When looking at documents like the balance sheet and income statement, you may come across account terms that you’re not aware of. However, understanding these terms is vital. Doing so will help you better understand your financial statements so that you can improve your firm’s fiscal health.
One term that’s incredibly relevant to business owners is “operating costs.” Curious about what operating costs are and how they impact your company? We’ll provide you with a complete guide to operating expenses. After defining and explaining the term, we’ll outline a few of the things you can do to decrease your operating expenses.
What are operating costs?
Operating costs are those required for the day-to-day maintenance and administration of your business. People also commonly refer to operating costs as operating expenses, operational expenses, operating expenditures, operational expenses, or OPEX.
One of the primary components of operating costs is the cost of goods sold (COGS). COGS are the direct costs attributed to producing your business’s goods or services. Operating expenses also include things like:
- Labor costs, such as payroll
- Employee health insurance, pensions, and other benefits
- Sales commissions
- Maintenance costs
Knowing how to measure operating costs is important because it allows you to improve your bottom line. If you’re a for-profit business, reducing operating costs will have a direct impact on your profitability.
Operating cost ratios
Understanding your operating costs is significant because it allows you to derive many other relevant business figures and ratios. Below are the two most important data points that you can obtain through operating costs.
Operating costs can help you determine your operating income. Operating income is the total profit associated with your company’s operations. The formula to calculate operating income is:
Operating income = Total revenues – operating expenses
So imagine that a company earned $552,000 in revenue last year and has $100,000 in OPEX. The operating income for the year would be $452,000.
Operating expense ratio
Another ratio you can derive from operating costs is the operating expense ratio (OER). This ratio gives you a direct comparison of your expenses to your income, allowing you to track your efficiency.
For example, in the section above, we determined that the company’s operating income in the example was $452,000. If you run a Fortune 500 company, you’re perhaps disappointed by this figure. If you’re an entrepreneur who just opened your company last year, you’re jumping for joy. A good operating income is relative and doesn’t necessarily give a strong indication of financial health.
The operating expense ratio, on the other hand, does indicate financial health. By measuring efficiency as a percentage, it’s easier to compare yourself to others in your industry.
The equation for OER is:
Operating Expense Ratio = Operating Costs ÷ Revenues
Based on our example above, we would come up with
OER = $100,000 ÷ $552,000 = .1812 × 100 = 18.12%
Operating expense ratios can vary by industry. For instance, banks have low operating expense ratios, sometimes as little as 0.00%. Others, like the building materials industry, have OERs as high as 73%. You should be more concerned with how you rank within your industry. If you find ways to meet or beat the industry average, your business will be successful.
8 things you can do to cut operating costs
Improving your operating costs means putting yourself ahead of your competition. Small business owners should always be looking for ways to reduce their operating costs without sacrificing the quality of their offering or making the lives of their employees more difficult.
So, what are the best ways to reduce operating costs? Below are eight ideas that can help you reduce the operating costs of your business and enable you to reduce overhead and generate more revenue.
1. Embrace technology
There are dozens of online systems and software programs that can automate and streamline small business functions. These systems can cover an array of areas of operation, including accounting, website hosting, marketing communications, payroll, and more.
Technology is useful because it promotes efficiency. The result of efficiency is a reduction in OPEX in areas such as direct labor. Robots and automated intelligence can work faster than humans with fewer errors. Technology could improve supply chain processes as well, finding ways to reduce things like the cost of shipping raw materials.
To choose the right program or service for you, ask yourself the following questions:
- What do I know how to do well? (e.g., If you have an accounting background, you may want to consider using tech for marketing instead of finance.)
- What do I find myself spending an excessive amount of time on every week?
- If I could take one of my most time-consuming tasks off my plate, what would it be?
Hopefully, your answers to these questions will give you a clear indication of the task or subject matter area where you should use technology.
Another option to improve efficiency is to outsource certain business practices to a third-party specialist. For instance, if you don’t have a real estate or tax law background, you may find it challenging to pinpoint ways to reduce your lease payments or property taxes. Someone trained explicitly in this area could help.
One area that seems to especially benefit from outsourcing is advertising and marketing. For many entrepreneurs, this is a pain point. They find the amount of time they spend on advertising and marketing does correlate to the return on investment. But they don’t necessarily have time to dedicate to a marketing campaign.
While it might seem like hiring an outside vendor will result in spending more money, in the long run, delegating specific tasks to subject matter experts will save you money and generate even better results. Outsourcing certain operations is an investment that pays dividends over time.
3. Shop around for better rates
If you work with vendors regularly, you might want to set up a bidding system for projects and work. If you ask three different vendors to provide costs to you, then you pit them against one another to drive prices down.
Be sure to compile an accurate scope of work or request for proposal (RFP) for vendors to bid on, as missing information or added complexity can significantly affect the quoted rate. Having an accurate quote can allow you to better plan for anticipated operating expenses.
Leasing office space, paying utility costs, and managing a physical office can be a drain on your financial resources. Consider allowing your team to telecommute as a way to reduce total costs.
Telecommuting is on the rise across the United States. In 2005, 1.8 million US employees said that they telecommuted for half the week. In 2015, that number had grown to 3.9 million, and it’s continued growing ever since.
With the amount of connectivity available today, the difference between an employee sitting in an office and sitting at home is almost indiscernible. Employees will typically also find this advantageous, as they can cut down on their own commute times and expenses.
5. Pay invoices early or on time
Many vendors will offer a discount if you pay your invoice early. Even a savings of 2-3% can really add up. Let’s say annual operating costs are $100,000. You take advantage of paying invoices early and save 2%. You could end up saving $2,000 a year by doing so.
At the very least, make sure to pay your invoices on time to avoid any late fees or other penalties. The same goes for loans or any debt that you’ve taken out. Your interest expenses can increase if you’re late or begin to miss payments.
6. Identify inefficiencies
You should always be looking for ways to make your business more efficient. By tightening up your processes and procedures, you can reduce waste in both materials and time.
Encourage your employees to identify inefficiencies and suggest solutions to the problem. Consider providing an incentive to employees for doing so. Again, you can consider this an investment in your company. A small reward to an employee could end up saving you thousands of dollars.
7. Cancel unused services
Pore through your variable costs and identify services that you’re no longer using. If you haven’t used them in a couple months, look for a cheaper plan or consider canceling them altogether. If you’re not using them, then they’re not improving your operating income.
It’s easy to lose track of unused services, especially if you’ve set them up for auto-pay on your credit card. If you do find a service that you would like to keep, try shopping around to see if there are cheaper alternatives available.
8. Go green
If you have an office space, consider making it as green as possible. To reduce energy usage, replace regular light bulbs with compact fluorescent lighting, look to lower heating and cooling costs by improving your insulation and windows, and cut back on the amount of physical waste. Not only will you save on utility costs, you’ll save on your monthly office supply costs as well.
Take control of your business finances
Are you the type of owner who merely monitors business expenses and income without looking at detailed breakdowns? If so, it’s time to change that. As your business grows, understanding things like operating costs is going to become more and more important.
Operating costs allow you to take an in-depth look at how your expenses impact your profits. Quickbooks accounting software makes it easy for you to identify and correct areas of waste in your company so you can improve your financial health. Once you understand your costs, you can use the eight methods that we’ve provided to start cutting costs and boosting profits.