Operating Cost: What is it, How to Monitor, Adjust & Calculate It?

Introduction

Operating cost is a company’s expense to keep its operations running smoothly.

Operating costs are a monetary representation of what it takes to run a business. Wages, daily expenses, and various other costs are a part of it. These costs impact profitability, pricing, and a company’s growth strategy. 

This article will demystify operating costs and highlight why they’re more than just numbers on a spreadsheet. Dive in to grasp the heart of your business’s financial plan.

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What are operating costs? 

Operating costs are the expenses businesses face daily. They cover everything a company needs to function, from employee salaries to rent. 

Think of them as the bills a business must pay to keep running. By managing these costs, a business can succeed. They differ from capital expenses and one-time purchases like machinery or real estate. 

These costs are pivotal in helping organizations make informed decisions to thrive. From a higher level view, it’s somewhat the backbone of an effective financial strategy. 

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Understanding operating costs in detail

Operating costs are the silent players in the backdrop, influencing profitability and sustainability. Every time a company pays for utilities, rents a space, or processes paychecks, it’s tapping into its operating costs. These aren’t one-off purchases; they recur month after month.

To effectively manage these expenses, one must categorize them. Some fixed costs, like rent, remain constant irrespective of the company’s output. Others vary with production, such as raw materials. These fluctuating costs can increase or decrease based on how much a company produces.

Then, there are tricky semi-variable costs. A good example is electricity. A factory might use a baseline amount for basic operations, but as production ramps up, more power is consumed. It’s a mix of fixed and variable.

Operating cost vs. operating expense

Simply put, operating expenses are one part of operating costs. Operating expenses refer to costs an organization generates that don’t relate to the production of its products. On the other hand, operating costs are every cost you incur to run your business or perform revenue-generating activities.

Operating costs provide a clearer picture of a business’s financial standing. Knowing which costs can be trimmed during lean times and which remain constant helps in budgeting and forecasting. And it’s not just about cutting costs; it’s about optimizing them.

Types of operating costs

When we talk about operating costs, it’s not a one-size-fits-all concept. Different types exist, and each has its unique characteristics. Let’s break them down.

• Fixed costs remain unchanged no matter how much a business produces. Think of monthly rent or salaries for permanent staff; they don’t fluctuate with production levels.
• Variable costs change based on production. If a company manufactures more products, the cost of raw materials, for example, will rise. When production decreases, so do these costs.
• Semi-variable costs stand in the middle. They contain elements of both fixed and variable costs. Consider an electricity bill at a factory. A base fee is always present, but the more machines you run, the higher the bill.
• Direct costs can be directly attributed to a specific product or service. If you make shoes, the leather and laces are direct costs.
• Indirect costs aren’t linked to a specific product. Office supplies, general utilities, and administrative salaries fall under this category. They support the overall business operations but can’t be pinned to one product.

Understanding these categories allows businesses to make smarter financial decisions. They can predict how costs will change with production shifts, leading to more accurate budgeting and planning.

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Difference between operating costs and other types of business expenses

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Components of operating costs

Understanding the elements of operating costs makes companies aware of their financial health. They can optimize operations and boost profitability with a clear picture of where money flows.

• Salaries and wages: This is the money businesses pay to their employees. Whether hourly wages or monthly salaries, it’s a significant chunk of operating costs.
• Rent or lease payments: Many companies operate from rented spaces. This regular payment keeps the doors open for operation.
• Utilities: These include electricity, water, gas, and the internet. Like a household, businesses need these essentials to function smoothly.
• Raw materials and supplies: If you’re manufacturing a product, you need raw materials. For service industries, this could be office supplies or software subscriptions.
• Maintenance and repairs: Machines break, and spaces deteriorate. Keeping everything in working order is crucial.
• Marketing and advertising: Businesses invest in marketing campaigns, advertisements, and promotions to attract customers.
• Travel and transportation: This covers expenses related to business trips, vehicle maintenance, or delivery costs.
• Insurance: To safeguard against risks, businesses pay for various insurance policies, from property to liability.
• Taxes and licenses: Operating legally means paying taxes and securing necessary permits and licenses.
• Depreciation: While not a direct outlay of cash, accounting for the decrease in the value of assets is essential.
• Miscellaneous expenses: Every business faces unexpected costs. This category catches those unpredictable expenses that don’t neatly fit elsewhere.

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Operating cost formula

The operating cost formula helps companies determine how much they spend to keep the wheels turning. At its core, the formula is straightforward.

Operating Cost = Cost of Goods Sold (COGS) + Operating Expenses

But, why is this formula crucial? 

It provides clarity. A business can see where its money goes and how expenses shift with production changes. With these insights, strategies can be tweaked, costs minimized, and profits maximized.

How to calculate operating costs?

Let’s unpack the operating cost formula.

Operating Cost = Cost of Goods Sold (COGS) + Operating Expenses.

Start with the cost of goods sold (COGS). It represents the total cost of producing the goods a business has sold. It includes material costs, direct labor, and other direct costs tied to production. For instance, if you’re making shirts, the fabric, buttons, and wages of the workers crafting those shirts contribute to the COGS.

Next, consider the operating expenses. These costs don’t directly tie into production but are essential to running the business. Think of them as the backdrop costs. Rent for the office space, salaries for administrative staff, marketing expenses, and utilities all fall here. They’re the backbone expenses that support a business in its daily operations.

Next, it is time for some simple math. Once you’ve identified and summed up your COGS and operating expenses, just add them. The result gives you the total operating cost.

For a clearer picture, imagine a bakery. The flour, sugar, and labor to bake the cakes and cookies from the COGS. The rent for the bakery space, the electricity bill, and the cashier’s salary represent the operating expenses. You’d add these two components together to get the total operating cost.

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Example of operating costs for digital businesses

Let’s look at the flip side. Software businesses may not have many physical costs, but they too have operating costs, as follows:

• Server costs: Hosting their website or app is a priority. They regularly pay for cloud services or data centers.
• Software licenses: Every software tool has a price tag, from project management platforms to graphic design tools.
• Employee benefits: Beyond just salaries, the startup offers health insurance, retirement contributions, and gym memberships.
• Digital marketing: To grow their user base, they invest in online ads, social media campaigns, and email marketing tools.
• Freelancers and consultants: A young startup might not have all the expertise in-house. So, they hire external professionals for specific projects.
• Co-working spaces: Initially, many startups opt for flexible co-working spaces over traditional offices to save costs and foster networking.
• Training and development: They fund courses and workshops to keep their team updated with the latest technology and industry practices.
• Transaction fees: If their app involves financial transactions, there are charges associated with payment gateways and bank services.
• Customer support tools: Engaging with users requires platforms for chat support, ticketing, and feedback collection.
• Research and development: Innovating means investing. The startup allocates funds to explore new technologies or improve their current services.

Importance of managing operating costs

Managing operating costs isn’t just a financial task; it’s pivotal to a business’s survival and growth. Here’s why it’s so crucial:

• Ensures profitability. Businesses can maximize profits when they reduce operating costs. It’s simple math: higher expenses eat into potential profit margins.
• Drives competitiveness. In a market teeming with rivals, cost-efficient operations can give businesses an edge. They can price products or services more competitively, luring in more customers.
• Prevents wastage. Regularly reviewing and managing costs brings wasteful expenditures to light. Be it excess inventory or an underutilized subscription, money saved is money earned.
• Fosters stability. Consistent monitoring of operating costs helps businesses weather financial storms. In lean times, a company that’s streamlined its costs stands a better chance at survival.
• Encourages growth. Reinvesting saved money into the business can drive expansion. Perhaps it’s opening a new branch, launching a product line, or entering a new market.
• Aids in decision-making. Businesses can make more informed strategic choices with a clear picture of their costs. It’s about knowing where to cut back and where to invest.

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Strategies for reducing operating costs

Reducing operating costs is an art that every successful business owner must master. Let’s explore some strategies to achieve this.

• Negotiate with suppliers. Building strong relationships with suppliers can lead to better deals. It’s a win-win: they retain a loyal customer, and you enjoy discounted rates.
• Embrace technology. Automation can replace manual tasks, speeding up processes and cutting labor costs. Software solutions can manage inventory, handle accounting, or streamline customer interactions more efficiently.
• Outsource when beneficial. Sometimes, outsourcing certain tasks is cheaper and more efficient than keeping them in-house. Think of customer support, content creation, or IT support.
• Review contracts regularly. Staying on top of contracts, like leases or service agreements, ensures you’re not overpaying. Look for renegotiation opportunities or consider switching providers.
• Implement energy-saving measures. Switch to LED lights, invest in energy-efficient appliances, or encourage remote work to reduce utility bills.
• Cross-train employees. When staff can handle multiple roles, it offers flexibility. It means during busy times or staff shortages, you won’t need to hire temporary help.
• Encourage remote work. Renting office space is expensive. By fostering a remote work culture, businesses can downsize physical offices and save on overheads.
• Bulk buy. Purchasing items in bulk usually comes at a discount. But it’s a balancing act – ensure you’re not overstocking perishable items.
• Regularly review expenses. Setting aside time each month to scrutinize expenses can highlight areas for potential savings. Sometimes, it’s the small, unnoticed costs that accumulate.

As the saying goes, “A penny saved is a penny earned.” These saved pennies can pave the way for a brighter financial future in the business world.

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Technology’s role in managing operating costs

Embracing technology is about more than staying current. It’s a strategic move that can drastically cut operating costs, streamline processes, and offer better value to customers. For businesses eager to thrive in a modern marketplace, leveraging technology’s offerings is less of a choice and more of a necessity.

Technology can take over repetitive jobs. The software handles invoicing, data entry, and even customer communications, trimming labor costs. Advanced algorithms schedule staff or manage inventory more efficiently. It reduces idle time and ensures resources are used to their fullest.

Tools like video conferencing and project management software make remote work seamless. Businesses can save on office space, utilities, and commuting allowances. Moreover, data analytics tools provide insights into spending patterns. Companies can spot inefficiencies and address them promptly.

Below are some notable ways technology helps manage operating costs.

• Digital documents and signatures reduce the need for printing
• Technology-enabled supply chains track products from manufacture to delivery, reducing wastage and ensuring timely deliveries.
• Cloud storage and software-as-a-service (SaaS) models cut IT infrastructure and maintenance costs.
• Digital marketing tools analyze consumer behavior, helping businesses tailor their campaigns more effectively

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Monitoring and adjusting operating costs

Staying vigilant about operating costs isn’t a one-time effort. It’s an ongoing process of observation, analysis, and adjustment. By keeping their finger on the pulse, businesses ensure they’re always moving forward, making the most of every dollar spent.

Businesses should know their standard operating costs. Having clear benchmarks allows for easier tracking of any deviations. You can leverage accounting tools that can provide real-time insights. These tools flag unusual expenses or highlight patterns that might go unnoticed manually.

An in-depth review of finances, preferably monthly or quarterly, can unearth discrepancies. It’s a chance to delve deep and uncover hidden drains of resources. External factors like economic downturns or supply chain disruptions require swift adjustments. Proactively reducing costs in anticipation can prevent more significant financial setbacks.

As technology evolves, newer and more cost-effective solutions emerge. Staying updated on these developments helps organizations better monitor and adjust operating costs for more profitability.

What is the difference between operating costs and capital expenses?

Criteria	Operating Costs	Capital Expenses
Definition	These are daily expenses a business incurs during regular operations.	These are long-term investments made in the business to acquire or maintain assets.
Nature	Recurrent and usually varies based on production levels or service demand.	One-time or infrequent, related to obtaining or upgrading physical assets.
Examples	Salaries, rent, utilities, and office supplies.	Purchasing machinery, real estate, or investing in significant tech upgrades.
Duration	Short-term and typically within a fiscal year.	Long-term, often with benefits spanning multiple years.
Tax implications	Generally, they are fully deductible in the year they occur.	Often depreciated or amortized over the useful life of the asset.
Purpose	To support the day-to-day operations of a business.	To invest in the business for growth or long-term value generation.
Effect on Cash Flow	Immediate impact, as they’re recurring expenses.	Initial outlay might be high, but the expense spreads over several years.

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Long-term vs. short-term operating costs

Remember, understanding both types of costs helps in effective financial planning. Adjusting one can sometimes offset the other. Balance is key.

Long-term operating costs

• These costs stretch over a long period.
• You can’t avoid them easily.
• Examples include building maintenance and long-term equipment leases.
• Planning for these is crucial.
• They provide insight into a business’s financial health over the years.

Short-term operating costs

• These costs come and go quickly.
• Paying them is often a monthly or quarterly obligation.
• Think about utility bills or short-term software subscriptions.
• Businesses need to manage them regularly.
• Short-term costs impact immediate cash flow.

Operating cost vs. non-operating cost

The difference between operating and non-operating costs is similar to what we discussed while comparing operating costs and other business expenses. Here’s a brief overview: 

Criteria	Operating Costs	Non-Operating Costs
Definition	Costs incurred from the core operations of a business.	Costs unrelated to the main activities of the business.
Nature	Recurring,  directly linked to producing goods or providing services.	Often irregular or infrequent, arising from secondary or peripheral activities.
Examples	Salaries, rent, utilities, raw materials, and direct labor.	Gains or losses from the sale of assets, interest paid on loans, lawsuit settlements.
Duration	Typically short-term, aligning with a fiscal year.	Can be short or long-term, depending on the nature of the expense or income.
Impact on the income statement	Typically affects the gross and operating profit sections.	Operating profit affects only the net income.
Purpose	Essential for day-to-day operations and production.	Arise from events or transactions outside the usual business operations.
Business significance	Directly reflects the health and efficiency of main business operations.	Provides insights into financial decisions, strategies, and unexpected events outside of daily operations.

Operating cost on income statements

On an income statement, operating costs hold a spotlight. Starting with revenues at the top, the income statement deducts operating costs to arrive at the operating profit.

First, let’s talk about revenues. They’re the earnings generated from selling goods or services. Once the direct costs of producing these goods or services, like raw materials and direct labor (often termed “cost of goods sold” or COGS), get subtracted, we reach a figure called “gross profit.”

Following this, operating expenses come into play. These are the expenses involved in the day-to-day running of a business. Examples include rent, utilities, salaries (excluding those involved in production), and marketing expenses. These costs are essential for a business to keep its doors open and serve its customers.

We determine the operating profit after subtracting operating expenses from the gross profit. This figure is significant. It represents the core profitability of a business from its primary activities, excluding external factors like interest or taxes.

Lastly, it’s worth noting that the income statement will also list non-operating expenses or incomes. These arise from events or decisions outside the core operations.

Limitations of operating costs

Below are some notable limitations of operating costs.

• Short-term focus. Operating costs mainly focus on immediate expenses, potentially overshadowing a business’s long-term financial health.
• Misleading analysis. Solely evaluating a company based on operating costs might provide a skewed picture. Sometimes, high expenses arise from critical, long-term investments.
• Seasonal variations. Operating costs can fluctuate based on the time of year, and using them without context might not offer an accurate annual performance snapshot.
• Inconsistencies across businesses. Only some companies classify operating costs similarly, complicating direct comparisons within an industry.
• Vulnerability to external factors. Elements like inflation or sudden market shifts can artificially inflate these costs, potentially causing undue alarm without a broader context.

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Best practices for managing operating costs

Although calculating operating costs differ for organizations, there are a few best practices you can follow to increase profitability and your business’ bottom line. 

• Monitor regularly. Keep a close eye on operating costs to identify unusual spikes or drops. Adjustments can be more effective when made proactively.
• Improve operational efficiency.  Implement lean management principles to optimize processes, eliminate waste, and use resources effectively.
• Invest in technology. Adopting modern tools and systems can automate tasks, reduce manual errors, and streamline operations, ultimately reducing costs.
• Train employees. Train staff to enhance their skills, ensuring efficient performance and reducing costly mistakes.
• Create feedback loops. Encourage feedback from employees at all levels. Frontline staff often have firsthand insights into where costs can be minimized without compromising quality.

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Bottom line

Operating costs illuminate the health of daily operations, painting a vivid picture of a company’s efficiency. It’s not just about the numbers but their story regarding sustainability, adaptability, and profitability. 

You can navigate challenges with agility and proficiency in managing operating costs. Cut down unnecessary expenses but ensure quality and growth don’t take a back seat while you’re at it. 

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