensed in the period incurred | Capitalised and depreciated over asset life |
| Cash flow classification | Operating cash flow | Investing cash flow |
| Tax treatment | Generally deductible in the period incurred | Deducted over time through depreciation or amortisation |
The practical test is whether the spending creates an asset with a useful life beyond the current accounting period. Maintaining delivery vehicles is OpEx, while purchasing them is CapEx. Companies under earnings pressure may have an incentive to capitalise recurring costs because doing so inflates EBIT in the current period, which is why analysts compare capital expenditure with depreciation and assess whether the classification is consistent with the economics of the business. This is part of the investment appraisal discipline within corporate finance.
In Practice
Operating expenses sit at the centre of financial statement analysis because they connect day-to-day operations with profit, cash flow, valuation, and capital allocation. A board assessing margin performance should therefore look beyond the headline OpEx number and ask how much of the cost base is structurally required, how much can flex with revenue, and how much has been adjusted out of management's preferred figures.
For executives, the decision relevance is clear. Sustainable cost discipline improves operating leverage and increases free cash flow, while poorly understood cuts can weaken revenue capacity or defer costs into a later period. The strongest analysis treats OpEx as an operating system rather than a single accounting total, linking each major cost category to the revenue model, investment plan, and long-term value creation case.
References
Brealey, R.A., Myers, S.C., and Allen, F. Principles of Corporate Finance. McGraw-Hill, 14th edition, 2022.
IFRS Foundation. IAS 1 Presentation of Financial Statements. IFRS Standards.
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