No company can exist without expenses. In fact, they start haunting your team as soon as you make the decision to create a new venture. Once a startup launches its operations, it faces a vast array of different startup costs.
As the business scales, you need to analyze the company’s performance and make copious strategic decisions. When fundraising, you have to prepare a solid financial forecast for investors. In any case, expenses are an indispensable part of analysis and decision-making, therefore it’s crucial to understand how different examples of startup expenses must be recognized and accounted for.
Operating expenses (OPEX) usually constitute a large chunk of the business’s costs, and it’s essential to make sure your calculations for them are correct. What startup costs fall into the operating expenses bucket? What factors do you need to consider when you’re figuring them out? Let’s find out together!
How do you recognize OPEX and differentiate them from other types of business startup expenses?
Operating expenses are obviously an integral part of every company’s P&L statement since all businesses incur some costs to maintain their daily operations. This aligns with the startup costs definition of OPEX: costs related to the company’s core operational activities. The question is, how do you differentiate this expense group from others to accurately account for everything?
OPEX vs. Cost of goods sold (COGS) / Cost of revenue
The core differentiating factor of operating expenses is the fact that they are not directly tied to the sales volume, number of users or clients, number of units sold, etc. Every business requires these expenses to continue its day-to-day operations, and they can exist even if the company doesn’t produce goods or provide services for a period of time. Following this logic, raw materials used in the production will be COGS, while office rent will be OPEX.
OPEX vs. Capital expenditures
Operating expenses tend to be more regular and have short-term effects (e.g., monthly office expenses, insurance, bank charges, salaries, professional services, etc.). Capital expenditures, by their nature, are not regular, usually including some one-time payments; they also have more long-term effects (i.e., you can use the asset purchased for a significant time span). For example, you can buy a one-year license for your company or invest in app development, either of which will be categorized as capital expenditures, not OPEX.
What should be included in OPEX?
Let’s delve into some typical examples of startup costs that are usually included in the operating expenses category. Generally, they can be categorized into three core groups, each one representing a different aspect of the business’s operations: Sales & Marketing, General & Administrative, and Research & Development. Every bucket can be broken down into separate, more detailed categories.
- The Sales & Marketing group usually includes marketing budgets, salaries, and other team expenses, as well as other costs related to customer acquisition.
- The General & Administrative group can include rent (e.g., office, coworking space, warehouse), utilities and other office overheads, software, insurance, bank charges, and professional services, as well as salaries and other expenses for the team.
- The Research & Development group focuses on all expenses related to the improvement and enhancement of your product/services. For example, this category can include costs for an in-house or outsourced tech/data/development team.
What factors should be considered when forecasting operating expenses?
If you need to build a forecast for your business, no matter what its purpose is – fundraising, discussing future strategic moves, or working on company valuation – operating expenses must be scrutinized. Moreover, since your projections need to be as realistic as possible, it’s not always enough just to include relevant categories of expenses; you need also to consider a range of other factors. Let’s look at some examples:
- Roll-out schedule: If your company plans to enter several markets or expand its facilities and offices to other regions, this schedule should be considered in the forecast. Each new office will incur additional overheads.
- Team growth: Some expenses can grow in line with the number of employees, and it’s important to factor this possibility into your projections. For example, this could include software or travel expenses for your team members.
- Growth: Even though operating expenses aren’t directly dependent on the sales volume, number of users or clients, or number of units sold, they also increase over time as the business scales gradually. Thus, some acknowledgement of your growth rate must be added to the forecast to make it credible and logical.
How do you analyze your company’s OPEX?
Apart from forecasting, it’s also vital to be able to analyze the influence of your company’s operating expenses on its overall financial performance. As an essential part of core operations, this costs category makes up a large chunk of total business expenses. Needless to say, it’s important to ensure your company moves in the right direction here. To do this, you have to keep a close eye on some indicators, which we will review below:
EBITDA margin
A measure of a company’s operating profit as a percentage of its revenue.
This is one of the key financial indicators, which depends greatly on the size of your operating expenses. If you spend carelessly or your expenses are not comparable with the gross profit or revenue, it will inevitably reduce this metric to zero or even less. Therefore, this option is far from the best, especially considering the fact that this ratio is one of the first to draw the investors’ attention.
Always track this value and make sure it’s in line with the average indicators of your competitors in the sector in which you operate, especially the companies with the same revenue level or at the same growth stage.
OPEX breakdown
A percentage share of each category in the total bucket.
As we mentioned earlier, operating expenses are usually broken down into three categories depending on the type of activities: sales & marketing, general & administrative, and research & development.
What is the reason for breaking them like this? The ultimate goal is not just to track how much your business spends on each aspect but also to see the ratio between all the figures. It’s quite important to keep this indicator healthy. Benchmarks are of great help here, as seeing what percentage of their OPEX other companies spend on customer acquisition or product development will certainly help you to avoid overspending or underspending, keeping your OPEX balanced.
WAVEUP STORY:
Do you know some of the most common issues in the OPEX sheets we see in the financial models submitted to us for review or redevelopment? A large chunk of the startup costs being allocated to salaries (mostly for the management team) and unrealistically low amounts for product development budgets. We have nothing against your payroll – indeed, it’s one of the most important categories of expenses for every business! Nevertheless, other aspects of your operations must be considered too. In addition, your forecast must be in line with your future strategy. For example, if you plan to do some significant product updates or launch new features, the relevant expenses must appear in the calculations of your R&D costs.
Our other articles can help you dive deeper into the peculiarities of hiring plans and sales & marketing budgets in financial forecasts.
OPEX as percentage of revenue
The ratio between each category of expenses and revenue.
Calculating what percentage of revenue is attributed to each OPEX category can also be quite helpful. The approach is similar to the OPEX breakdown; you just have to ensure your level of expenses per category is reasonable.
For example, it’s a normal practice for early-stage startups to spend most of their revenue on the Sales & Marketing category to build brand awareness and drive customer growth. However, the revenue share received due to these costs tends to decrease over time, implying that your customer acquisition engine becomes more efficient. When marketing channels are fine-tuned, users love the product and recommend it to others, and the sales team constantly improves its performance, you’ve got a perfect combo for spending less and earning more!
Summary
Operating expenses may be underestimated. We see the same common mistakes in the financial forecasts submitted for our review: some categories are overlooked, and some are calculated incorrectly. However, this bucket of costs is extremely important. It’s closely tied to daily business operations and can exist even if you are not generating any revenue. Operating expenses have an impact on one of the most important financial indicators – EBITDA margin. It’s crucial to keep this ratio healthy.
Here at Waveup, our project count has already exceeded 500 cool businesses, a significant share of which have received best-in-class help from our finance team. If you need to nail your financial forecast or prepare solid investment materials for your business, feel free to contact us.