Projecting Operating Expenses and Depreciation
Accurately projecting operating expenses and depreciation is crucial for building robust financial models and performing reliable business valuations. These components directly impact a company's profitability, cash flow, and ultimately, its intrinsic value.
Understanding Operating Expenses
Operating expenses (OpEx) are the ongoing costs incurred to maintain a business's operations. They are typically categorized into Cost of Goods Sold (COGS) and Selling, General, and Administrative (SG&A) expenses. Understanding the drivers of these costs is key to projecting them accurately.
Cost of Goods Sold (COGS)
COGS includes the direct costs attributable to the production or purchase of goods sold by a company. For service businesses, this might be referred to as Cost of Sales or Cost of Revenue.
COGS is directly tied to sales volume and production efficiency.
For manufacturing, COGS includes raw materials and direct labor. For retail, it's the purchase cost of inventory. Projecting COGS often involves a percentage of revenue or a per-unit cost calculation.
When projecting COGS, analysts often look at historical gross profit margins. If a company has consistently maintained a 60% gross margin, it implies COGS is 40% of revenue. Alternatively, if the business is unit-driven, projecting COGS might involve estimating the number of units sold and multiplying by the direct cost per unit. Factors like supplier price changes, labor costs, and production efficiency improvements need to be considered.
Selling, General, and Administrative (SG&A) Expenses
SG&A expenses are the costs associated with selling products and managing the overall business, but are not directly tied to production. This includes salaries for sales and administrative staff, marketing and advertising, rent, utilities, and professional fees.
SG&A can be projected based on revenue, headcount, or fixed components.
Some SG&A costs, like salaries for core administrative staff, might be relatively fixed. Others, like sales commissions or marketing spend, can be more variable and tied to revenue growth or specific strategic initiatives.
Projecting SG&A requires a nuanced approach. Fixed costs can be projected based on historical trends and known changes (e.g., rent increases). Variable costs, such as marketing, can be projected as a percentage of revenue or based on planned campaigns. Headcount projections are also critical, as salaries and benefits often form a significant portion of SG&A. It's important to consider the operating leverage of the business – how much SG&A increases relative to revenue growth.
Understanding Depreciation
Depreciation is a non-cash expense that accounts for the wear and tear or obsolescence of a company's tangible assets over their useful life. It's a critical component of the income statement and impacts taxable income.
Depreciation spreads the cost of an asset over its useful life.
Common depreciation methods include straight-line, declining balance, and sum-of-the-years'-digits. The choice of method impacts the timing of the expense recognition.
In financial modeling, the most common method is the straight-line method, where the cost of an asset minus its salvage value is divided equally over its estimated useful life. For example, a 2,000 ($10,000 / 5). When projecting, you need to consider the company's capital expenditure plans, the existing asset base, and their respective depreciation schedules. New capital expenditures will add to the depreciation base in future periods.
| Feature | Operating Expenses (OpEx) | Depreciation |
|---|---|---|
| Nature | Cash outflow for ongoing operations | Non-cash expense reflecting asset usage |
| Impact on Income Statement | Reduces operating income | Reduces operating income and taxable income |
| Relationship to Assets | Costs of using assets and running the business | Allocates the cost of tangible assets over time |
| Projection Basis | Revenue, headcount, fixed costs, strategic plans | Capital expenditures, asset useful life, depreciation method |
Integrating OpEx and Depreciation into Financial Models
In a financial model, OpEx and depreciation are projected line items on the income statement. Depreciation is also linked to the balance sheet (accumulated depreciation) and the cash flow statement (added back as a non-cash item).
Accurate projections require understanding the business's cost structure, growth drivers, and capital investment plans. Sensitivity analysis on these line items is crucial for assessing the robustness of valuation outputs.
Operating expenses represent actual cash outflows, while depreciation is a non-cash expense.
Cost of Goods Sold (COGS) and Selling, General, and Administrative (SG&A) expenses.
The straight-line method.
Learning Resources
This blog post provides practical insights into how to effectively model operating expenses, covering common pitfalls and best practices.
Investopedia offers a comprehensive explanation of depreciation, including its accounting treatment and various calculation methods.
A detailed guide on projecting SG&A expenses, breaking down the components and offering a structured approach for financial modelers.
A video lecture from a Coursera course explaining the concepts of depreciation and amortization within the context of corporate finance.
This YouTube tutorial walks through projecting Cost of Goods Sold and Gross Profit, essential components of operating expenses.
A clear explanation of the straight-line depreciation method, including examples and its impact on financial statements.
This article covers the broader topic of expense projections in financial modeling, providing a framework for various expense types.
Khan Academy offers introductory modules on financial modeling, which often touch upon expense and depreciation projections.
The official International Accounting Standards Board (IASB) standard for Property, Plant and Equipment, which governs depreciation accounting.
The FMVA certification program from CFI covers financial modeling extensively, including detailed modules on projecting operating expenses and depreciation.