Operating Expense Control
Operating expenses are expenses other than your costs of goods sold, direct expenses, other income or other expenses. They are considered the continuous financial obligations incurred in the daily operation of the business. Your operating expense control can make a huge difference in your gross profit margin.
It’s commonly thought that operating expense control happens out of necessity, not as an on-going business practice. In good times, expense control is viewed as unnecessary in light of increasing revenues and net income. There are two problems with this thinking:
- Expense control takes practice
- Expense control needs to be consistent
In order to track operating expenses effectively, it is important that all expenses are properly allocated. Shifting expense items back and forth between a direct expense and an operating expense to make one or the other look good harms a business in the long run.
Expense control is used either as a percentage of revenues or an absolute dollar increase compared to the absolute dollar increase in revenues for the period being measured. It’s important to note that the real revenue dollar increase is more important than the absolute dollar increase. Only real revenue dollar changes are what actually affect the operating expenses.
Let’s look at an example. We’ll take a company with a nominal dollar increase in revenues of 10% and operating expenses up 8%. The real revenue increased 2% (taking the expense increase out of the revenue increase) so we can say there was a potential expense control issue of around 75% (the ratio of real revenue to operating expenses). This is an expense control issue that needs to be investigated, as there may be important inflationary increases in specific expenses like wages or payroll.
The second way to look for expense control is looking at the absolute dollars over the year prior. Many firms use this method as the primary expense control method. We call this a “dull knife approach,” which means it’s not really strategic or tactical.
If the ratio of operating expenses to revenues alerts one to a potential operating expense issue then the expenses need to be looked at line-by-line. The focused analysis needs to be done using a statistics, not just “eyeballing the numbers.” A statistical approach identifies the real issues and the critical ones to address.
Another helpful method for looking at operating expenses is to graph the gross profit margin percentage – operating expense as a percentage to revenues – and the net income pre-tax margin. Both of these margins are divided by revenues so they are comparable.
We can also graph the dollar amounts for gross profits, operating expenses, and net income in the same graph as the percentages. This helps business owners see the changes that are occurring in percentages before the owner may perceive them by looking at the dollar amounts.
When viewing the operating expenses, particularly for smaller firms, it is best to look at “core” operating expenses. Core operating expenses are the total operating expenses less officers’ salaries, depreciation expense, and amortization expense.
Expense control takes practice, patience, and a focused, analytical look at detailed expense data. We can help your business avoid both knee-jerk reactions to incomplete information as well as complex and dangerous expense control issues.