Operating expenses in accounting are the recurring costs a business pays to keep running that aren’t directly tied to producing its product or delivering its service. Rent, office salaries, utilities, insurance, marketing, software subscriptions. On the income statement, they sit right below gross profit, and subtracting them produces operating income, the clearest measure of how profitably a company runs its core business before financing and taxes enter the picture.
What Qualifies as an Operating Expense
The federal tax code sets the outer boundary. To be deductible, a business cost must be “ordinary and necessary” for carrying on a trade or business.1Office of the Law Revision Counsel. 26 U.S.C. 162 – Trade or Business Expenses “Ordinary” means common in your industry. “Necessary” means helpful and appropriate, not that the business literally couldn’t survive without it. A law firm’s Westlaw subscription is ordinary and necessary. A law firm buying a yacht probably isn’t.
In accounting terms, operating expenses share three traits. They recur, whether monthly, quarterly, or annually. They support the revenue-generating infrastructure rather than physically creating a product. And they get expensed in the period they’re incurred, not spread across multiple years the way a building or machine would be. That last trait is what separates them from capital expenditures.
Accrual accounting drives the timing. A December utility bill paid in January still hits the December income statement, because costs get matched to the period they helped produce revenue in.
Common Categories of Operating Expenses
The largest bucket in most companies falls under Selling, General, and Administrative costs, usually shortened to SG&A. Within that umbrella, a handful of categories show up on almost every income statement.
Payroll, Benefits, and Payroll Taxes
Salaries for employees who aren’t on the production line are operating expenses. Executives, accountants, HR, salespeople, administrative staff. On top of base pay, the employer owes a matching 6.2% for Social Security and 1.45% for Medicare, totaling 7.65% in FICA taxes.2Internal Revenue Service. Topic No. 751, Social Security and Medicare Withholding Rates Federal unemployment tax adds another 0.6% on the first $7,000 of each employee’s wages, assuming the employer qualifies for the standard state credit.3Internal Revenue Service. Topic No. 759, Form 940, Employers Annual Federal Unemployment Tax Return
Employer-paid health premiums and retirement contributions land here too. When an employer covers accident or health insurance for employees, those payments aren’t treated as wages and are exempt from Social Security, Medicare, and FUTA withholding.4Internal Revenue Service. Employee Benefits One notable exception: S corporation shareholders who own more than 2% of the company must include employer-paid health premiums in their wages.
Rent and Facilities
Office and retail rent is one of the most predictable operating expenses, especially when a company locks in a multi-year lease. Under current accounting standards, operating lease payments show up as a single lease expense, typically recognized on a straight-line basis over the lease term, even if the actual monthly payments fluctuate. Maintenance, janitorial services, and property insurance sit alongside rent.
Utilities and Technology
Electricity, water, internet, and phone service are standard operating costs. So are the software tools that keep a modern business running: email, accounting software, project management, and CRM systems. Cloud software classification depends on the arrangement. If a company simply accesses software hosted on someone else’s servers without a contractual right to take possession of the code, the subscription is a service contract and gets expensed as an operating cost. Only when the deal includes a transferable software license might it qualify as an intangible asset instead.
Marketing and Sales
Advertising, trade shows, sales commissions, promotional materials. These tend to be variable, meaning management can dial them up or down with the budget cycle or competitive pressure. Sales commissions in particular scale directly with revenue.
Office Supplies and Small Purchases
Pens, paper, printer toner, and similar supplies get expensed immediately. For slightly larger purchases, the IRS de minimis safe harbor lets businesses expense items outright instead of capitalizing and depreciating them. Businesses with an applicable financial statement (such as audited financials) can expense items costing up to $5,000 per invoice. Businesses without one can expense items up to $2,500 per invoice.5Internal Revenue Service. Tangible Property Final Regulations A $2,000 laptop for an office manager gets written off in the year of purchase rather than depreciated over several years.
Depreciation and Amortization
This one trips people up. Depreciation isn’t a cash payment. It’s an accounting charge that spreads the cost of a long-term asset (office furniture, a company vehicle) across the years you use it. Even though no cash leaves the bank, the depreciation charge still appears as an operating expense on the income statement. Most companies show it as a separate line item within operating expenses or fold it into SG&A with a disclosure note. Either way, it reduces operating income the same way rent or payroll does.
Insurance Premiums
General liability, professional liability, workers’ compensation, and directors and officers policies are all operating expenses. They’re typically fixed and don’t move with sales volume, though premiums adjust at renewal based on claims history and payroll size.
Fixed vs. Variable Operating Expenses
Fixed operating expenses stay roughly the same regardless of how much revenue the business generates. Rent, insurance premiums, and salaried payroll are the classic examples. If sales drop 30% next quarter, you still owe the same lease payment. These costs create a financial floor the business has to cover before earning a dime of profit.
Variable operating expenses move with activity. Sales commissions, shipping, credit card processing fees, and advertising budgets all flex. A company scaling rapidly will see variable operating expenses climb, but that’s expected because revenue is climbing too. The warning sign is when variable costs grow faster than revenue and squeeze margins. Understanding the split helps management figure out what can be cut quickly in a downturn (variable) and what requires renegotiation or restructuring (fixed).
What Operating Expenses Are Not
Three categories of spending sit outside the operating expense line, and mixing them up is one of the most common mistakes in financial reporting.
Cost of Goods Sold
Cost of goods sold covers the direct costs of creating a product or delivering a service: raw materials, factory labor, manufacturing overhead. COGS appears above operating expenses on the income statement and gets subtracted from revenue to produce gross profit. A furniture maker’s lumber is COGS. The salary of the furniture maker’s accountant is an operating expense. Both are real costs, but they answer different questions. COGS tells you how efficiently the company produces. Operating expenses tell you how efficiently it runs everything else.
Capital Expenditures
When a business buys a long-term asset like machinery, a building, or a delivery truck, the full purchase price doesn’t hit the income statement in one shot. The tax code requires those costs to be capitalized and recovered through depreciation deductions over the asset’s useful life.6Office of the Law Revision Counsel. 26 U.S.C. 263 – Capital Expenditures A $500,000 piece of equipment might generate depreciation expense of $50,000 per year for ten years. Only that annual depreciation flows through operating expenses. The rule prevents a single large purchase from wiping out a profitable year on paper.
Interest and Income Taxes
Interest on loans and corporate income tax bills are excluded from operating expenses. They appear below the operating income line as non-operating items. Interest reflects how the company chose to finance itself; income tax reflects the government’s take on profits. Neither says anything about how the business actually operates. A company drowning in debt can post excellent operating income, and a debt-free company can have terrible operations. Keeping these below the line lets analysts compare operational performance without financing decisions clouding the picture.
Where Operating Expenses Sit on the Income Statement
The income statement follows a set sequence. Revenue at the top. Subtract cost of goods sold to get gross profit. Subtract operating expenses to get operating income, sometimes called EBIT (earnings before interest and taxes). That figure tells you whether the business makes money from its actual operations, stripped of financing structure and tax bills.
Public companies present this information in standardized formats in their annual 10-K and quarterly 10-Q filings. Auditors scrutinize how expenses are classified because shifting costs between categories can make a company look more profitable than it is. A business that quietly buries a recurring operating cost inside a one-time charge inflates its operating income and misleads investors.
Tax Rules Worth Knowing
Most operating expenses are straightforward deductions under 26 U.S.C. ยง 162, which allows businesses to deduct ordinary and necessary expenses paid during the taxable year, including reasonable compensation, business travel costs, and rent.1Office of the Law Revision Counsel. 26 U.S.C. 162 – Trade or Business Expenses A few categories carry special rules.
Business Meals
For 2025 and 2026, business meals are 50% deductible. Half the cost of a client meal, a working team lunch, or food while traveling on business, as long as the expense isn’t lavish and has a legitimate business purpose. Other travel expenses like lodging and transportation are generally fully deductible when reasonable and business-related.
Research and Development
R&D has been a moving target. For tax years beginning after December 31, 2024, domestic research and experimental expenditures can once again be deducted immediately under the newly enacted Section 174A, reversing a provision of the 2017 Tax Cuts and Jobs Act that had forced companies to amortize these costs over five years. Foreign R&D expenditures still must be capitalized and amortized over 15 years. For financial reporting under GAAP, most R&D costs are expensed as incurred regardless of tax treatment.
Home Office Deduction
Self-employed individuals who use part of their home regularly and exclusively for business can deduct home office expenses. The simplified method allows $5 per square foot, up to 300 square feet, for a maximum deduction of $1,500.7Internal Revenue Service. Simplified Option for Home Office Deduction W-2 employees cannot claim this deduction, even if they work from home. That rule has been in effect since 2018 and runs through at least 2025 under the Tax Cuts and Jobs Act’s suspension of miscellaneous itemized deductions.
The Operating Expense Ratio
Total operating expenses divided by total revenue gives you the operating expense ratio. A company spending $700,000 on operating expenses against $1,000,000 in revenue has a ratio of 70%, meaning seventy cents of every dollar goes to keeping the lights on. Lower is better, because more of each revenue dollar survives as operating profit.
What counts as a good ratio depends on the industry. Software companies routinely post operating margins above 30% because their product costs almost nothing to reproduce once built. Grocery retailers work on margins of 2% to 3% because cost of goods sold eats most of their revenue before operating expenses even enter the picture. Comparing a SaaS company’s ratio to a grocery chain’s is meaningless. The useful comparison is against direct competitors in the same sector.
The trend line matters more than any single quarter. A company whose ratio creeps from 55% to 65% over three years is losing efficiency, whether through hiring too fast, letting vendor contracts inflate, or failing to automate repetitive tasks. That’s a red flag even if the absolute number looks reasonable for the industry.
Record-Keeping Requirements
The IRS requires businesses to keep records supporting every deduction shown on a tax return. For most operating expense deductions, the general retention period is three years from the date the return was filed.8Internal Revenue Service. How Long Should I Keep Records? Employment tax records (payroll, withholding) must be kept for at least four years after the tax is due or paid, whichever is later. Records for depreciable property should be retained until the statute of limitations expires for the year you dispose of the asset.
Supporting documents need to show the amount paid and confirm the expenditure was for business. That means invoices, receipts, cancelled checks, or account statements.9Internal Revenue Service. Publication 583, Starting a Business and Keeping Records For assets, records should show when and how the property was acquired, what was paid, and how it was used. If you pay cash and can’t get a receipt, write a contemporaneous note explaining the payment. That detail matters in an audit. An expense with no documentation is an expense the IRS can disallow.
Consequences of Misclassifying Expenses
Getting classification wrong has real financial consequences. The most common mistake is deducting a capital expenditure as an operating expense, which overstates the current year’s deductions and understates taxable income. If the IRS catches it, the business faces an accuracy-related penalty of 20% of the resulting tax underpayment, plus interest that accrues until the balance is paid.10Internal Revenue Service. Accuracy-Related Penalty
For public companies, the stakes climb higher. Misclassifying operating expenses to inflate earnings is a form of financial fraud that draws SEC enforcement, and even unintentional misclassification can force a restatement of financial results, which typically hits the stock price and erodes investor trust in ways that take years to rebuild.