Operating Cost

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DEFINITION of 'Operating Cost'

Operating costs are expenses associated with the maintenance and administration of a business on a day-to-day basis. The operating cost is a component of operating income and is usually reflected on a company’s income statement. While operating costs generally do not include capital outlays, they can include many components of operating a business including:

The formula for operating cost can be expressed in the following way:

Operating Cost = Cost of Goods Sold - Operating Expenses

BREAKING DOWN 'Operating Cost'

Businesses have to keep track of both operating costs and costs associated with non-operating activities, such as interest expenses on a loan. Both costs are accounted for differently in a company's books, allowing analysts to determine how costs are associated with revenue-generating activities and whether or not the business can be run more efficiently.

Generally speaking, a company’s management will seek to maximize profits for the company. Because profits are determined both by the revenue that the company earns and the amount the company spends in order to operate, profit can be increased both by increasing revenue and by decreasing operating expenses. Because cutting costs generally seems like an easier and more accessible way of increasing profits, managers will often be quick to choose this method.

However, trimming operating costs too much can reduce a company’s productivity and, thus, its profit as well. While reducing any particular operating cost will usually increase short-term profits, it can also hurt the company’s earnings in the long-term. For example, if a company cuts its advertising costs its short-term profits will likely improve, as it is spending less money on operating costs. However, by reducing its advertising, the company is also reducing its capacity to generate new business, and earnings in the future can suffer, as can the company’s growth potential. The best course of action, then, is to keep operating costs as low as possible while still maintaining the ability to increase sales.

Components of Operating Cost

A business’s operating costs are comprised of two components, fixed costs and variable costs, which differ in important ways.

A fixed cost is one that does not change with an increase or decrease in sales or productivity and must be paid regardless of the company’s activity or performance. For example, a manufacturing company must pay rent for some sort of factory space regardless of how much it is producing or earning. While it can downsize and reduce the cost of its rent payments, it cannot entirely eliminate these costs, and so they are considered to be fixed. Fixed costs generally include overhead costs, and other examples of fixed costs include insurance, security and equipment.

Fixed Costs

Fixed costs can help in achieving economies of scale, as when many of a company’s costs are fixed the company can make more profit per unit as it produces more units. In this system, fixed costs are spread out over the number of units produced, making production more efficient as production increases by reducing the average per-unit cost of production. Economies of scale can allow large companies to sell the same goods as smaller companies for lower prices.

This principle can be limited in that fixed costs generally need to increase with certain benchmarks in production growth. For example, a manufacturing company that increases its rate of production over a certain period will eventually reach a point where it needs to increase the size of its factory space as well in order to accommodate the amount of the product it is making.

Variable Costs

Variable costs, like the name implies, are comprised of costs that may vary. Unlike fixed costs, variable costs will increase as production increases and decrease as production decreases. Examples of variable costs include raw material costs, payroll and the cost of electricity and other utilities. For example, in order for a fast-food restaurant chain that sells French fries to increase its French fry sales, it will need to increase the size of its purchases from its potato supplier.

It is sometimes possible for a company to achieve a volume discount or "price break" when purchasing supplies in bulk, wherein the seller agrees to slightly reduce the per-unit cost in exchange for the buyer’s agreement to regularly buy the supplies in large amounts, thereby diminishing the correlation somewhat between an increase or decrease in production and an increase or decrease in the company’s operating costs. For example, the fast-food company may buy its potatoes at $0.50 per pound when it buys potatoes in amounts of less than 200 pounds, but the potato supplier may offer the restaurant chain a price of $0.45 per pound when it buys potatoes in bulk amounts of 200 to 500 pounds. Yet, volume discounts generally have a small impact on the correlation between production and variable costs and the trend otherwise remains the same.

Generally speaking, companies with a high proportion of variable costs relative to fixed costs are considered to be less volatile, as their profits are more dependent on the success of their sales. In the same way, the profitability and risk for the same companies are also easier to gauge.

Semi-variable Costs

In addition to fixed and variable costs, it is also possible for a company’s operating costs to be considered semi-variable (or “semi-fixed”). These costs represent a mixture of fixed and variable components and thus can be thought of as existing between fixed costs and variable costs. Semi-variable costs vary in part with increases or decreases in production, like variable costs, but still exist when production is zero, like fixed costs. This is what primarily differentiates semi-variable costs from fixed costs and variable costs.

A relatively simple example of semi-variable costs is overtime labor. Regular wages for workers are generally considered to be fixed costs, as while a company’s management can reduce the number of workers and paid work-hours, it will always need a work force of some size in order to operate. Yet, overtime payments are often considered to be variable costs, as the number of overtime hours that a company pays to its workers will generally rise with increased production and drop with reduced production. Because wages paid in conditions allowing for overtime have both fixed and variable components, they are considered to be semi-variable. 

 

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