Operating costs: What they are and how to reduce them
From advertising software to the espresso fueling your next meeting, every business expense has an important part to play. The nature of your spending—and what qualifies as important—will ultimately depend on your company’s product or service.
That said, all companies need to know exactly how much money it takes to maintain operations and generate revenue. Without an accurate estimate of the funds needed to keep the lights on, success and sustainability are a long shot. In other words, you need to calculate your operating costs periodically, and definitely before you start your business.
This article defines operating costs and explains what generally is and isn’t included in this number. We’ll cover how to use operating costs in your decision-making, as well as tips to reduce spending in some of these areas.
What are operating costs and why do they matter?
Operating costs are expenses you incur to run your business and sell your product on a day-to-day basis.
Basically, if a cost is associated with revenue-generating activities, like administering your services or producing your goods, it’s part of your operating costs. This includes payments like rent, wages, office expenses, equipment repairs, and vehicle costs.
Broadly, your company’s operating costs will fall into three different categories:
- Fixed costs: These are costs that you need to pay regardless of business performance. Examples include rent, insurance, or loan payments.
- Variable costs: These are costs that may fluctuate depending on your sales and production levels. These include labor wages, credit card processing fees, or shipping costs.
- Semi-variable costs: These are costs that blend aspects of fixed and variable costs. One common example is overtime pay. At your normal production levels, overtime pay may be nonexistent or fixed. When production increases, overtime pay may increase or vary.
Keeping your operating costs down is one of the easiest ways to improve your company’s profitability and create free cash flow. Once you’ve tallied up your total operating costs, you’ll list it on your income statement for you, your investors, and shareholders to analyze. With this data in hand, you can better identify the sources of profits or losses, discover opportunities to optimize spending, and gain control over your financial health.
What do operating costs include?
If the operating cost definition seems broad, you can break these costs down into two slightly neater categories: operating expenses and cost of goods sold.
Operating expenses (OPEX) are the costs a business incurs to stay up and running. They’re also called Selling, General, and Administrative (SG&A) expenses. Examples of operating expenses are rent, payroll and benefits, inventory, banking fees, marketing ads, business licenses, and transportation.
Although you may see “operating cost” and “operating expense” used interchangeably in other articles, there is a difference. Operating expenses are only one part of your total operating costs.
Cost of goods sold
The cost of goods sold (COGS) refers to the costs that a business incurs to produce its goods or services. They’re also called the cost of sales or cost of services.
COGS includes the expenses that are directly related to production, like the materials needed to build your product. It doesn't include indirect costs, like the electricity powering the machines used to build your product.
When you’re calculating COGS, consider only the direct costs of creating the goods or services you've actually sold. Examples of COGS are raw material costs, wages and benefits for production workers, equipment repairs, and certain factory overhead costs. A production facility, for instance, would list rent as a direct cost.
You now have the two main ingredients in the simplified operating cost formula:
Operating costs = Operating expenses (OPEX) + Cost of goods sold (COGS)
Finally, operating costs also factor in depreciation and amortization. Depreciation is the loss in value of tangible assets, like equipment. There are a few different methods to calculate an asset’s depreciation. Amortization is a technique that spreads the cost of intangible assets, like patents or software, over time. This article shows you how to calculate the amortization of your assets.
Before you can plug your variables into this formula, you need to catalogue your costs for the time period you’re measuring. You should also ensure that you don’t include any non-operating costs.
Examples of operating costs
Your total operating cost will sum up your normal business expenses, cost of sales, and other cash outflows that support your operating activities. It’s a large bucket, but here are some reliable operating cost examples you can refer to:
- Accounting and bookkeeping fees
- Administrative expenses
- Advertising and marketing costs
- Bank charges
- Credit card processing fees
- Direct labor costs
- Direct material costs
- Entertainment costs
- Health insurance fees
- Home office costs
- Inventory costs
- Legal fees
- License fees
- Office supplies
- Maintenance costs
- Membership fees
- Rent and lease payments
- Utility costs
- Repair costs
- Research and development
- Salaries and wages
- Sales commissions
- Property taxes
- Travel expenses
- Utility costs
- Vehicle expenses
Put together an effective digital expense-tracking system—or optimize the one you currently use—so these costs don’t slip through the cracks. Another strategy is to let the experts handle your business accounting and bookkeeping. Use our free accounting partner search tool to explore your options.
3 ways to lower operating costs
When it comes to operating costs, one of the best tools a business owner has is scrutiny. By regularly evaluating these expenses, you can vastly extend your cash runway. Bear in mind, however, that reducing certain operating costs can actually limit productivity and the potential for profit.
For instance, if a company chops away at its employee benefits package, it could fail to attract top industry talent. Although short-term profits would increase, an inexperienced team could stifle the product development process and cause investors to lose confidence. And a meal kit company that starts using lower quality ingredients to reduce its COGS runs the risk of losing long-time subscribers.
You don’t have to compromise your product or service to keep operating costs in check. Bringing your employees in on this process can help you spot inefficiencies and start saving money sooner.
Here are three ways to lower some major expenses.
1. Ask vendors about early payment discounts.
Suppliers depend on healthy cash flow, just like you. As a result, many vendors offer discounts if you pay your invoices early. A 2% to 3% discount is common. Look over your vendor’s payment terms and see if there’s an opportunity to save.
2. Be selective with your office location or skip it entirely.
Remote work is the new reality for thousands of businesses due to the COVID-19 outbreak. If you still need a physical office space, locations away from heavily populated areas tend to cost less. And a partially remote workforce will allow you to rent a smaller space. If you’re already leasing, consider subleasing part of your commercial space. And always remember: The 11th Commandment is not Thou shalt be in an office. Be creative in how you address your business’s physical footprint.
3. Choose a high-ROI marketing strategy.
If you want to generate more leads, you have to invest in marketing and advertising. But not all strategies are created equal. Prioritize high return-on-investment (ROI) tools like email marketing and search engine optimization (SEO). In addition, a set-it-and-forget-it advertising budget doesn’t work for every company. Measure your ad performance by channel on a regular basis.
The cost of doing business
To recap, your company’s operating costs represent the costs you incur to create your product, staff your business, and maintain your operations. The final figure is the sum of your operating expenses and cost of goods sold, along with depreciation and amortization.
Running a successful business is a constant battle between revenue and costs. If you use our tips to reduce operating costs—while taking steps to improve your revenue—there’s nothing to stop your business from becoming profitable.
Once you’ve accounted for your expenses, you’re ready to answer another important question: How much income do I have left? For that, you’ll need the net income formula.