Discovering the Essence of Operating Costs
Operating costs refer to the day-to-day expenses related to maintaining and managing a business. These costs encompass both the direct Cost of Goods Sold (COGS) and various Selling, General, and Administrative (SG&A) expenses like rent, payroll, raw materials, and maintenance tasks. Crucially, operating costs exclude financing-related non-operating expenses such as interest and investments.
Operating costs are deducted from revenue to ascertain operating income, which is then reflected on the company’s income statement.
Key Takeaways
- Operating costs are the continuous expenses incurred from daily business operations.
- These costs include both COGS and operational expenses, also known as SG&A expenses.
- Common operating costs, beyond COGS, comprise rent, equipment, inventory, marketing, payroll, insurance, and R&D funds.
- Analysis of operating costs can be conducted via a company’s income statement.
Understanding Operating Costs
Businesses must monitor both operating costs and non-operating activities, such as interest expenses, separately. This allows for a clear understanding of cost associations with revenue-generating activities and identifies efficiency improvements.
Managers strive to maximize company profits by managing revenues and operating costs. However, excessive cost-cutting can impede productivity and long-term profitability. For instance, reducing advertising expenses may boost short-term profits but potentially harm long-term earnings by limiting new business generation.
How to Calculate Operating Costs
To calculate a business’s operating cost, follow these steps:
Operating cost = Cost of Goods Sold + Operating Expenses
- Identify the total Cost of Goods Sold (COGS) from the income statement.
- Locate total operating expenses further down the statement.
- Sum the COGS and operating expenses to determine the total operating cost.
Types of Operating Costs
Operating costs include various expenses, such as:
- Accounting and legal fees
- Bank charges
- Sales and marketing expenses
- Travel and entertainment costs
- Non-capitalized R&D
- Office supplies
- Rent fees
- Repairs and maintenance
- Utility charges, salaries, and wages
COGS are also part of operating costs and include:
- Direct material costs
- Direct labor wages
- Rent for production facilities
- Production workers’ benefits and wages
- Equipment repair costs
- Production utilities and taxes
Fixed Costs
Fixed costs remain unchanged regardless of production levels and continue to be incurred irrespective of the company’s performance. These include overheads, insurance, security, and equipment costs.
Fixed costs can facilitate achieving economies of scale, which allows large companies to reduce per-unit production costs as production volume increases.
Variable Costs
Variable costs scale with production changes. Examples include raw materials and utilities needed for production.
Purchase agreements can somewhat stabilize these costs through volume discounts, but the overall trend that variable costs align with production remains.
Semi-Variable Costs
Semi-variable costs contain elements of both fixed and variable costs. For instance, overtime labor costs are semi-variable: regular wages are fixed, while overtime costs vary with production levels.
Real-World Example: Apple Inc.
Consider Apple Inc.’s financials for 2021:
- Total revenue: $365.8 billion
- Total cost of sales (COGS): $213 billion
- Operating expenses: $43.9 billion
Thus, operating costs were $256.9 billion ($213 billion + $43.9 billion).
SG&A vs. Operating Costs
SG&A covers all costs not directly linked to product creation or service delivery but includes myriad expenses required to run the company, while operating costs comprehend both COGS and SG&A.
Insights on Operating Costs
Long-term business analysis should consider operating costs over multiple periods. Temporary cost-cutting might inflate earnings, but sustainable profit growth requires balanced cost management.
Total Cost Formula
The total cost formula incorporates both fixed and variable costs:
Total Cost = (Average Fixed Cost per Unit + Average Variable Cost per Unit) × Total Units Produced
Impact on Profit
High operating costs can diminish net profit. Maintaining operational efficiency involves balancing cost stability or reduction while fulfilling consumer demands, thus determining the final pricing of products.
Operating Costs vs. Startup Costs
Operating costs are ongoing, routine expenses, while startup costs include one-time expenditures essential to initiate a business, such as R&D, equipment purchase, and securing office space.
Related Terms: Revenue, Profit, Income Statement, Overhead Costs, SG&A Expenses
References
- Apple. “Form 10-K, Apple Inc.”, Page 29.
