Operating Expenses: Mostly Fixed
Operating expenses are the costs of running a business that are not directly attributable to producing what it sold, subtracted from gross profit to give operating income. Most of the total is fixed in the short term, which is the mechanism behind operating leverage.
How it works
Operating expenses are what it costs to be a company, as distinct from what it costs to make the product. Sales teams, marketing, head office, finance, legal, research.
They sit between gross profit and operating income on the income statement, which is why the two profit figures can move in opposite directions.
Selling, general and administrative is normally the biggest component, and it bundles two quite different things: the cost of acquiring customers, which should scale with growth, and the cost of existing, which should not.
The fixed portion is the whole story
Rent, salaries, systems and premises do not shrink when sales do. That is the defining property of the category, and it produces the effect everything else on this page follows from.
Operating leverage is that arithmetic. If revenue grows 20% and gross margin holds, gross profit grows 20%; if operating expenses grow 5%, operating income grows far faster than either. The same mechanism runs in reverse in a downturn, and it runs harder, because the fixed costs are still there.
Which is the most useful thing to carry away: a company with high fixed operating costs is a leveraged bet on its own revenue, and the leverage is visible in the accounts before anything goes wrong.
In practice: what to watch
Research spending is an expense today that is meant to produce revenue later. Accounting requires most of it to be expensed as incurred rather than capitalized, so a company investing heavily reports lower profit than one that is not — and the accounts cannot tell you whether the investment was any good.
Which makes it the easiest lever to pull. Cutting research raises this year’s operating income immediately and shows up in revenue several years later, if at all. Profit rising while research as a share of revenue falls is one of the few genuinely readable patterns in a set of accounts.
One-off charges land here more than anywhere else — restructuring, impairments, legal settlements. They are disclosed, and they make year-on-year comparisons meaningless unless you strip them out yourself.
Always read it as a percentage of revenue. A company that grew expenses 12% while revenue grew 20% is improving; one that grew expenses 12% while revenue grew 4% is not, and the dollar figure is identical in both cases.
And trading the shares on any of this is a separate cost: the spread and any commission, paid on every round trip whatever the accounts say.
The ratio worth tracking is research spending divided by revenue, over several years. A company holding it at 7% through a weak year is funding the future out of a smaller base; a company where it drifts from 7% to 4% while operating income improves has bought this year’s profit with next decade’s products, and the income statement presents the two identically.
The same test applies to selling and marketing. Rising sales spend with rising revenue is a company buying growth, and the question is what it costs per unit of revenue gained. Falling sales spend with flat revenue is a company that has stopped trying. Both look like ordinary cost lines until you divide them by the top line and put five years side by side, which is an afternoon’s work in the filings.
What operating expenses are not
They are not cost of goods sold. That is the cost of the product; this is the cost of the company.
They are not all discretionary. Rent and salaries are contractual in the short term.
They are not comparable in dollars. Only as a share of revenue, and only within an industry.
And they are not always recurring. One-off items sit inside the reported total and have to be removed before comparing years.
How this connects
The category has formal names in the filings. In a 10-K it usually appears as SG&A plus R&D, and management tends to explain movements in both on the earnings call.
It sits above EBIT, and it is where EBITDA gets generous. Operating expenses include depreciation on premises and systems, and adding that back flatters exactly the companies whose fixed cost base is largest.
Cash timing is recorded on other statements. An expense recognized this year may have been paid last year or next, so the cash flow statement shows whether reported costs match money actually leaving, and the balance sheet holds the prepaid and accrued amounts that bridge the two.
Inflation reaches this line through wages and rent. A company that cannot pass rising costs on in its prices watches the fixed base grow while revenue stands still.
And it is core material for fundamental analysis. Anyone talking about a margin of safety in a business is partly asking how far revenue can fall before these costs consume the profit.
When it fails
Expenses growing faster than revenue is the ordinary way a growth company stops being one. Each year looks like investment; the cumulative effect is a business whose costs have found a level its revenue cannot reach.
The second failure is treating a cut as an improvement. Operating income up because research was cut is a different event from operating income up because revenue grew, and the income statement presents both identically.
A third is ignoring the one-off items. A restructuring charge makes this year look bad and next year look good, and neither figure describes the underlying business.
A fourth is missing the leverage in reverse. A company with high fixed costs loses profit far faster than it loses revenue, and the accounts show that risk clearly before it materializes.
And a fifth is comparing dollars across companies of different sizes, which produces confident conclusions from an arithmetic that does not hold.
The original data
Of the 24,971 trading and investing videos in this site’s corpus, “earnings” returns 23 videos at a median of 2,286 views; “valuation” returns 8 at a median of 160,764; “index fund” returns 132 at a median of 69,951. No video is counted twice, however many searches surfaced it.
132 videos on index funds at a median of 69,951 views, against 594 on one oscillator at 5,377, is a striking ratio and it points somewhere useful. The subjects with almost no supply are getting an order of magnitude more attention per video than the subjects everyone covers. For a reader that means the scarcity of material about how a company actually earns money is a feature of what gets made, not a measure of how much it matters — and the operating expense line is one of the places where a couple of hours in an annual report tells you something a year of chart study cannot.
Related
Operating income is what is left once these come out. Gross profit is what they come out of. And income statement is the sequence they sit in the middle of.
The line I watch is research spending as a share of revenue, because it is the easiest thing to cut and the cut looks like an improvement for about two years. Profit rising while that ratio falls is one of the few genuinely informative patterns on the income statement.
— Michael Whitman
This page is educational, not financial advice. Test every idea on your own charts before risking money.