What are operating costs and expenses?

Operating costs refer to the money a business spends on its daily operations, which includes the production and distribution costs of your products or services or general expenses such as rent or travel.

The importance of knowing your operating expenses

Operating costs directly affect the profitability of a company, as this type of cost is deducted from overall revenue to determine your final profits. By gaining a full understanding of your operating costs, you can efficiently manage the financial health of your company and potentially increase your profits through smart short-term and long-term decisions.

Profits can generally be increased by making adjustments to a company’s operating costs, although this can either be a short or long-term solution depending on the types of changes you make to your expenses. For example, reducing your staff force or putting a temporary stop to pay rises and overtime can be a viable way of increasing profitability in the short term.

However, this type of tactic may prove harmful to your business model in the long-term, as your overall productivity will be reduced due to smaller staff numbers or employees leaving for better financial prospects elsewhere. This, in turn, will reduce your overall profits.

Calculate your overhead costs with QuickBooks.

Conversely, long-term solutions to increasing revenue may see your short-term expenses increased for the purpose of generating more profit later on. For instance, using the above example, a company could actually increase its staff numbers or offer employees more overtime to increase their rate of production, which would present higher operating expenses and a bigger loss in revenue in the short term, but if handled correctly could provide a considerable increase to long-term profits. 

Understanding your operating expenses will allow you to analyse and make informed decisions that could increase your overall revenue.

Cost of goods sold (COGS) / cost of sales (COS)

The Cost of Goods Sold refers to the direct costs associated with manufacturing or acquiring the products you sell in a specific period; which includes production and manufacturing costs, labour costs, and material acquisition. However, COGS does not include anything considered an ‘indirect’ expense such as distribution, sales, or marketing. COGS is used to calculate a company’s gross profit and is essential for understanding how much it costs a business to create its products.

How to Calculate Cost of Goods Sold (COGS)

You can calculate your Cost of Goods Sold using the following method:

COGS = (Beginning Inventory + Purchases During the Period) - Ending Inventory

For example, if a company starts the year with £10,000 in inventory, buys £20,000 worth of goods during the year, and has £5,000 in inventory at the end of the year, the COGS would be:

COGS = (£10,000 + £20,000) - £5,000 = £25,000

COGS is crucial for tax purposes because it helps businesses determine their taxable income by reducing the total revenue earned during the year.

Sales general and administrative (SG&A)

Sales, General, and Administrative (SG&A) costs refer to the operating expenses that are not directly tied to the production of goods or services. These are the day-to-day costs of running a business and include expenses related to selling, corporate management, and overheads. SG&A costs are subtracted from a company’s gross profit to calculate its operating profit.

Components of SG&A:

Sales Expenses:

• Salaries and commissions of sales staff

• Advertising and marketing costs

• Promotion and distribution expenses

General Expenses:

• Office rent and utilities

• Depreciation on office equipment and buildings

• Insurance costs

Administrative Expenses:

• Salaries of executives and management

• Accounting, legal, and HR costs

• Office supplies and administrative support

SG&A costs are reported on a company’s income statement and can significantly impact a company’s profitability. Companies strive to control SG&A costs because they are fixed expenses, which do not vary directly with sales levels, unlike the variable costs in COGS. For example, If a company spends £50,000 on salaries for executives, £30,000 on office rent, £20,000 on marketing, and £10,000 on utilities, the total SG&A cost would be:

SG&A = £50,000 + £30,000 + £20,000 + £10,000 = £110,000

These expenses are essential for the functioning of a business, but they do not contribute directly to the production process, making them a key focus for cost management.

Fixed costs vs variable costs

When looking into operating costs it is important to consider whether an expense has a fixed or variable cost associated with it. Fixed costs can generally be relied upon to remain the same, and can help you to create an accurate financial forecast of your spending. Fixed costs may include rent for your office, warehouse, or shop, payroll, and equipment depreciation.

Variable costs are those that are likely to change over time, such as delivery fees and shipping charges, commissions, and advertising or marketing costs. Whilst you will usually have a general idea of what these services may cost, they are likely to fluctuate over time, making them not entirely predictable. 

What are examples of operating expenses?

Operating expenses are the day-to-day costs that a business incurs to keep running smoothly, which differ from capital expenditures - long-term investments, and are essential for calculating what operating income is. By understanding what operating costs are, businesses can effectively manage cash flow and improve profitability. Below, we'll break down what are operating expenses and what is included in different categories.

Salaries and wages

Employee salaries and wages are one of the largest types of operating expenses for most businesses. These costs cover payments to employees, both full-time and part-time, as well as any benefits like pensions, bonuses, and health insurance. When understanding what are considered operating costs, salaries are at the top of the list because they are essential for day-to-day operations.

Rental costs

Rental costs, whether for office space, warehouses, or retail outlets, are another key operating expense. Businesses that don’t own their premises must account for regular rent payments, which can significantly impact what is operating income. In addition to rent, this may include utility bills and maintenance fees associated with the leased property.

Advertising and marketing costs

Marketing and advertising are essential for growing and maintaining customer bases. These operating expenses cover everything from digital marketing campaigns and social media ads to print and TV advertising. Costs also include market research and branding efforts. In terms of operating expenses, marketing is vital for driving business growth.

Proper market research can also help to grow your business. Learn more in our blog.

Insurance and legal fees

Business insurance (liability, property, and workers' compensation) and legal fees are necessary to protect a company from potential risks. Whether it's securing professional indemnity insurance or hiring lawyers to draft contracts, these expenses form a crucial part of the answer to what are considered operating costs.

Office equipment and supplies

Operating a business involves regular purchases of office equipment and supplies, from computers and printers to stationery and software subscriptions. These are ongoing expenses that help keep the office running efficiently, and they are an integral part of what are operating expenses.

Maintenance and repairs

To keep operations running smoothly, businesses need to maintain their equipment and infrastructure. Maintenance and repairs for machinery, office facilities, or IT systems ensure that breakdowns don’t halt productivity. These costs, while variable, are essential to consider in what operating costs are.

Vehicle costs

If a business uses vehicles for deliveries, services, or employee transportation, vehicle expenses are a critical component of operating costs. This includes fuel, leasing or purchasing vehicles, maintenance, and insurance. For businesses in transportation or logistics, vehicle-related operating expenses can be substantial.

Other operating costs

In addition to the more common operating expenses, there are various other costs that businesses need to account for to maintain daily operations, and these often depend on the nature of the business.

Membership fees

Many businesses pay membership fees to professional organisations, trade associations, or industry-specific networks. These memberships offer resources, networking opportunities, and access to industry information. While not every business has these fees, they are a part of operating expenses that are included for those that do.

Travel, dining, entertainment

For businesses with employees who travel for work or entertain clients, travel, dining, and entertainment costs can be considerable. These operating expenses include flights, accommodation, meals, and any client-facing entertainment or events. Managing these costs effectively is crucial for controlling what is operating income.

General losses

General losses can occur due to bad debts, depreciation of assets, or losses from legal disputes. These expenses reduce operating income and can fluctuate from year to year. Although difficult to predict, they are part of what are considered operating costs and need to be factored into a business's financial planning.

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