Operating costs: Formula, how to calculate [with examples included]

Tracking and analyzing your business’s operating costs is essential for increasing efficiency and ensuring your business is making a profit. For example, many companies sign up for subscription services and don’t use them very often or forget they exist. Periodically auditing your operating costs can help you identify unnecessary spending. 

Be careful not to cut costs too severely. As you optimize your spending to minimize operating costs, keep an eye on your business’s long-term health, as changes that are too severe can reduce both productivity and profitability.

Let’s look at what operating costs are, how to calculate them, the different types, and examples to learn how to manage them:

• What are operating costs?
• How do you calculate operating costs?
• Uses for operating cost ratio
• Operating cost categories

• Real-world example of operating costs
• Operating costs on financial statements
• How to reduce operating costs

• Streamline your accounting and save time
• Operating costs FAQ

What are operating costs?

Operating costs are the day-to-day costs to keep a business running. Some of these costs are unavoidable, like fixed costs, and others change with an increase or decrease in production, such as variable costs. The third type has a base cost but increases with higher production—known as semi-variable costs. 

Operating costs may include:

• Rent
• Cost of goods sold (COGS)
• Utilities
• Depreciation
• Insurance
• Payroll
• Advertising

Operating costs appear in the income statement after your company’s gross income. Operating costs impact a company’s profitability. The more you can reduce your operating costs, the higher your profit margin will be. However, cutting operating costs too much can be risky, as it could decrease the company’s output, resulting in fewer sales.

How do you calculate operating costs?

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

Operating costs = 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 (OPEX) include the selling, general, and administrative expenses of a business. These are the costs that you incur to conduct normal business operations that are unrelated to production.

Here’s a step-by-step breakdown of how to determine your operating costs:  

Step 1: Choose a period 

Select the time frame for which you want to calculate operating costs (e.g., monthly, quarterly, annually).

Step 2: Locate your income statement 

Find the income statement for the chosen period.

Step 3: Identify COGS 

Find the total cost of goods sold (COGS) on the income statement. This represents the direct costs associated with producing or acquiring the goods or services you sell.

Step 4: Identify OPEX 

Locate the total operating expenses (OPEX) on the income statement. These are the ongoing costs of running your business, such as rent, salaries, utilities, and marketing.

Step 5: Apply the formula 

Use the following formula to calculate operating costs: Operating costs = COGS + OPEX

Step 6: Analyze the Result 

Review your calculated operating costs to gain insights into your business's financial efficiency and identify potential areas for cost reduction.

Understanding operating cost ratios

Operating cost ratios are financial metrics that can help you assess your business’s operational efficiency and profitability. They provide insights into how well your company manages expenses relative to revenue. By understanding and analyzing operating cost ratios, you can identify areas for improvement and make informed decisions to optimize financial performance.

Key operating cost ratios

Key operating cost ratios are invaluable to measuring a company’s efficiency and profitability. Utilizing and understanding these ratios can help businesses make informed decisions to optimize operations and enhance overall performance. 

Operating Expense Ratio (OER)

This ratio measures the percentage of a company's revenue that is consumed by operating expenses. It is calculated by dividing operating expenses (excluding depreciation and amortization) by total revenue. A lower OER indicates greater efficiency, as it means the company is spending less to generate each dollar of revenue.

Formula: OER = (Operating Expenses (excluding depreciation and amortization)) / Total Revenue

• Operating Expenses: The total expenses incurred during normal business operations, excluding depreciation and amortization.
• Total Revenue: The total income generated from the company's core business operations. 

Example Calculation: 

If a company has operating expenses of $500,000 (excluding depreciation and amortization) and total revenue of $2,000,000, the OER would be calculated as follows:

OER = $500,000 / $2,000,000 = 0.25 or 25%

This means that 25% of the company's revenue is consumed by its operating expenses. A lower OER indicates greater efficiency, as it signifies the company is spending less to generate each dollar of revenue.

Gross Profit Margin

This ratio reveals the percentage of revenue that remains after deducting the cost of goods sold (COGS). It is calculated by dividing gross profit (revenue minus COGS) by total revenue. A higher gross profit margin suggests that the company is effectively managing its direct production costs.

Formula: Gross Profit Margin = (Gross Profit / Total Revenue) * 100

• Gross Profit: Total Revenue - Cost of Goods Sold (COGS)
• Total Revenue: The total income generated from the company's core business operations.

Example calculation: If a company has total revenue of $2,000,000 and the cost of goods sold (COGS) is $1,200,000, the gross profit would be calculated as follows:

Gross Profit = Total Revenue - COGS Gross Profit = $2,000,000 - $1,200,000 = $800,000

Then, the Gross Profit Margin would be calculated as follows:

Gross Profit Margin = (Gross Profit / Total Revenue) * 100 Gross Profit Margin = ($800,000 / $2,000,000) * 100 = 0.4 * 100 = 40%

This means that 40% of the company's revenue remains after deducting the cost of goods sold, indicating that the company is effectively managing its direct production costs.

Net Profit Margin

This ratio represents the percentage of revenue that remains as profit after deducting all expenses, including operating expenses, taxes, and interest. It is calculated by dividing net profit by total revenue. A higher net profit margin indicates greater profitability.

Formula: Net Profit Margin = (Net Profit / Total Revenue) * 100

• Net Profit: Total Revenue - Total Expenses (including operating expenses, taxes, and interest)
• Total Revenue: The total income generated from the company's core business operations.

Example calculation: If a company has total revenue of $2,000,000 and total expenses (including operating expenses, taxes, and interest) of $1,600,000, the net profit would be calculated as follows:

Net Profit = Total Revenue - Total Expenses Net Profit = $2,000,000 - $1,600,000 = $400,000

Then, the Net Profit Margin would be calculated as follows:

Net Profit Margin = (Net Profit / Total Revenue) * 100 Net Profit Margin = ($400,000 / $2,000,000) * 100 = 0.2 * 100 = 20%

This means that 20% of the company's revenue remains as profit after deducting all expenses, indicating greater profitability.

Uses of operating cost ratios

Operating cost ratios help managers, investors, and analysts assess performance, make informed decisions, and identify areas for potential improvement across various aspects of business operations. Here are their primary uses:

Performance evaluation

Operating cost ratios help businesses evaluate their overall financial performance and identify trends over time.

Benchmarking

These ratios can be compared to industry averages or competitors to assess a company's relative efficiency and profitability.

Cost control

By analyzing operating cost ratios, businesses can identify areas where costs are excessive and implement strategies to reduce them.

Pricing decisions

Operating cost ratios can inform pricing decisions by helping businesses understand the minimum price needed to cover costs and generate a desired profit margin.

Investment decisions

Investors use operating cost ratios to assess the financial health and potential profitability of a company before making investment decisions.

Important considerations

When analyzing operating cost ratios, it's important to consider industry-specific factors and compare ratios to relevant benchmarks. Additionally, trends over time can be more informative than a single snapshot in time.

OPEX typically includes: 

• Advertising and marketing
• Administrative payroll
• Research and development
• Insurance premiums
• Office expenses

For example, if a company had a factory on one side of town and administrative offices on another side of town, the factory rent would be an operating cost, while the administrative office rent would be an operating expense. That’s because the employees in the administrative office do not contribute to the company’s production.

Operating cost categories

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 has to halt production, they still have to pay rent each month. Rent is a fixed cost because it occurs regardless of increases or decreases in the company’s activities.

Examples of fixed costs include:

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

As a business owner, you determine the fixed costs via contract agreements or cost schedules. Fixed costs only change when you enter into new contractual agreements or cost schedules. 

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. 

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

Variable costs

Unlike fixed costs which are always the same, variable costs increase or decrease based on a company’s production. For example, a surfboard factory may double its 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 of gasoline is zero. When several food delivery requests are made, the restaurant’s gasoline costs go up. When the demand for delivery drops, the spending on gasoline also goes down.

Examples of variable costs include:

• Direct and raw 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 the variable cost per unit of output.

Semi-variable costs

The third type of business costs are known as semi-variable and are similar to 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 pauses.

Examples of semi-variable costs include:

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

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.

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 increase with additional usage.

Real-world example of operating costs

Say a small manufacturer is looking to understand better how their profitability works. Its income statement includes the following for the last year: 

• Sales revenue of $225,000
• Cost of goods sold (COGS) of $75,000
• Salaries of $90,000
• Rent expenses of $10,000
• Advertising and marketing $4,000
• Insurance costs of $6,000
• Office suppliers of $5,000
• Interest expenses $1,000
• Tax expenses $2,500

The operating costs are COGS plus the operating expenses. Operating expenses include all of the above except the interest and tax expenses. So, for the manufacturer, the operating costs are $190,000, which is COGS of $75,000 plus the total operating expense of $115,000.

The company can then analyze its operating costs from period to period to see which costs can be reduced or eliminated.

Operating costs on financial statements

The income and cash flow statements are two essential financial reports that provide a comprehensive view of a company's financial health. While both statements deal with operating costs, they present them differently due to their distinct focuses: the income statement highlights profitability, while the cash flow statement emphasizes liquidity. 

Knowing how operating costs are depicted on each statement is essential for understanding a company's financial performance and making informed business decisions.

Income statement

Both direct and indirect operating costs ultimately contribute to the calculation of net income, which is the final figure on the income statement.

• Direct costs: The income statement primarily focuses on matching revenues with the expenses incurred to generate them. Operating costs related to the direct production of goods or services (COGS) are listed separately, usually right after revenue.
• Indirect costs: Operating expenses not directly tied to production (OPEX) are often categorized and listed separately below gross profit. These can include categories like selling, general, and administrative expenses (SG&A).
• Non-operating costs: Costs unrelated to core operations, such as interest expense or losses from asset sales, are listed separately below operating income.

Cash Flow Statement

The cash flow statement prioritizes the actual cash transactions related to operating costs, providing insights into the company's liquidity and ability to generate cash from its core business activities.

• Indirect method (most common): The cash flow statement begins with net income from the income statement. Then, it adjusts for non-cash expenses (like depreciation) and changes in working capital (like accounts receivable and payable). The goal is to show the actual cash flow from operating activities.
• Direct method (less common): This method directly lists cash inflows and outflows from operating activities, such as cash received from customers and cash paid to suppliers and employees. This provides a clearer picture of where cash is being generated and used.
• Impact: Operating costs affect the cash flow statement through their impact on net income (indirect method) or through direct cash payments (direct method).

How to reduce operating costs

Want to boost your bottom line? These 16 strategies can help reduce your operating costs and enhance your company’s financial health. It's important to assess which methods are most suitable for your business and consider their potential impact carefully.

Automate: Identify repetitive tasks that can be automated with software or technology.

Eliminate: Review workflows and remove unnecessary steps or duplicated efforts.

Optimize: Implement just-in-time inventory practices to reduce holding costs.

Negotiate: Leverage your buying power with suppliers for better prices or discounts.

Compare: Regularly shop around to ensure you get the best suppliers' deals.

Explore: Consider alternative suppliers for more competitive rates.

Cross-train: Train employees to perform multiple tasks for greater flexibility.

Outsource: Consider outsourcing non-core functions for cost-effective specialization.

Consider flexible hiring: Utilize part-time or contract workers for specific tasks or projects.

Upgrade: Replace old equipment with energy-efficient models.

Conserve: Implement energy-saving practices in the workplace.

Go green: Explore solar or wind power to reduce energy costs.

Renegotiate: Review and renegotiate lease agreements, service contracts, and insurance policies for potential savings.

Utilize the cloud: Leverage cloud solutions for software, storage, and data backup to eliminate hardware costs.

Go virtual: Conduct meetings and training online to reduce travel expenses.

Collaborate online: Use online platforms to streamline communication and reduce the need for in-person meetings.

Streamline your accounting and save time

Understanding and managing operating costs is an important part of running a business. If you don’t track and try to reduce your operating costs when needed, your profit margin may suffer. Easy-to-use accounting software like QuickBooks Online makes these costs apparent and helps you eliminate unnecessary expenses.