To run a business effectively, managers must pay close attention to the balance of expenses to revenues. In some cases, it's helpful to break expenses out into different categories, such as operational or administrative expenses, to help identify places to cut costs. In this process, it's critical to understand the accounting differences between operational and administrative expenses and make sure the right accounts are identified for analysis.
Operational expenses are all of the costs a company incurs for its primary business activities, including sales, production costs and salaries. Not included are expenses that arise from non-operating activities such as interest expenses, taxes and unusual costs that aren't related to the normal business -- such as significant litigation. Businesses usually have the most control over their operational expenses, so this breaking this number out of total expenses sometimes provides valuable insight into the business's management.
Administrative expenses are the costs of business associated with management and information processing. They usually include the costs of the payroll and human resources department, the salaries of company officers, accounting expenses and supplies used for management. Production costs not associated with management -- for example, staff wages, cost of sales or materials -- are not administrative expenses. Companies often benchmark their administrative expenses with industry expectations to ensure they're keeping their management costs under control.
Administrative expenses are a subset of operational expenses. These costs sometimes make up a small portion of the business's total operating costs, depending on the industry. Operational costs, by contrast, include other expenses such as the cost of inventory, which should not be factored into administrative expenses unless directly associated with management activities. Operational costs not included in administrative expenses are called production costs.
Both administrative and operational expenses are used by management to calculate accounting ratios that help them analyze performance. The operating ratio, which looks at operational expenses as a percentage of total sales, gives the business a picture of its likely profitability. In some cases, it's helpful to look at the administrative ratio, or the portion of sales represented by administrative expenses. This analysis is useful because administrative costs are less likely to vary with sales than production costs, which will likely increase with the level of production. In this way, administrative expenses are relatively fixed costs.