Operating Cost

Updated on April 5, 2024
Article byRutan Bhattacharyya
Edited byRutan Bhattacharyya
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Operating Cost?

Operating costs refer to the expenses incurred by business owners for the administration and maintenance of their organization on a daily basis. Computing this metric is crucial for businesses to determine how much it costs to generate a certain income. Moreover, the calculation is vital for determining tax liability accurately.

Operating Cost

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Typically, such costs include direct COGS or cost of goods sold and operating expenses, such as overhead costs, rent, raw materials, and more. That said, these costs do not cover the financing-related non-operating expenses, like foreign currency translation and interest. There are three types of these costs. They are variable, fixed, and semi-variable costs.

Key Takeaways

  • Operating costs refer to the expenditures businesses incur as a consequence of their day-to-day operations. Individuals can find it in a company’s income statement.
  • One must compute the sum of operating expenses and the cost of goods sold to calculate the cost of running a business on a daily basis. 
  • A key difference between operating cost and operating expense is that the latter is a part of operating cost.
  • A key advantage of determining such costs is that it allows entrepreneurs to know the total expenses incurred to run their business’s operations.

Operating Cost Explained

Operating costs refer to a business’s direct cost of day-to-day operations. Individuals must determine such costs to understand how a business is performing financially. Moreover, knowing the costs enables business owners to make changes that can help them carry out operations more effectively.

Generally, a company’s management team looks to maximize an organization’s profits. Since the revenue earned by the organization and the amount spent to carry on daily operations determine profitability, a business can increase profits by minimizing operating costs and generating more revenue. That said, cost-cutting is typically easier. Moreover, it is a more accessible way of improving the bottom line. Hence, an organization’s managers often choose this strategy over using techniques to increase revenue.

However, one must remember that reducing the cost of maintaining the daily operations of a business too much can negatively impact a business’s productivity. As a result, an organization’s profitability may also take a hit, especially in the long run.

These costs may vary widely from one organization to another. For instance, a retail store may have to pay high utility bills. On the other hand, a manufacturing business has high labor costs as it employs more workers. Individuals must deduct such costs from their revenue to compute their operating income. One can find a business’s operating cost in its income statement.

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Types

Let us look at the different types of such costs.

#1 – Variable Costs

These costs refer to the ones that change with the output level. In other words, variable costs decrease or increase based on the production level. When the output level increases, variable costs rise. On the other hand, these costs fall when the output level decreases.

A few examples of variable costs are as follows:

  • Utility costs
  • Sales commission
  • The cost of packaging
  • Direct labor cost
  • The cost of raw materials, etc.

Entrepreneurs can compute their business’s variable cost by multiplying the quantity of the output by the output’s variable cost per unit.

#2 – Fixed Costs

These costs are the ones that do not increase or decrease with a change in the productivity or sales of a business. Organizations must pay fixed costs irrespective of their performance or activities. A few examples of such costs are as follows:

  • Insurance
  • Overhead costs
  • Lease rentals
  • Property taxes
  • Salaries
  • Interest expense

Business owners can determine these costs through cost schedules or contract agreements. Such expenses are the foundational costs businesses must incur to carry on operations. However, one must remember that fixed costs do not change over a contract’s lifespan or cost schedule.

Such costs can help companies in the achievement of economies of scale. This is because when many of an organization’s costs remain fixed, the business can generate more profit per unit. In addition, economies of scale enable large organizations to offer the same products as smaller organizations for lower prices.

#3 – Semi-Variable Costs

Besides variable and fixed costs, companies may incur semi-fixed or semi-variable costs. Such costs represent a combination of variable and fixed components. These costs may vary with the production level, similar to variable costs. That said, semi-fixed costs, like fixed costs, still exist even when the production is 0.

Examples of semi-variable costs are as follows:

  • Travel expenses
  • Personnel costs
  • Maintenance costs

Formula

One can use the following formula to compute operating costs.

Operating Cost = Operating Expenses + COGS

Examples

Let us look at a few operating cost examples to understand the concept better.

Example #1

Suppose ABC Company, a tire manufacturer, recorded a total revenue of $100 million over one year. However, the overall cost of goods sold was $30 million, and the total operating expenses stood at $20 million.

One can compute the total operating cost for the 12 months by using the above formula.

Operating Cost = $30 million + $20 million = $50 million

Example #2

One of the leading financial institutions in India, HDFC Bank, recorded a steep increase in operating costs in Q4 (fourth quarter) due to an increase in its employee benefit expenses and branch expansion.

The bank’s operating expenses jumped to ₹13,462.1 crores, a 32% rise from the previous year. In the financial year 2023, the private sector loan provider opened 1,479 branches, which included 638 branches in Q4 alone.

Advantages And Disadvantages

Let us look at the benefits and limitations of such costs.

Advantages

  • Determining this cost helps businesses determine the total expenses incurred for carrying out operations.
  • Calculating this cost helps businesses compute their overall tax liability accurately.
  • Computing this cost as a percentage of overall sales is a benchmark of performance over a duration within an industry.

Disadvantages

  • One must compare this metric over different reporting periods to identify a trend or gain useful insight.
  • Reducing such costs for a short duration inflates a business’s earnings. Moreover, if an organization reduces the costs too much, profit can be negatively impacted. 

Operating Cost vs Operating Expenses

Many people new to accounting concepts believe that operating costs and operating expenses are the same. However, they are not. There are some critical differences between the two. If individuals are unaware of such differences, they cannot prepare financial statements accurately. So, let us look at the vital distinct features of the two concepts.

Operating CostOperating Expenses
Such costs include the cost of goods sold and operating expenses. Operating expenses include salaries paid, rent, director fees, etc.  
Knowing this cost is essential to determine the amount a business must earn to make a profit.Calculating the total operating expenses is not enough to know how much income is necessary to record a profit. 

Frequently Asked Questions (FAQs)

1. How to reduce operating costs?

Businesses can take the following measures to reduce operating costs:
– Normalize remote work 
– Embrace and work smarter by utilizing technology 
– Identify operational inefficiencies 
– Ensure that the insurance offerings are competitive 
– Minimize infrastructure costs 
– Cancel unused service, etc.

2. Are operating costs direct or indirect?

These costs are direct costs that a business must bear to produce products or services.

3. Does the operating cost include depreciation?

Depreciation refers to an accounting technique that involves allocating the loss in value of any fixed asset over time. Since a business’s fixed assets play a crucial role in its day-to-day operations, according to accounting rules, depreciation is an operating expense. Thus, it is included in operating costs.

4. Is the operating cost the same as the cost of sales?

They are not the same. A business’s cost of sales measures the expenses contributing to a product or service’s production. On the other hand, operating cost determines the amount a company spends to cover its overhead costs.

This article has been a guide to what is Operating Cost. We explain its examples, formula, types, comparison with operating expense, advantages, & disadvantages. You may also find some useful articles here –

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