What is an Operating Expense?
Operating expenses are the expenses you incur to run your business. These costs reduce your revenue. Operating expense is a deduction from your Gross Profit to come up with Net Profit (Loss). So if you don’t manage it properly, your business will incur a loss.
Your operating expenses include your office-related expenses, marketing expenses, and non-production related salaries. Known shortly as OpEx. If you are a home-based business, you can declare a portion of your home expenses as business expenses. However, you have to properly declare how much of it is actually used up by your business. This includes rent and utilities (water, electricity, internet/WiFi).
The costs directly incurred to render the service or produce the product are part of your Cost of Goods Sold. I have covered that in this post.
Importance of Preparing Operating Expense Budget
Your spending can spiral in the wrong direction if you have no access to your up-to-date expenses. Consequently, you may end up with a huge bill and a loss. Thus, it is critical to have an estimate of all your expenses before the start of the financial period.
The operating expense is a big chunk of deductions from your revenue. So tracking your expenses help manage it. However, tracking your actual expenses is only reactive. It does not help you drive actions that would help you grow your business. Furthermore, it does not provide the opportunities that can bring more results.
That’s the relevance of an operating expense budget. It is the estimate of expenses that you will incur to continually run and grow your business. Having visibility of your expense estimates allow you to identify areas for improvement. It shows you where you can be more efficient and cut costs, if possible.
What to Include in the OpEx Budget
Tracking your business expenses can be a tedious task so it is good to have it outsourced. During your planning session, first list down all current expenses. When you do your marketing plan, identify additional expenses you might incur. These are expenses you plan to take on to drive your marketing strategy. Thus, essential to the growth of your busieness. This can be your Facebook Ads not directly linked with your service or product.
Since your operating expense is a reduction of your revenue, it’s also a tax deduction. However, CAUTION here. Not all business expenses are allowed as a tax deduction. Check with your revenue bureau or your accountant first. The following items are common expenses included in your operating expense budget.
Advertising and Marketing Costs
This includes the monthly costs specified in your marketing plan. Examples are social media marketing, online advertising, promotion activities, and other marketing activities. Direct advertising costs which you can specifically point to a service or product are part of Cost of Goods Sold. You can read about that here.
Rent or Lease
You should include full year rent/lease cost when you do your operating expense budget. You can claim the cost of the lease or rent and all other costs associated with the lease as tax deduction. The assumption here is you are leasing a commercial space and solely used for your business. You can only deduct your lease payments for the current year.
Home Office Expenses
If you are using your house as your business location, budget for the amount of space you use. There is a simple way to calculate it. First, identify the square footage of the space you are using for your business. Then multiply it with $5. For US residents, the max allowed is $1,500. You can also do itemized deduction to claim other home expenses. There are other methods so check with your accountants.
You can also claim some home expenses as a tax deduction. However, there are two requirements you have to meet. Set a specific space in your home solely for your business use. The space should be your principal place of business AND used both regularly and exclusively for business purposes.
This includes your electric, gas, water, and other city services. In some cases, this is part of your rent. If your workplace is separate from your home, setting the estimate is straightforward. Base it on average historical usage for the past 3-6 months. Though you have to note fluctuations with your usage. There may be months where the usage is too low or high. Disregard them and just use the more reliable data.
For the rate, check the history of rate increases. If you don’t expect significant changes, use the current rate. If you’re using your home as an office, check with your accountant how to compute for the estimate. You can also refer to your revenue bureau guidelines.
Phone and Computer Expenses
These include the costs of internet subscriptions or lines and cell phones. If you are home-based, you cannot deduct the cost of your home landline. But you can deduct the cost of a second line exclusively for business use.
Supplies and Other Office Expenses
Your estimate would depend on the kind of business you have. Your estimate should not include your inventory of supplies you use to produce a product. That is part of Cost of Goods Sold. You can deduct your purchases of materials and supplies. For incidental supplies, you can deduct if the cost is not material enough. Meaning it has no impact to your income.
Salaries and Wages
If you have regular employees, factor in salary increase. Reflect it on the month where you do the salary increase and going forward. This also includes employee benefits and social services costs associated with the employment. So make sure to include any potential increase when you do your budget.
Salaries and wages for all employees are deductible. You can also deduct your own salary. But you also need to pay tax for your own income. Contractors are not considered employees but do the test to classify them correctly.
This includes payments to your CPA , tax accountant, attorney, and other professional consultants. However do not include payments to an accountant to process your personal tax filing. Because it is not deductible as business expense.
This covers costs associated with your equipment, furniture, and machinery. You cannot deduct the full purchase price of these items. This is for big equipments and does not include small items.
Quick explanation on Depreciation Cost
A quick note on assets. When you buy equipment, machine, or computer, you record them as asset. Examples are your computer and office table. They are not considered as out outright expense and not part of your income statement. Instead, you reflect them on your balance sheet. A balance sheet is where you present your assets, liabilities, and capital (equity).
Meaning, the full purchase amount is not deductible as an expense from the gross profit. You depreciate them for a number of years according to your local regulations. That is the amount you budget and can claim as business expense.
Take the computer as an example. The common life of a computer is 5 years. The assumption is the computer is usable for 5 years. So the purchase cost of the computer will be distributed over its 5-year life. To get the depreciation amount, first you divide the purchase price over the total number of years. Next, multiply with how many months or years the computer has been in use. That is the part of the computer cost that you have “consumed” or “used up”.
Travel and Business Meal Expenses
Plan your business travels when you do your sales and marketing plan. Set an estimate based on the expected business travels. Keep all records of air travel, hotels, and meals so you can claim them as a deduction. A good practice is to write at the back of the receipt the date and purpose. If that is a restaurant receipt, you can write the names of the people you dine with.
It is easier to prove them as business expenses during tax audit. You can also scan them or use an app to keep a record. Business meals, however, are only 50% deductible. On the other hand, you can no longer deduct business entertainment expenses.
Include this in your operating expense budget and tax deductions. However, you can only apply current year’s insurance payment.
Budget your subscriptions to software you use for your business. When you do plan your marketing and sales strategy, this is something you can already plan ahead. If subscribing to a software can help drive your marketing strategy, then include it in your budget. If you are planning to launch a course, you need to consider getting a susbcription for a course platform.
- email newsletter,
- hosting services,
- landing page,
- creative software like Adobe, Canva,
Education / Training
Includes all trainings, including online learning courses. If you plan to level up your skills, you should provide an estimate for training costs. However, you need to prove that the training / education is beneficial for your business for it to be deductible.
Make sure to budget for bank charges, membership fees, and licenses and regulatory fees. These are all deductible expenses, too.
The list seems exhaustive but there are still other costs not covered here. I am a licensed accountant but you need to consult your own accountant about tax deductions. This post is not in anyway an advice for your tax filing.
Introduction to Budgeting and Forecasting
What’s the difference between budget and forecast? Why do you need a budget and a forecast? When to do a budget and a forecast?