What Are Operating Costs?

What Are Operating Costs?

Let me explain operating costs directly to you: these are the daily expenses you need to keep your business running, maintaining it, operating it, and administering it. They cover both direct and indirect costs. Remember, they don't include non-operating expenses like currency translation fees, interest on debt, or investments that finance your business. You calculate a company's operating income by subtracting these operating costs from revenue, and you'll find these figures on its income statement.

Key Takeaways

You should know that operating costs include the cost of goods sold, selling expenses, and general and administrative expenses such as rent or insurance. If you reduce operating costs, you can increase profits, but cut too much and you'll see sales and revenue drop, which decreases profits over time. Fixed operating costs stay the same even when sales or productivity change, while variable ones do change with those factors. Semi-variable or semi-fixed costs adjust with sales or productivity but persist even if production hits zero.

Understanding Operating Costs

As you track your business expenses, you'll see two main categories: operating costs, which are the daily costs for producing goods and running the operation, and non-operating costs like interest on loans. These are recorded separately in your accounting, so you can identify which expenses are crucial for generating revenue and how to operate more efficiently.

Your primary goal in business is to maximize profits, which come from revenues minus expenses. When revenue goes up, profits rise; but higher expenses eat into those profits. That's why you might focus on cutting operating expenses to boost profits—it's often quicker and easier than increasing revenue.

Be cautious, though: drastic cuts to operating costs can damage profits in the long run by lowering productivity and sales. For instance, if you lay off three out of four customer service employees, your payroll drops, saving money and increasing short-term profits. But one person can't handle the workload of four, leading to unhappy customers who leave, which cuts revenue and profits over time.

You must balance keeping operating costs low while allowing your business to grow and increase sales.

How to Calculate Operating Costs

To calculate operating costs, you add the cost of goods sold (COGS) and other operating expenses—these are right there in your company's income statement, where COGS might be labeled as cost of sales. The straightforward equation is: Operating cost = Cost of goods sold + Operating expenses.

These costs fluctuate over time with your business's expenses, so you calculate them for specific periods like a month, quarter, or year based on the income statement you're using.

Types of Operating Costs

Operating costs consist of COGS and operating expenses, and they typically exclude capital outlays. COGS covers direct expenses tied to producing your goods or services, such as materials, wages and benefits for production workers, rent or property taxes on production facilities, repairs to production equipment, and utility costs for those facilities.

Operating expenses are the everyday costs of running your business that aren't directly linked to production, including wages and benefits for administrators or executives, legal, banking, or accounting fees, marketing and advertising, travel or entertainment costs, rent and utilities for non-production facilities, office supplies, and non-capitalized research and development.

You can break operating costs down further into fixed, variable, and semi-variable or semi-fixed categories, depending on how they respond to changes in sales or productivity.

Fixed Costs

Fixed costs are ones you pay regardless of whether productivity or sales go up or down—even if production stops entirely, they don't disappear. Rent is a classic example; if you rent a factory, you pay it no matter what you're producing. Other fixed costs include utilities, insurance, or equipment costs.

These fixed costs help you achieve economies of scale. Since the cost is fixed, increasing production lets you make more profit without raising that expense. For example, factory rent stays the same even if you manufacture more goods, reducing the per-unit cost and making production more efficient. That's why large companies can often undercut smaller ones on price.

Keep in mind, economies of scale have limits. You can only ramp up production so much in one factory before you need a second one, which then increases your fixed costs.

Variable Costs

Variable costs rise when production increases and fall when it decreases—if production stops, these costs drop to zero. Think of electricity or raw materials: to make more products, you need more materials, but if you halt production, you don't buy any.

The cost increase isn't always linear. For example, if you're buying fabric as a raw material, you might get a volume discount—$3 per yard for 500 yards, but $1.50 per yard for 1000. Even with the discount, total costs still rise as production grows.

Semi-Variable Costs

Some operating costs are semi-variable or semi-fixed, blending fixed and variable traits. They change with production like variable costs but remain even when production is zero, like fixed costs. Overtime wages fit this category: regular wages are fixed because you can't eliminate your labor force entirely if you want to keep operating, but overtime fluctuates with production needs, behaving as both fixed and variable.

SG&A vs. Operating Costs

Selling, general, and administrative (SG&A) expenses are a subset of operating costs, covering costs for running and managing your company, advertising and selling goods and services, and delivering products to customers. They exclude the direct costs of making a product or service, which is COGS. Together, SG&A and COGS form your total operating costs. Direct costs are COGS, while indirect costs include SG&A like payroll, rent, maintenance, insurance, or raw materials as overhead.

Real-World Example of Operating Costs

Take Apple's income statement for the year ended September 2024: cost of goods sold (or cost of sales) was $210.4 billion, operating expenses were $57.5 billion, so operating costs totaled $267.9 billion. You can pull this data from Apple's 10-K filings to review operating costs over multiple quarters or years, comparing them to see if the company manages costs effectively over time.

The Bottom Line

Operating costs are your business's necessary, everyday expenses, and you subtract them from revenues to find profits over time. Don't evaluate them alone—like any financial metric, compare total operating costs across years or quarters to spot increases or decreases, then weigh them against overall performance and revenue to gauge how well you manage costs and profits.