How to Calculate Operating Cost: Operating Cost Formula

Operating costs include all expenses associated with the day-to-day maintenance and administration of a business. More specifically, operating costs are costs associated with revenue-generating activities. Examples of operating costs include:

• Accounting and legal fees
• Bank charges
• Sales and marketing costs
• Travel expenses
• Entertainment costs
• Non-capitalized research and development expenses
• Office supplies costs
• Rent or lease payments
• Repair and maintenance costs
• Utility costs, the cost of electricity
• Salary and wage expenses
• Raw materials
• Overhead costs
• Property taxes
• Office expenses

You can’t figure out how much money you’re making if you don’t know how much it costs to make that money. That’s the idea behind operating costs.

If you subtract operating costs from total sales, you come up with your operating profit (otherwise known as operating income). That’s the measure of profitability from your core business, not including income from non-core sources, such as investments, sales of assets or the like.

Operating costs include the cost of goods sold (COGS) and operating expenses (OPEX). They also include depreciation and amortization.

Operating costs don’t include interest expenses (from debt service, for example) or taxes (on income or property, for example). They also don’t include startup costs or capital expenses, such as the cost of buying a new building or equipment.

Operating costs consist of three types of costs:

1. 1. Fixed costs. Fixed costs are those that do not change as sales rise or fall. They do not reflect the productivity of a company, and a company must continue to pay them irrespective of its performance. Such costs include overhead, administrative expenses, insurance, security, and equipment, among other things.
2. 2. Variable costs. Variable costs are those that change as a company's sales and production rise or fall. They include such line items as the cost of raw materials, production payroll, and electricity. As production increases, a company must buy more raw materials, hire more production personnel or use more electricity, incurring higher costs.
3. 3. Semi-variable costs. There is a third category of costs: Semi-variable costs, also known as a semi-fixed or mixed costs. Such costs may resemble fixed costs at or below a particular level of sales or production, but change as sales or production rise above that level. An example is overtime wages: Below a certain level of production, overtime is non-existent and fixed; above that level, it becomes variable and rises or falls as production does.

Total operating costs = Cost of goods sold (COGS) + operating expenses (OPEX)

Cost of goods sold, also called the cost of sales, are the expenses directly tied to the production of goods or services. (Subtracting COGS from revenues yields gross profit or loss.) The cost of goods sold includes the following:

• Direct costs of material
• Direct costs of labor
• Rent of the plant or production facility
• Benefits and wages for the production workers
• Repair costs of equipment
• Utility costs and taxes of the production facilities

Operating expenses are the expenses a business incurs through its normal business operations that are not otherwise accounted for in the cost of goods sold. Operating expenses are different from the cost of sales because operating expenses cannot be linked directly to the production of the products or services a company sells. Operating expenses include "selling, general and administrative expenses" (SG&A), which are the sum of all direct and indirect selling expenses and all general and administrative expenses of a company. Operating expenses include:

• Rent
• Equipment
• Inventory costs
• Advertising and marketing
• Payroll
• Insurance premiums
• Research and development

You can make smart choices about your business if you know how much you’re spending on goods and services, salaries and other operating costs.

For example, knowing how much you spend on staff salaries can help you decide whether you employ too many people. If you cut staff too much, you may see a short-term gains but suffer in the long term.

As another example, if your operating costs show that you’re spending a large, fixed amount on a factory that generates only a certain number of widgets, you can choose to increase the number of widgets with the knowledge that your factory rent will remain the same. The means a lower cost-per-widget for rent, or an economy of scale.

In order to make the best long-term decisions for your company, you must consider operating costs over many periods, noting whether trends emerge.

Similarly, investors can monitor how operating costs rise or fall relative to a company's profitability as a way to assess a company's management. They can also determine a company's operating margin—the amount of profit a company makes on a dollar of sales after paying for variable costs of production such as wages and raw materials, but before paying interest or taxes—by dividing a company’s operating profit by its net sales.

If you run or work for a retail business, consider the unit economics of the business.

• What is your sales-to-investment ratio?
• What is your operating cost and operating margin?
• Are these figures within range of a best-in-class retail business?
• How familiar are you with your business’s income statement and balance sheet? What more can you do to maintain financial visibility into your company? Questions to ask yourself regarding the details of your business’s financial performance include:
• What is the cost of each product or service you sell?
• How quickly does your business collect its accounts receivables?
• If your business does what you expect it to, when will your cash flow reach its highest and lowest points of the year? Roughly how much cash will it have in both of those dates?
  
• What is your break-even volume?

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