Operating costs are one of the crucial costs that are incurred for the day-to-day production, selling, and administration-related activities of the business. For example, cost of goods sold, marketing expenses, salaries, rent, etc. Here we have explained all about operating costs, types, how to calculate, the operating costs formula, why you must monitor it, the difference between operating expenses and non-operating expenses, and more. Let’s dive in.
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What are operating costs?
Operating costs are the costs associated with the day-to-day operations of the business. These costs primarily occur due to the production of goods and to meet expenses like salaries, electricity, wages, transportation expenses, rent, etc. Operating costs are shown on the income statement in a company’s financial statements.
Calculating operating costs is important because it helps assess the company’s operating efficiency and helps forecast future business requirements.
Also, every company should aim at minimising its operating costs. This is because increasing operating expenses depict lower profits for the business. Also, if a company has higher operating expenses than its competitors, it may lose an investor’s interest.
However, a company should not reduce its operating expenditure too much. This is because there might be cases wherein the company may reap future benefits from the operating expenses incurred presently. For example, advertisement expenditure can help increase revenue.
Operating Costs – Key Points!
- Operating costs are costs that are incurred in order to meet the daily requirements of the business.
- There are broadly two types of operating costs- fixed cost and variable cost.
- Some examples of operating costs include the cost of raw materials, packaging costs, rent, wages, salaries, etc.
Types of operating costs
There are two main components of operating cost- fixed cost and variable cost.
Fixed cost
Fixed costs are those costs that remain constant regardless of the change in the output of goods and services. For example, the rent of the office space or factory is considered a fixed cost because the rent does not change with the change in the level of production.
Fixed costs can help achieve economies of scale. This is because more units of goods can be produced with the same amount, lowering the cost per unit and making the production more efficient.
However, the fixed cost usually remains constant up to a point and tends to increase if production drastically increases. For example, assume a factory space can accommodate up to 1,000 tonnes of production. In order to produce more than 10,000 tonnes, the factory space will need to be increased, leading to higher rent.
Variable cost
Variable costs are those costs that vary with changes in the level of output. For example, cost of raw materials, cost of electricity, packaging cost, etc. Now, suppose if the cost of raw materials increases; naturally, the operating costs registered are higher.
Variable costs can help determine the price, contribution margin, break-even points, and expense structure. Budgeting for variable expenses is comparatively more challenging. This is because these expenses can change rapidly over time due to innumerable factors and production.
Variable expenses may be recurring or non-recurring, depending on the nature of the business.
Semi-variable cost
As the name suggests, semi-variable cost is a mixture of fixed and variable components. For example, overtime payments for employees. Employees’ regular wages are a part of the fixed expenses for the company. However, the number of overtime hours a company pays to its workers varies. It may increase with increased production and drop with a reduction in requirement.
How to calculate operating costs?
Operating cost can be calculated using the below formula-
Operating cost formula = Cost of goods sold + Operating expenses
The cost of goods sold includes all the expenses incurred directly due to the production of a good or product. These expenses include direct material costs, labour costs, power, etc.
Another commonly used formula is-
Operating cost = Opening inventory + Purchases + Direct expenses – Closing inventory
Here, operating expenses include selling, general, and administrative expenses, salaries, insurance, rent, etc.
Operating expense examples
Some operating expense examples are stated below –
- For a consulting company, operating expenses are mainly from salaries and other employee compensation expenses.
- For a manufacturing company, operating expenses are the cost of raw materials, wages, production, etc.
- For a technology company, R&D, employee salaries, etc., might be some of the highest operating expenses.
How do operating costs affect your profit?
Operating costs can be one of the most important factors in determining whether a business is making money or losing money on a project. Hence, it’s essential to understand the operating costs and how they can impact your bottom line.
The more operating costs your business has, the harder it will be for it to turn profitable. The opposite of this is true as well; if there are no operating costs involved, the chances of your business earning any money are thin. Hence, determining whether a new business will be profitable or not is also important.
For this purpose, calculating the break-even point helps. Here’s how to do it –
Break-even point formula:
Fixed costs + variable cost per unit x units sold = Break-even point
Operating costs can vary widely from one business to another. A textile manufacturer might have more labour costs because of the workers, while an IT company may have more electronic costs.
Why does monitoring your operating costs matter?
Here are a few reasons why you should monitor your operating costs.
- One of the top reasons to monitor your operating expenses is to save your business from going out of business or going bankrupt. For instance, if you don’t know how much operating costs you have, you may not have enough to pay them off at the right time. Hence, monitoring your operating costs allows you to have better cash flow management.
- As a business owner, you want to ensure that the right people are doing their jobs at the right time. This can allow you to maximise profits and minimise costs. In some cases, even a small reduction in operating costs can significantly boost the bottom line.
- Monitoring your expenses can help you in budgeting and financial planning. It allows you to set realistic targets and allocate resources efficiently. It also gives insights into where to invest for future growth.
Operating expenses vs non-operating expenses
| Operating expenses | Non-operating expenses |
| Operating expenses are those expenses that are incurred by the business during its normal course of activities. | Non-operating expenses are those expenses that are incurred from non-routine business activities. |
| These expenses include office supplies, wages, rent, production costs, etc. | These expenses include interest paid on loans, lawsuit expenses, reorganisation expenses, etc. |
| Such costs are used in measuring the performance of the business. | Such costs cannot be used to measure the performance of the business since they are non-routine or one-time expenses. |
| These costs are usually controllable. | These costs are non-controllable. |
Operating expense vs capital expense
| Operating expense | Capital expense |
| Operating expenses are the expenses that are incurred for the day-to-day operations of the business. | Capital expenses are those expenses that a company incurs at a certain point, but the benefits of these expenses are long-term. |
| These expenses include wages, raw materials, electricity, production, etc. | These expenses include purchasing machinery, building, equipment, etc. |
| Such expenses ensure the smooth functioning of the business. | These expenses aim at improving the performance of the business. |
| These expenses usually do not involve heavy amounts. | These expenses are usually capital-intensive. |
| These expenses are not capitalised and are shown in the income statement. | These expenses are capitalised and shown in the balance sheet of the company. |
| These expenses are regular or routine expenses for the business and are considered short-term expenses. | These expenses are long-term expenses and are usually irreversible. |
Conclusion
Understanding operating costs is essential for a business. This is because a company must know its requirements and how much it is spending on producing goods. Furthermore, classifying these operating expenses into fixed and variable is also crucial for a business. Companies should try to minimise operating expenses to generate higher operating profits.
