How do operating expenses affect profit?

As a general rule, an increase in any type of business expense lowers profit. An income statement has three levels of profit, however, and the relationship between operating expenses and profit can be seen most directly when looking at operating profit, also known as profit before income and taxes.

On an income statement, profit calculated by deducting the cost of goods sold (COGS) from total net sales is called gross profit. The COGS includes both fixed costs and variable production costs. Both types of production costs can reduce gross profits. However, fixed production costs, such as buildings and equipment, are unaffected by production levels, whereas variable costs, such as the wages paid to factory workers and the cost of raw materials, increase when production levels rise.

At the second level of profitability, operating profit is calculated by subtracting operating expenses from gross profit. Also known as sales, general and administrative expenses (SG&A), these are overhead expenses not directly related to production. SG&A typically includes the cost of administrative buildings, as opposed to production plants, the salaries of salespeople and executives, and expenditures for office supplies, for example.

Net profit is then calculated by deducting non-operating expenses such as taxes and interest from operating profit. At the bottom line, net profit is equal to revenue minus the cost of goods sold (COGS), operating expenses, and taxes and interest. Cutting back on operating expenses or the COGS can increase net profit, at least in the short term, but a business must be careful not to cut back so much that the sales are adversely impacted by shoddy production quality or a failure to meet customer demand.

On the other hand, some business expenses, such as purchases of new information technology innovations, can lower net income over the short term but raise income potential over the long term. Capital expenses on equipment and other fixed assets can be depreciated over several years, lowering the immediate impact on profits.