The next section of the income statement focuses on the operating expenses that arise during the ordinary course of running a business. Operating expense includes salaries paid to employees, research and development costs, legal fees, accountant fees, bank charges, office supplies, electricity bills, business licenses, and more.
The general rule of thumb is that if an expense doesn't qualify as a cost of goods sold, meaning it isn't directly related to producing or manufacturing a good or service, it goes under the operating expense section of the income statement. There are several categories, the biggest of which is known as Selling, General, and Administrative Expense, but we'll get to that in a few pages.
Whether you are a new investor trying to study a company's annual report and 10K, or a business owner examining your operations or considering buying or starting a new undertaking, understanding the role of operating expenses is vital to your success.
Agency Cost and Operating Expenses
The biggest challenge to controlling operating expenses is a risk known as agency cost. It is the inherent conflict between owners and managers. Those that work in the business are always going to want nicer offices, more secretaries, better facilities, faster computers, free lunches, or whatever else they can imagine. These are easier to control if you have a small business but your options are limited if you own shares in a large corporation.
You'll also find that some companies purposely chose to run higher expense ratios than their competitors. One major, well-known bank makes an intentional choice to run 10% to 15% higher operating expenses, and thus lower profit margins, to keep the branches fully staffed. They believe that by making banking as convenient as possible and avoiding long lines, the improved customer service will cause more of their clients to keep a larger portion of their household's accounts with them. Their goal is to eventually become a one-stop shop so that you can do your banking, manage your credit cards, open a brokerage account, or get insurance, all on an integrated statement. Only you, as the investor, can decide whether you think the plan is intelligent and the higher operating expense are worth it.
In general, you want to work with managements that strive to keep operating expense as low as possible, while not damaging the underlying business.
This page is part of Investing Lesson 4 - How to Read an Income Statement. To go back to the beginning, see the Table of Contents.