Operating costs: Definition, formula, and examples

Operating costs are the day-to-day costs that are required to keep a business running. Some of these costs are unavoidable (fixed costs), others change with an increase or decrease in production (variable costs), and the third type has a base cost but increases with higher production (semi-variable costs).

Fixed costs like rent and electricity are considered overhead costs because they can’t be avoided. Variable costs and semi-variable costs, on the other hand, can be monitored and managed to reduce spending.

In this article, we’re going to discuss the three different types of operating costs, show examples of each type, and learn how to manage them.

• What are operating costs?
• How do you calculate operating costs?
• Types of operating costs
• Fixed costs
• Variable costs
• Semi-variable costs
• Operating costs FAQ

What are operating costs?

Operating costs refer to the costs incurred to maintain the day-to-day operations of your business. 

Operating costs may include:

• Rent
• Cost of goods sold (COGS)
• Property taxes
• Utilities
• Inventory costs
• Depreciation
• Amortization
• Equipment
• Insurance
• Payroll
• Legal fees
• Advertising and marketing

Operating costs appear in the income statement after determining your company’s gross income. The operating costs are deducted from the gross income to calculate your business’s net income. Net income is the last item appearing on your company’s income statement.

It’s important to track and analyze operating costs because they impact a company’s profitability. The more you can reduce your operating costs, the higher your profit margin will be. Cutting operating costs too much can be risky, however, as it could decrease the company’s output, resulting in fewer sales.

Some costs are categorized as non-operating costs, which are costs that aren’t related to the day-to-day operations of your business. Some examples of non-operating costs include interest charges, loss on the sale of assets, cost of investments, and business relocation.

How do you calculate operating costs?

To determine the operating cost, select a period from your income statement. Then, use the following operating cost formula:

Operating Cost Formula

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

COGS includes all the expenses that are directly associated with the production of goods or services. 

COGS includes the following expenses:

• Cost of raw materials
• Direct labor cost
• Rent of plant or manufacturing unit
• Wages
• Costs of repair
• Utility costs and taxes

Operating Expenses

Operating expenses are the costs that you incur to conduct normal business operations that are unrelated to production. These costs are not accounted for in the COGS, and therefore operating expenses are separate from the cost of sales. That’s because operating expenses are not directly linked to the production of goods or services.

If a company had a factory on one side of town, and the administrative offices on another side of town, the rent for the factory would be considered an operating cost, while the rent for the administrative office would be an operating expense. 

That’s because the employees in the administrative office do not contribute to the company’s production.

Operating expenses (or OPEX for short) include the selling, general, and administrative expenses of a business.

Types of operating expenses include:

• Inventory cost
• Cost of advertising and marketing
• Administration payroll
• Cost of research and development
• Insurance premiums
• Rent
• Property taxes on real estate
• Equipment
• Office expenses

How to calculate the operating cost

To calculate the operating cost, you first need to determine the cost of goods sold (COGS).

COGS = Opening Stock + Purchases + Direct Expenses – Closing Stock

Then calculate the total operating expenses.

Operating Expense = Revenue – Operating Income – COGS

Finally, add COGS and operating expenses to determine the total operating cost of your business.

COGS + Operating Expenses = Total Operating Cost

Understanding operating costs

Tracking and analyzing your business’s operating costs is essential because it allows you to increase efficiency and eliminate any wasteful expenses. 

For example, if you find that salaried employees spend most of their day completing simple, repetitive tasks, you can hire interns or outsource that aspect of work so employees with higher payroll costs can focus on more important projects. 

Many companies also sign up for subscription services and don’t use them very often, or forget they exist. Periodically auditing any recurring monthly services like apps or programs can help you identify wasted operating costs.

Be careful to not cut costs too severely, however, as it could backfire. Instituting a freeze on raises can help reduce operating costs in an emergency, but if it goes on for too long you may lose skilled employees to companies that offer better pay.

As you optimize your spending to minimize operating costs, keep an eye on the long-term health of your business, as changes that are too severe can reduce both productivity and profitability.

Types of operating costs

Generally, business operating costs are divided into three categories. These categories are fixed costs, variable costs, and semi-variable costs.

Fixed costs

Fixed costs are the costs that do not change with the change in the level of output of goods or services. This means that such costs remain constant with an increase or decrease in the volume of output.

A common example of a fixed business cost is rent. If a company is forced to halt production, they still have to pay their rent each month. Rent is considered a fixed cost because it occurs regardless of increases or decreases in the company’s activities.

Examples of fixed costs include:

• Salaries
• Rent
• Leases
• Depreciation
• Insurance
• Property taxes
• Certain utilities (like trash removal)

Your business has to pay fixed costs irrespective of any specific business activity. When totaled up, the fixed costs, variable costs, and semi-variable costs result in the total costs of your business operations.

As a business owner, you determine the fixed costs via contract agreements or cost schedules. These are the foundational costs incurred to carry out your business operations.

Fixed costs only change when you enter into new contractual agreements or cost schedules. However, fixed costs do not change with the change in the level of production.

Impact of fixed costs on financial statements

Fixed costs can be categorized as either direct or indirect. Direct fixed costs could include costs like direct labor or rent. Indirect fixed costs may include depreciation, salaries, and office supplies.

Fixed costs can decrease on a per-unit basis if your business produces large quantities of goods. In this regard, fixed costs can contribute towards economies of scale. 

Fixed costs in your income statement also reflect on your balance sheet and cash flow statement. The fixed costs on your balance sheet may either reflect your short-term or long-term liabilities, whereas fixed charges paid in cash get reflected in your company’s cash flow statement.

Besides considering fixed costs, your business will keep a track of its cost structures through cost statements. These statements help you in understanding the fixed and variable costs of your business, and how these costs impact different aspects of your business.

While other types of costs increase or decrease based on activity, fixed costs will always be consistent whether the business makes any sales or not.

Variable costs

Unlike fixed costs that are always the same, variable costs increase or decrease based on a company’s production.

For example, a surfboard factory may double their staff to increase production just before summer begins, and then return to normal staff levels in the fall. 

Gasoline is a variable cost for a restaurant that offers food delivery. If there are no requests for delivery orders, the cost spent on gasoline is zero. When several food delivery requests are made, the restaurant’s costs for gasoline go up. When the demand for delivery drops, the spending on gasoline goes down as well.

Examples of variable costs include:

• Direct materials
• Packaging
• Utility cost
• Payroll
• Sales commissions

Large increases or decreases in a company’s output can lead to variable costs in categories like utility bills, payroll, or distribution.

The per-unit variable cost of production remains constant for a given level of output, but the per-unit variable cost increases as the volume of output increases.

Likewise, the per-unit variable costs decrease with the decrease in the level of output. You can calculate the total variable cost of your business operations by multiplying the quantity of output with variable cost per unit of output.

Semi-variable costs

The third type of business costs are known as semi-variable costs, and are similar to both fixed and variable costs. Semi-variable costs are variable because they increase with increased production, but are also fixed because they still occur even when production is completely paused.

A semi-variable cost is similar to a smartphone with a limited data plan. The monthly cost for the smartphone is fixed, but if the user exceeds their data limit, the cost increases and becomes variable. Semi-variable costs will have a base minimum cost that can go up with additional usage.

A common example of a semi-variable cost in business is overtime pay. A business will have a minimum cost for payroll that will increase when employees are needed to work overtime. The standard payroll cost is fixed while the overtime costs are variable.

Examples of semi-variable costs include:

• Overtime pay for hourly employees
• Internet bill when extra bandwidth is used
• Electricity costs when production is increased
• Sales commissions for a salaried salesperson

Real-world example of operating costs

To illustrate operating costs, here is an actual income statement from Microsoft:

• Microsoft reported total revenue of $143.01 million for the period
• Total COGS or cost of revenue was $46.07 million
• Total operating expenses for Microsoft during the accounting period amounted to $43.97 million
• Therefore, the total operating cost for Microsoft for the year is $46.07 million + $43.97 million = $90.04 million

Due to Microsoft’s size, their operating expenses are huge. With total revenue of $143 million, and operating costs of $43 million, they’re spending a third of their revenue on operating costs. Microsoft can analyze their operating costs from period to period to see which costs can be reduced or eliminated.

Master your operating costs

Understanding and managing operating costs is an important part of running a business. If operating costs aren’t tracked, the profit margin will be reduced, resulting in slim profit margins or, in more serious cases, an unprofitable business. Easy-to-use accounting software can make these costs apparent and help you eliminate unnecessary expenses.

To learn about ways to reduce your operating costs, read this collection of simple tips for reducing operating costs.

Operating costs FAQ

Below we answer some commonly asked questions about operating costs.

What are business operating costs?

Operating costs include any costs a company must pay in order to stay in business. This includes rent, electricity, and payroll.

What’s included in operating costs?

Any mandatory costs that a company has to pay in order to function is considered an operating cost.

What are examples of operating costs?

Rent, utilities, payroll, and insurance are common examples of operating costs.

For a lemonade stand, operating costs would include lemons, sugar, and water. For a car factory, operating costs could include rent, parts, payroll, licensing, legal fees, and much more.

How do you calculate operating costs?

The formula for determining operating costs is: Cost of Goods Sold + Operating Expenses. 

What are operating expenses and non-operating expenses?

Any operating expenses that aren’t related to production are considered non-operating expenses. Purchasing new tires for a fleet of delivery trucks is an operating expense, while repainting the office building is a non-operating expense.