Operating Cost definition

If you’ve ever glanced at a business’ balance sheet, you may have spotted an entry labelled “operating costs.” Though the term sounds relatively simple, it encompasses a great deal and can be surprisingly complex. To ensure that you have a firm understanding of what the term means, we’ve created this helpful guide to operating costs and the terminology associated with this concept.

What is operating cost?

Operating cost encompasses all of the expenditures that constitute a business’ day to day spending. In other words, it is all the costs associated with keeping the business operating. These can include property leases, accounting and legal fees, marketing expenditure, employee salaries, maintenance costs, and research and development outlay.

Together, these are known as a business’ “operating expenses.” They play an essential role in determining how profitable a company will be, as all operating expenses are deducted from revenue to establish the business’ profit margin.

What are operating costs examples?

Generally, operating costs are split into one of two categories. They are either fixed costs or variable costs. A fixed cost is one that doesn’t increase or decrease with changes in sales and productivity figures. Essentially, they are not tied to the performance of the company. An excellent example of a fixed cost is rent. To a certain degree, it doesn’t matter how much the business produces or sells, the amount of rent they pay for their property will stay the same.

On the other hand, variable costs are those that vary depending on the productivity of the business. This includes things like raw materials, wages, and utilities. For instance, if a business manufactures wooden furniture and needs to increase its output, they’ll need to purchase more timber, reimburse their staff for more hours, and pay a higher electricity bill for the energy required to power tools and factory equipment. This will drive up operating costs – hence why these costs are “variable.”

What are semi-variable costs?

Though the vast majority of operating expenditures fit into one of the two groups mentioned above, there are a few examples that could apply to both. We call these expenditures semi-variable costs. These are costs that do increase or decrease in line with changes in productivity and sales, but that also exist when there is no production. For instance, overtime payments are generally considered semi-variable costs. This is because wages are a fixed cost (you’ll always need to pay your workers) but the number of overtime hours a business needs to pay for will increase or decrease with production levels.

Operating cost calculation

The basic calculation for operating cost is as expressed in the following way:

Cost of Goods Sold + Operating Expenses = Operating Costs

If you’re to reach an accurate conclusion, it’s vital that both the direct cost of manufacturing a product (e.g. raw materials) and the indirect costs (e.g. marketing expenditure) are incorporated into the calculation. It’s also necessary to recognise that operating costs don’t encompass all business expenditures.

For instance, capital outlays are not typically considered operating costs and are therefore not included in the calculation. Likewise, debt servicing is not likely to be thought of as an operating cost. As a rule of thumb, operating expenses are those outlays that cover the day-to-day operation of the business.

Operating cost vs capital cost

There is also a significant difference between operating costs, commonly referred to as operating expenses (OPEX), and capital costs, otherwise known as capital expenses (CAPEX). The distinction between the two can be explained in terms of the time period over which they occur.

For instance, OPEX are short-term expenses that can typically be attributed to a single tax year. CAPEX, on the other hand, are an expenditure that may impact the business over many years. For investment, a company may invest in a new piece of equipment that helps them manufacture their primary product. Though the business pays for the equipment at the point of purchase, it's an expenditure that will affect it for the foreseeable future. In this way, it's more of a long-term investment. The depreciation of such an asset is also significant. So this must also be recorded as expenditure on a business’ balance sheet.

Operating cost ratio

The operating cost ratio, more commonly known as the operating expense ratio (OER), attempts to assess the cost efficiency of an asset by comparing the expenditure required to sustain it against the income it generates. To do this, we divide the asset’s operating cost by its gross income. This is generally expressed in the following way:

Operating Cost / Revenues = OER

To demonstrate how OER functions, it’s useful to apply it to a concrete example. For instance, a business owns a property that requires it, on an annual basis, to pay £10,000 in management fees, £500 for rubbish removal, £2,000 in insurance costs, £5,000 in taxes, and £2,500 in repairs. Consequently, the total annual expenditure is £20,000. In return, the property brings in £80,000 a year in rent. In this case, the OER calculation would look like;

£20,000 / £80,000 = 25%

Generally, the lower the OER, the better, as the asset is generating more income on the same or less expenditure.

How to reduce operating cost

A business can reduce operating costs in many different ways, but it must be careful that it doesn’t cut them too far; otherwise they may find that it affects their productivity and profitability. Operating costs must be trimmed carefully and diligently. Reducing operating costs without impacting profitability is something of a specialism, and numerous individuals and businesses put a significant amount of time and energy into developing expertise in this area.

If a business cuts its marketing expenditure, it will drive down operating costs, but it is also likely to result in decreased sales. If a furniture manufacturer purchases lower quality wood at a reduced rate, they’ll cut operating costs but also put out an inferior product, potentially losing customers in the process. When it comes down to it, lowering operating costs is a delicate balancing act that requires a thorough understanding of business management.

>> Read More: What is Operating Lease?