Operating Expenses and the Operating Result
After gross profit is determined, a business subtracts the expenses of selling its goods or services and managing its operations to find operating income. This measure focuses on the results of the organization’s operating activities before considering how it is financed or its income tax expense. Correct classification matters: an amount can be a real expense or cash outflow and still not belong in this calculation.
The earlier material on cost of goods sold and gross profit distinguishes the cost assigned to goods sold from the expenses of running the business. Here, take gross profit as the starting point, classify operating expenses by function, and calculate the amount remaining after those expenses. Keep all amounts tied to the same reporting period.
Selling Expenses and Administrative Expenses
Selling expenses arise from efforts to obtain customers, make sales, and deliver products or services to customers. Examples include sales commissions, sales staff salaries, advertising, and delivery costs that the business incurs to distribute goods to customers. The specific accounts used depend on the business and its accounting policies.
Administrative expenses support the organization as a whole rather than a particular sale. Examples can include executive and office staff salaries, office rent, utilities, office supplies used during the period, and depreciation on administrative equipment. A cost is not classified by its name alone: its purpose and the entity’s accounting policy matter. For example, salaries may be selling expenses when paid to sales staff and administrative expenses when paid to office staff.
These functional categories organize expenses according to what the business uses them for. They do not change the underlying fact that both kinds of expense reduce operating income when recognized for the period. Amounts should be recognized in the period to which they relate, not automatically in the period when cash is paid. For example, a cash payment for an item of equipment does not necessarily represent an expense for the full amount paid in that period.
| Item | Typical treatment in calculating operating income | Reason |
|---|---|---|
| Sales commissions | Selling expense | Related to obtaining or completing sales |
| Advertising | Usually a selling expense | Supports marketing and selling activity |
| Office rent | Usually an administrative expense | Supports general operations |
| Interest on borrowing | Excluded from operating expenses | Relates to financing, not selling or administration |
| Income tax expense | Excluded from operating expenses | Operating income is calculated before income tax expense |
| Purchase of a long-lived asset | Not automatically an expense | The purchase generally creates an asset; depreciation may be recognized over time |
Calculating Operating Income
Start with gross profit for the reporting period. Add the selling and administrative expenses recognized for that same period to find total operating expenses. Then subtract that total from gross profit. Interest expense and income tax expense are excluded, even when both are listed among the company’s accounts.
The relationship follows from what each figure represents. Gross profit is what remains from net sales after subtracting cost of goods sold. Selling and administrative expenses are additional costs of conducting the business’s operations during the period. Subtracting them from gross profit leaves the result of those operations, before financing costs and income taxes:
This derivation is an accounting relationship, not a claim that every cash payment in the period is an expense. Use the expense amounts recognized for the period, and do not subtract an amount twice if it has already been included in cost of goods sold. The calculation also does not attempt to include financing or income tax effects; those are outside the definition of operating income used here.
Worked Example: Separating Selling and Administrative Costs
A distributor reports gross profit of $336,000 for the year. For that same year, it records sales staff salaries of $68,000, advertising expense of $24,500, customer delivery expense of $13,500, office salaries of $47,000, office rent of $21,000, office insurance expense of $6,000, and depreciation expense of $8,000 on administrative equipment. Calculate total operating expenses and operating income. All listed expense amounts apply to the full year.
Method. Classify each cost by function, add the operating expenses, and subtract the total from gross profit. The statement that the depreciation amount applies to the full year makes its period clear.
Selling expenses. Sales salaries, advertising, and customer delivery are related to selling and delivering the distributor’s goods:
Administrative expenses. Office salaries, rent, insurance, and depreciation on administrative equipment support general operations:
Total operating expenses.
Operating income.
Check. Total expenses equal $106,000 + $82,000 = $188,000, and gross profit exceeds those expenses by $148,000. Operating income is $148,000 for the year. The method avoids mixing expenses from different periods or omitting an operating cost because it is noncash.
Worked Example: Excluding Financing, Tax, and an Asset Purchase
A manufacturer has quarterly gross profit of $275,000. The quarter’s accounts include sales commissions of $18,000, sales staff salaries of $42,000, marketing expense of $9,500, customer delivery expense of $7,500, office salaries of $36,000, office supplies used of $4,200, office rent of $15,000, and depreciation of $3,800 on office equipment for the quarter. It also reports interest expense of $6,400, income tax expense of $12,000, and a $5,000 cash purchase of a computer. Calculate operating expenses and operating income for the quarter.
Method. Include the selling and administrative expenses recognized in the quarter. Exclude the interest expense and income tax expense because operating income is measured before them. Do not treat the computer’s purchase price as an expense merely because cash was paid; depreciation is separately given as the period’s expense.
Selling expenses. Commissions, sales salaries, marketing, and customer delivery are selling expenses:
Administrative expenses. Office salaries, supplies used, rent, and quarterly depreciation are administrative expenses:
Total operating expenses.
Operating income.
Check. Interest, income tax, and the computer purchase have not been subtracted. Total operating expenses are $136,000, leaving operating income of $139,000. This avoids confusing a cash outflow or a below-operating-income item with an operating expense for the quarter.
Worked Example: Calculating the Result for a Stated Period
A service company reports gross profit of $412,000 for the six months ended June 30. For those six months, sales commissions are $32,000, sales staff salaries are $54,000, customer delivery costs are $11,000, advertising is $26,000, executive salaries are $72,000, office rent is $30,000, utilities are $8,400, and a software subscription used during the six-month period is $6,600. Calculate total operating expenses and operating income. All listed amounts are for the six months ended June 30.
Method. Use the period stated for every account, classify the expenses by function, and subtract their total from gross profit. Because the subscription amount is stated as the expense for the six-month period, do not substitute an annual amount or a cash payment for another period.
Selling expenses.
Administrative expenses.
Total operating expenses.
Operating income.
Check. Selling and administrative expenses sum to $240,000, and $412,000 less $240,000 is $172,000. Both the gross profit and expenses refer to the same six-month period.
Common Mistakes and Why They Matter
A frequent exam trap is to subtract every expense account shown in a list, even when the question asks for operating income. For the manufacturer in the second example, an incorrect calculation might subtract interest, income tax, and the computer purchase as though all three were operating expenses:
That calculation is wrong for operating income. The $139,000 already results from subtracting the correct operating expenses from gross profit. Interest and income tax are excluded from this measure, and buying a computer is not by itself an expense for its full purchase price. The corrected operating income remains $139,000; the stated $3,800 quarterly depreciation is the relevant operating expense in this calculation.
A second trap is to use an amount from the wrong time period. Annual depreciation cannot be treated as a quarterly expense without information about how much applies to the quarter. Likewise, a six-month expense should not be combined with annual gross profit unless the question gives a valid basis for aligning the periods. Always check the period attached to each amount before adding.
Finally, check whether a cost has already been included in cost of goods sold. If it has, subtracting it again as an operating expense would count the same cost twice. Classification depends on the facts and the accounting presentation, so do not classify a cost solely from a short account label when the question gives more specific information about its function.
Check Your Understanding
For each problem, classify the relevant expenses, calculate total operating expenses, and find operating income. Use only amounts that belong in the requested period.
- A retailer has gross profit of $96,000. Its period expenses are sales salaries of $12,800, advertising of $7,200, customer delivery of $3,000, office salaries of $18,000, rent of $4,500, and depreciation on office equipment of $2,500. Find total operating expenses and operating income. (Answer: Operating expenses $48,000; operating income $48,000.)
- A parts supplier has gross profit of $318,000. Selling expenses are sales payroll of $48,000, advertising of $16,000, and delivery costs of $14,000. Administrative expenses are salaries of $55,000, rent of $22,000, supplies used of $7,000, and equipment depreciation of $5,000. Interest expense is $8,000 and income tax expense is $24,000. Find operating income. (Answer: Operating expenses $167,000; operating income $151,000.)
- A company reports gross profit of $505,000 for the six months ended June 30. Selling costs for that period are commissions of $41,000, advertising of $22,500, and delivery of $13,500. Administrative costs are salaries of $68,000, rent of $28,000, insurance of $6,000, and $9,000 of depreciation that applies to those six months. Find total operating expenses and operating income. (Answer: Operating expenses $188,000; operating income $317,000.)
- A maker of household goods has net sales of $760,000 and cost of goods sold of $456,000 for the year. During the year it records sales payroll of $39,000, promotion expense of $17,000, delivery costs of $8,000, administrative salaries of $52,000, rent of $24,000, utilities of $5,500, and depreciation of $7,500. It also reports interest expense of $10,000, income tax expense of $18,000, and a $12,000 cash purchase of production equipment. Find gross profit, operating expenses, and operating income. (Answer: Gross profit $304,000; operating expenses $153,000; operating income $151,000.)