Updated: May 14
Welcome back to "All About The Profit & Loss Statement" series. We are covering the topic of operating expense (OPEX) in this article. OPEX are expenses that are used to keep the business running smoothly. Common overheads are advertising and promotion, salaries of administrative and sales officers
Sounds familiar isn't it? Without further ado, let us kick-start the exciting journey into the world of OPEX. Do leave a like or comment.
TABLE OF CONTENT
What is OPEX?
Sales & Distribution
General & Administrative
Research & Development
Budgeting for OPEX
OPEX VS CAPEX
WHAT IS OPEX?
OPEX are periodic costs incurred for the smooth-running of the business. It is important to differentiate OPEX from the cost of goods sold (COGS) which measures the cost incurred to produce the products that were sold. Unlike COGS which is related to sales, OPEX is a periodic expense as it is incurred at specific time intervals. OPEX appears immediately after gross income and is deducted from gross income to calculate operating income (EBIT).
OPEX can be subdivided into 3 categories, selling and distribution (S&D), general and administrative (G&A) and research and development (R&D) expenses. All classes possess their unique cost model. We will discuss further on the nature of each OPEX class later in the article.
SALES & DISTRIBUTION EXPENSES
Costs that are incurred during the act of selling (in Red) are classified as S&D expenses, including costs arising from market research, referral program, and remuneration for distribution, sales support staff.
The Sales/Marketing ratio measures the success of a marketing campaign. It is usually used to measure the effectiveness of a specific marketing campaign, such as those relating to a special sale event, new product launch, rebranding, etc. To yield meaningful insights, one has to evaluate the performance against peers' and past performances. Generally, the higher the ratio, the more effective the marketing campaign.
Karen is the manager of Skynet Inc., a firm that provides security solutions. She sets aside $5,000 advertising expense every 4th quarter (Q4). This year, she decides to spend $5,000 more on advertising to take advantage of the double 11 sales and that results in 3x more sales. Her Q4 sale last year was $100,000.
The sales/marketing ratio this year is 30x ($300,000 ÷ $10,000), compared with 20x last year ($100,000 ÷ $5,000). With everything else equal, the advertising campaign is a resounding success and she should continue doing it next year.
GENERAL & ADMINISTRATIVE EXPENSES
G&A expenses are cost items that support the production, R&D and selling activities. Fixed overheads represent investments in capacity and are typically fixed in the short and intermediate terms. They are, therefore, susceptible to overcapacity when demand does not match expectations.
For example, Karen hires an administrator to manage the firm's distributor network as she expects the business to rapidly grow. However, a competitor enters the market with a technologically-superior product which causes 30% of the distributors to drop Skynet. That results in the new-hire being underutilized.
RESEARCH & DEVELOPMENT
R&D is an innovative and systematic initiative to develop new and/or improve existing products, services, and intellectual property rights. Although R&D is a risky endeavour whose outcome is uncertain, its reward could outweigh its initial investments and bring economic benefits to the organization in the years to come. From this perspective, R&D looks similar to a capital investment because if successful, it brings future economic benefits like an asset.
However, the accounting standard does not allow managers to record R&D spending as an asset as its ability to bring in future economic benefit is not probable. Under IFRS, research costs are expensed when incurred. But development cost can be capitalized after technical and commercial feasibility is established,
R&D is important for a business that is pursuing a differentiation strategy. The products are said to have the unique selling proposition such as cutting-edge technology, brand equity, etc, and are sold at a premium. Such companies conduct R&D to keep ahead of the competition. If a firm charges less for its products and is focused on trading profit margin for volume, it is said to be following the cost leadership model. Although not as prevalent, some corporations do conduct R&D to further lower cost.
An organization is said to be operationally leveraged when its cost structure comprises significantly of fixed overhead. In another word, a change in sales number is going to have a magnified effect on profits because of the spreading of fixed cost. With higher sales, the decrease in per-unit fixed cost enhances overall profitability. But when sales number decreases, per-unit fixed cost increases and hurts profitability.
As OPEX represents sunk investments, they are incurred regardless of the level of capacity utilization. It is also expensive to exit from an OPEX commitment within a short to intermediate time-frame. However, higher overheads are typically accompanied by a lower per-unit variable cost. For example, Karen may opt to invest in a costly system to automate administrative tasks. Although more sales are required to cover the fixed expense, it leads to lower variable cost per unit and the firm benefits if the demand is sufficiently big.
Karen may also opt to contract the work to a vendor instead of automation. Consequently, the business requires lesser sales to cover fixed expenses. But the more costly per-unit variable cost will dampen profitability when sales increase to a certain threshold. Ultimately, the question of assuming operational leverage lies with the firm's conviction in their own sales projections, risk appetite, fund availability, etc,
When an external user of the financial statement projects OPEX for analysis and modelling purposes, she does not enjoy the same level of access to information as insiders. Therefore, to forecast with reasonable basis, one should first understand the company's strategic direction by reading the management discussion and analysis (MD&A) and the news, Secondly, she should comprehend the cost structure of various OPEX items to better work with limited information.
For cost-centres such as G&A expenses, the spending level generally revolves around the question of capacity (supply) and expected demand, The most straightforward approach is to examine the G&A items and measure their size relative to revenue. If the historic percentage has been stable, one can reasonably forecast G&A as a percentage of expected revenue. But if the company announces a restructuring or rebranding exercise, one should examine the likelihood of the percentage rising or failing to meet its strategic intent.
Alternatively, the incremental approach works if historical data has exhibited consistent growth rate. One merely has to factor in the compounded annual growth rate (CAGR) to compute the next period's OPEX. Again, it pays to be aware of the company's strategy as a future percentage rise or fall might be radically different from the past when the firm's strategic direction is radically reoriented.
On the other side of the spectrum, to forecast R&D spendings, one has to study the firm's long-term strategic plan. For example, to better meet the challenges of the new competitor, Karen decides to research it and she finds out that the young company is spending a disproportionately high percentage on R&D, making its business model sustainable in the long-term. Although the added dimension of strategy makes forecasting more challenging, it is foolhardy to keep a blind eye to the company's strategy.
BUDGETING FOR OPEX
Budgeting for OPEX is an important exercise for managers and accountants. Unlike external analysis which is done with plenty of inference, budgeting can be done with more certainty due to greater access to data. Managers also have the discretion to buck the historical trend and pursue a new strategy.
The OPEX budget is, thus, more than just mere capacity-planning as it also encompasses setting performance targets and allocating resources to achieve long-term strategic initiatives, For example, Skynet Inc. decides to meet the challenge of the new competitor by innovating and lowering prices to gain back market shares.
Karen has to rethink what USP she intends to create for her product. Instead of the usual 2% of revenue on advertising and promotion, she increases the budget allocation to 4% and plans a market research project for year 1 and rebranding exercise for year 2. She also increases R&D from 0% to 2% of revenue going forward, The additional 4% allocation to S&D and R&D comes at the expense of G&A.
The capacity-based approach is relatively straightforward and it measures how much support is needed to achieve the budgeted KPIs, such as expected revenue. The incremental approach builds on the previous period's budgets and adjusts to the tune of the firm's strategic initiative. Lastly, the Zero-based budgeting (ZBB) approach restarts budgeting to zero at the onset of the budgeting cycle to eliminate budgetary slack and realign resources to achieve strategic goals.
For example, to achieve the goal of making G&A leaner, Karen kicks off the ZBB restructuring exercise with the accounting department. To save cost, its processes are re-engineered to make them more lean and effective. A new budget is then proposed to meet the modified objectives and eliminate budgetary slacks.
As part of the budgeting exercise, Karen is also interested to find out the true cost of her products by taking into consideration the overhead needed to support them. Before this, she just took the market price as a reference when assigning a price and deduct the costs of purchasing and installation to compute a profit.
Since the products and services that Skynet Inc. is offering are largely homogeneous, she may adopt the activity-based costing (ABC) method that:
Identifies all overhead activities in the firm
Aggregates related activity overhead costs into their respective cost pools
Assigns the overhead cost by actual consumption to each good and service
Sums the direct costs and assigned overheads to get the total cost for the product
Divides total cost with the no. of units produced over the past period to get the unit cost
In our simple illustration which illustrates the 5-step process, Karen manages to calculate the true cost of Skynet's security cloud solution on her per unit basis. With the information, she can use it to better plan and manage fixed overhead costs. She also gets more clarity on the cost which allows her to better price her product. If one's products and services are largely unique, like construction, one should adopt the job costing system. We have shared some detail on the system in our previous article on COGS.
OPEX VS CAPEX
OPEX is in essence, an articulation of the corporation's long-term long term strategic objectives into shorter-term actionable plans. Want to measure the company's resolve to achieve the strategy? Have the managers "put money where the mouth is" by allocating the resources to the correct OPEX items?
Contrary to the short-term nature of OPEX, capital expenditure (CAPEX) is an investment in assets which appear in the balance sheet and the assets are expected to generate probable economic benefits beyond the current financial reporting period. Managers should view CAPEX as longer-term and bigger steps to achieve the firm's ultimate strategic intent.