Definition, Formula, Types, and Examples

What Are Operating Costs?

Operating costs are the daily expenses necessary to maintain, operate, and administer a business. These include direct costs and indirect costs.

Operating costs do not include non-operating expenses necessary for financing a business, such as currency translation fees, interest on debt, or investments. A company’s operating income is calculated by subtracting operating costs from revenue, and these values are shown on its income statement.

Understanding Operating Costs

Two main buckets of expenses that businesses track are operating costs, which are the daily costs of producing goods and running the business, and non-operating costs, such as paying interest on a loan. These costs are recorded separately in the company’s accounting, allowing the business to determine which expenses are necessary to generate revenue and to operate more efficiently.

One of the main goals of a business is to maximize profits, which are the revenues the company generates minus the expenses it incurs. When revenue increases, profits also increase; an increase in expenses, however, can cut into profits. As a result, businesses often try to reduce operating expenses to increase profits, which can often be done more quickly and easily than increasing revenue.

Drastic cuts to operating costs can hurt profits over time by decreasing productivity and sales. If a company lays off three out of four customer service employees, payroll expenses will drop, leading to immediate savings while increasing short-term profits. But one person can’t provide the same service as four people. This may lead to unhappy customers, who may take their business elsewhere, resulting in a decrease in revenue and lower profits in the long run.

How to Calculate Operating Costs

Operating costs are calculated by adding the cost of goods sold (COGS) and other operating expenses. These numbers can be found in a company’s income statement. COGS is sometimes labeled as the cost of sales.

The equation to calculate operating costs is:

$\text{Operating cost} = \text{Cost of goods sold} + \text{Operating expenses}$Operating cost=Cost of goods sold+Operating expenses

Operating costs change over time, as do a company’s expenses. As a result, operating costs can be calculated for the specific time (such as a month, quarter, or year) reflected in a given income statement.

Types of Operating Costs

Operating costs are made up of the COGS and operating expenses. They usually do not include capital outlays.

The costs of goods sold are the direct expenses associated with the production of a company’s goods or services, such as:

• Materials
• Wages and benefits for production workers
• Rent, mortgage, or property tax on a production facility
• Repairing production equipment
• Utility costs for the production facility

Operating expenses are the daily costs of running the business that aren’t specifically associated with the production of a good or service. These can include:

• Wages and benefits of administrators or executives
• Legal, banking, or accounting fees
• Marketing and advertising
• Travel or entertainment costs
• Rent and utilities for an office or other non-production facility
• Office supplies
• Non-capitalized research and development (R&D)

Operating costs can be further subdivided into fixed and variable costs, as well as semi-variable or semi-fixed costs. These divisions reflect how expenses change when a business’s sales or productivity changes.

Fixed Costs

Fixed costs are paid even when productivity or sales increase or decrease. Even if production goes to zero, fixed costs do not. Rent is a fixed cost; a company that rents a factory to manufacture its products must pay rent even when there is a change in what it produces. Other fixed costs include utilities, insurance, or the cost of equipment.

Fixed costs make it easier to achieve economies of scale. When a cost is fixed, a company can make more profit at the same cost if it increases production. Rent on a factory, for example, will stay the same, even if the company begins manufacturing more goods there. This makes production more efficient and cost-effective by reducing the per-unit cost. Economies of scale are one of the reasons large companies can sell their products at lower prices than smaller companies.

It’s important to note that the principle of economies of scale is limited past a certain point. For example, a company can only increase production so much in a single factory. At some point, it will need to expand to a second factory to keep growing, which would then increase its fixed costs.

Variable Costs

Unlike fixed costs, variable costs increase when production goes up and decrease when production drops. When production goes to zero, these costs also go to zero. Examples of variable costs include electricity or raw materials. If a manufacturing company wants to increase production, it needs more raw materials. But if a company stops producing that product entirely, it doesn’t need to purchase any raw materials. As production stops, the cost of raw materials is zero.

An increase in cost is not always consistent at different production levels. A manufacturing company that purchases fabric as one of its raw materials, for example, may be able to get a volume discount on that fabric. If it buys 500 yards, the cost may be $3 per yard. But if it buys 1000 yards, the supplier may offer a rate of $1.50 per yard. However, even with the price break, there is still an increase in cost as production increases.

Semi-Variable Costs

Some of a company’s operating costs may be considered semi-variable or semi-fixed. These costs display a mixture of fixed and variable behaviors. They change in response to changes in production, like variable costs. However, like fixed costs, they still exist even when production is zero.

For example, overtime wages are often considered a semi-variable cost. Regular wages are a fixed cost: a labor force, and its corresponding wages can be reduced but not eliminated completely if the company wants to function. However, overtime wages will increase and decrease as production increases and decreases. If productivity conditions allow for overtime wages, the cost of those wages will behave like both a fixed and variable cost.

SG&A vs. Operating Costs

Selling, general, and administrative (SG&A) expenses are a subset of operating costs. These are the costs associated with:

• Running and managing a company
• Advertising and selling goods and services
• Delivering a product or service to customers

SG&A expenses do not include the direct cost of making a product or performing a service (the cost of goods sold). Together, SG&A and COGS make up a company’s operating costs.

Real-World Example of Operating Costs

If we look at an income statement for Apple (AAPL) for the year that ended in September 2024, we can see:

• Cost of goods sold (cost of sales): $210.4 billion
• Operating expenses: $57.5 billion
• Operating costs = COGS + Operating expenses = $210.4 billion + $57.5 billion = $267.9 billion

Investors can use the data from Apple’s 10-K filings to examine total operating costs for several quarters or years. They can then compare these numbers to determine whether the company effectively manages operating costs over time.

The Bottom Line

A company’s operating costs are its necessary, everyday expenses. Operating costs can be subtracted from revenues to determine a company’s profits over time.

Like any financial metric, operating costs shouldn’t be evaluated in isolation. Instead, investors should compare total operating costs for several years or quarters to see whether they increase or decrease, then compare those results to the company’s overall performance and revenue to see how well a business manages its costs and profits over time.