How operating expenses and cost of goods sold differ?

Both operating expenses and cost of goods sold (COGS) are expenditures that companies incur with running their business. However, the expenses are segregated on the income statement.

Operating expenses and COGS measure different ways in which resources are spent in the process of running a company. When an income statement is generated, cost of goods sold and operating expenses are shown as separate line items subtracted from total sales or revenue.

Operating expenses or OPEX are expenditures that are not directly tied to the production of goods or services. Typically, selling, general, and administrative expenses are included under operating expenses as a separate line item. SG&A expenses are expenditures that are not directly tied to a product such as overhead costs. Examples of operating expenses include:

• Rent
• Utilities
• Office supplies
• Legal costs
• Sales and marketing
• Payroll
• Insurance costs

A company's management must keep operating expenses under control without adversely affecting the company's earnings and ability to compete with its competitors.

Businesses incur several different costs that are independent of the level of sales they produce. For example, a coffee shop must continue to pay rent, utilities, and employee salaries on its facilities even if customers are not buying any of its beverages. Operating expenses are the recurring costs that are not directly related to actual goods.

Cost of goods sold is the direct costs tied to the production of a company's goods and services. COGS excludes indirect expenses such as distribution costs and sales force costs. 

COGS represents the business expenses that are directly incurred because a transaction has taken place. When the coffee shop sells a coffee, this expense account captures the price of the cup, the coffee sleeve, the water, the processed beans, etc.

Examples of COGS include: 

• Labor directly tied to production
• Depreciation of the manufacturing plant
• Utilities of the facilities tied to production
• Direct materials needed for the production of goods and services
• Taxes on the production facilities

In the retail industry, cost of goods sold could be the inventory and merchandise purchased from the supplier or manufacturer.

Below is the income statement for J.C. Penney Company Inc. (JCP) from their 2017 10K statement. 

• The top portion shows that total revenue was $12.5 billion (rounded).
• Under expenses, COGS is listed as a separate item totaling $8.1 billion. 
• SG&A was $3.5 billion.
• Total operating expenses was $12.4 billion. 

As a rule of thumb, if you want to know if an expense falls under COGS, ask: "Would this expense have been an expense even if no sales were generated?" 

With a warehouse full of goods, the cost of goods sold includes all of the money spent to create the goods and bring them to the warehouse. The operating expenses represent the other day-to-day expenses necessary to keep the business running.

Payroll can be either type of expense depending on the labor involved. Office payroll, for example, might include a secretary, an accountant, marketing specialists or janitorial workers who would be operating expenses. However, an assembly-line auto worker would be directly tied to production and would likely be included under costs of goods sold.

For more about the expenses captured on the income statement, please read "Fundamental Analysis: The Income Statement."