What is An Operating Cost and Its Importance in a Business (A Guide)

Businesses incur expenses from their daily operations throughout their existence in any industry. These expenses are known as operating costs (OpEx), and they include the primary needs of a business. Operating costs significantly factor in the profitability of any business. Hence, understanding everything about operating costs can help you run a more efficient business and increase profits.

Operating expenses keep your business running, meaning they’re repetitive to allow the company to run smoothly. These costs aren’t dependent on making or selling products in a business but must be fulfilled whether the business is making profits or not. 

Since operating costs are INEVITABLE when running a business, managing these costs will keep your business afloat and thriving. Whether you’re a novice or a seasoned entrepreneur, Foundeck in this informative post answers this question: what are operating costs and their importance in a business?

Operating expenses involve the daily business operations like: 

1. Salaries 
2. Utility bills - Water, gas, electricity
3. Rental equipment
4. Office Supplies - Stationery, paper, ink, cleaning supplies, toner
5. Technology and Equipment - Laptops, computers, tablets, printers, phones
6. Commercial rentals and Lease Payments - Office or warehouse space, Desk space leases
7. Insurance Expenses - Liability insurance for the business and employees 
8. Legal and Accounting Fees - Tax preparation services, legal counsel fees 
9. Marketing or Advertising Costs - Web design services and campaigns 
10. Transportation Expenses - Fuel costs for delivery vehicles, riders, travel expenses like business trips
11. Employee Wages and Benefits - Salary payments, health insurance coverage
12. Business Licensing and Permit Fees - paying for relevant permits to operate the business

OpEx makes the basic expenses of a business, and their proper management can help companies create accurate budgets. Without good management and budgeting, expenses can quickly eat up your profits and bring down the business. 

Understanding the operating costs of your business also helps you have financial strategies that minimize expenses to increase profits. Besides, you can make informed decisions when investing to improve business operations. 

With the proper understanding of operating costs, business owners can set accurate prices for their products or services, keeping them relevant to the competition. As a result, the business is appropriate in the market and doesn’t lose profit margins. By evaluating the company’s performance, you can identify where to cut down or reallocate resources to keep the business’s functions running and making profits. 

Operating Expenses and Capital Expenditures

In a business, operating costs are the daily costs that enable a business to function like purchasing supplies, utility bills, advertising, wages, rent, and administration fees.

Capital expenditures are the properties purchased to facilitate business operations like machinery. However, repairing and maintaining these machines is considered an operating expense.

Although operating and capital expenditures are expenses in the business, differentiating them is crucial. WHY, yet they’re all expenses? In accounting, both expenditures are treated differently. 

Components of Operating Costs

There are two components of operating costs, and they consist of: 

1. Fixed Costs never change, no matter what the production level is. They include rent, insurance expenses, and lease payments. Fixed costs are constant regardless of whether there’s an increase or decrease in the production of goods or services. 
2. Variable Costs fluctuate depending on the business. They include direct labor, sales commissions, raw materials, fuel and utilities used during production, or outsourced services for specific projects in production. Variable costs increase when production increases but will also decrease when production decreases. For instance, when production is high, raw materials will need to be improved to match the production. 

The Importance of Operating Costs

Operating costs are crucial in assessing a company’s running costs and stock management efficiency. A company can know the level of expenses needed to generate revenue, which is the primary objective of any business. 

A business with higher opex than the sales percentage may indicate less efficiency at generating sales. The major problem of using OpEx to assess a company’s financial strength is that it’s all about numbers, not a ratio of what goes into the business Vs. what comes out. Hence, using the metric to compare businesses in the same market is unreasonable. Here’s why watching operation costs in your business is essential:

1. Determining base expenses is what makes a business functional. They include tools, assets, equipment, administrative, and maintenance needs. Base expenses will help a company analyze the value of its primary assets and the materials or equipment costs. 
2. Provide investors with financial information to determine whether the business is worthwhile or beneficial. Low operating costs can increase profit margins, making it an attractive business any investor would love to invest in. Determine ways to save money, like cutting back on operating costs. A business can increase its profitability even without hiking the costs of its goods and services. 
3. Calculating profits for shareholders and executives can help determine the company’s financial health. Operating costs make the basis of a company’s expenses and the cost of generating earnings for members and shareholders to determine if the business will produce a Return On Investment (ROI). 

Managing Operating Costs

Figuring out how to manage and reduce the operating costs of any organization is a crucial step toward competing in a particular market. Although operating expenses are unavoidable, some companies use proven methods to cut back on operating costs and boost profits. Some of these methods include: 

1. Making Data-Driven Decisions: The softwares at work provides spending data that you can use to make wise spending choices. By analyzing the data, you can detect trends and identify things that stand out to make sound business decisions and fix any problems quickly.
2. Flexibility in Spending: Planning a budget is essential, but the ability to change it makes it even better. Factors like economic trends, current standing in your industry, and unexpected events can impact your business expenses. The ability to adjust your budget at times like this is helpful to any business.
3. Employee Engagement: Motivate your employees to make them value, prioritize their jobs, and perform better. Offer a platform for your employees to share their thoughts on less spending, which will leave them feeling involved in making decisions that contribute to growing the company finances. 
4. Continuous Improvement. Never stop at reducing spending costs, but always aim to make things better and encourage your team to come up with ideas that can save the company money. Assess how you do things in your business and find ways to work more efficiently. 
5. Benchmarking. Check your spending habits against competitors in your field to get ideas on how you can adjust for more efficiency. Learn from the best and make yourself better. 

Operating Costs Vs. Overhead Costs

Operating costs and overhead costs are unique concepts in business and finance. They also have different meanings and implications for a company’s financial health.

• Operating costs are the continuous expenses a business incurs when running a business, such as personnel expenses or the purchase of raw materials. 
• Overhead costs are financial commitments that keep a business functioning and are not directly related to the sales or production process. They include maintenance of office space, repair, accounting fees, marketing expenses, software licenses, and upgrades. 

Operating Costs Vs. Non-Operating Costs

Non-operating costs are not directly related to the main business functions. Mostly, non-operating costs are infrequent or one-time expenses that may not contribute to income generation. Here are some examples of non-operating costs:

1. Interest on debts or loans 
2. Losses from the sale of assets
3. Taxes on non-operating income
4. Penalties or fines
5. Donations or contributions
6. Legal settlements

Operating expenses are the necessary costs that keep a business running smoothly to generate revenue, but non-operating costs aren’t directly related to revenue-generating operations in a company. 

Operating Costs Vs. Startup Costs

Startup costs are the initial expenses when starting a business and are considered operating expenses. Analyzing startup costs helps investors understand the costs of starting a business as they determine if the investment is worthwhile. 

While startup costs put a business on the map, operating costs cover the expenses of a business throughout its existence. Startup Costs are included in the initial estimates of startup companies to help investors make informed investment decisions. If the startup costs are high and profit margins are low, it may be true to say it’s not doing well. 

SG&A Vs. Operating Costs

Selling, General, and Administrative (SG&A) are costs related to the necessary activities of running a business: 

1. Customer service
2. Marketing
3. Legal fees
4. Research and development

All operating costs directly affect the production of goods or services, and SG&A is concerned with activities needed to run a company, such as administration. For instance, when a company introduces a new product line, it would incur operating costs to produce the product and SG&A in Research and Development (R&D). If the company hires workers to work on the product, that’s an operating cost as it’s directly related to the product. 

Examples of operating Costs

A company’s expenses are what fuels day-to-day operations and are classified as operating costs. Every business undertakes different operational activities that generate revenue. 

The expenses that keep a business running differ depending on the company’s activities; some operational costs might be considered as such in another. Thus, it’s crucial to understand the distinction between all variations in business expenses due to tax deductions. 

To help you understand better and differentiate these business terms, here’s a detailed list of operating cost examples: 

1. Personnel Expenses 

Personnel costs cover all expenses connected to the people you hire. The size of your team can take away a significant chunk of your operating expenses. Personnel costs include benefits, salaries, and any fees you incur to train or help your employees travel. You can manage these costs by optimizing staff levels, evaluating compensation structures often, and creating a favorable environment to maximize their potential. 

2. Occupancy Costs (Rent Expenses or Purchase of Property)

The cost of renting property for business use like a production space, office, or storage go-downs. These expenses include the total cost of the lease and other administrative fees that make the space usable. If a company buys a property upfront, the purchase is an operating cost.

3. Marketing and Advertising

Marketing is the core of any business, and most strategies involve spending money. They include paying to create ads, running marketing campaigns, and conducting market research.

When looking to cut costs, the marketing budget can seem expensive and luxurious, pushing you to cut back. However, you must be careful about whatever you take away, since you must invest in marketing to ensure ongoing business growth. 

Instead, find a balance between the advertising strategies in place to maximize what brings more Return on Investment (ROI). For instance, running adverts on billboards or TV can be more costly than using digital marketing campaigns like email marketing targeting the exact target audience. Working smart through marketing strategies that use minimal budgets will have more impact on the business.

4. Licensing Fees

Licensing or regulatory fees make up part of operating costs. These fees include driver’s licenses, food service certifications, or any other regulatory items you need for your business to function. 

5. Research and Development (R&D) Expenses 

Research and development (R&D) costs are essential, especially for businesses that deal with technology. It encompasses the funds you use to build new concepts, explore new products, and enhance existing ideas. 

It’s not uncommon for businesses to want to cut back on technology expenses while safeguarding technological advancements. However, carrying out consistent R&D activities shows commitment to customers and investors in producing market-leading products.

6. Property Taxes

Property taxes must be paid to the local government if you own the property where your business operates. The taxes and all preparation expenses count as operating costs and can be included on the balance sheet. 

7. Interest and Finance Expenses

Any money borrowed by a business comes with an interest. Once these expenses are paid, they become part of operating expenses. The payment of these loans and any additional finance charges over some time makes the costs more manageable and favorable. 

The proper management of a debt can make repayment flexible. Additionally, you can control how much debt is taken on and create a favorable repayment plan to ensure the financial health of your business isn’t affected. 

8. Depreciation and Amortization

These terms describe how the value of assets decreases over time and are considered expenses on paper. Depreciation affects physical assets like machinery or vehicles, whereas amortization is about intangible things that cost the business, like patents or copyrights. 

These expenses don’t involve using cash, but they help a business accurately determine and report their financial health. Depreciation and amortization also play a significant role in paying business taxes. Both situations present a more realistic view of a company’s finances while ensuring they comply with tax regulations.

Frequently Asked Questions

Why are operating costs necessary?

Operating costs are essential in any business because they determine the profit margins. Lower operating costs translate to higher profits, so understanding everything about them will impact your business positively. 

What is the primary goal of operating expenses?

The primary objective of operating expenses is to run a business efficiently and make maximum profits. For this reason, it’s essential to minimize operation expenses, run a business efficiently,  and make good profits. 

Can operating costs affect profit?

Operating expenses can affect profits if they’re too high. Spending more money to run a business means you reap more, but the opposite is true. Therefore, with proper operating cost management, investors will have maximum ROI. It’s a general rule that an increase in business expenses lowers profits. 

What principle does operating cost operate on?

Operating costs operate on a formula: Operating Cost = Job Cost + Process Cost. For a business to be profitable, the operating costs must be lower to increase the profit margins.

What can increase operating expenses?

Operating expenses can increase when a company has to pay more wages and salaries to its employees. Suppose the cost of production is higher than sales. In that case, operating costs will be higher, not to mention payment of salaries, health insurance, paid time off, life insurance, or other benefits.

Form Your LLC with Foundeck Today

Foundeck offers a range of fast and efficient online company formation services, allowing you to register a business structure of your choice quickly from anywhere and keep it compliant. To get started, kindly contact us here.

In Summary

Operating expenses are unavoidable in any business because they make up the day-to-day functions of an organization. Operating expenses are classified as fixed or varied as long as a company is making profits. 

Understanding your business operating costs will give you a clear picture of your company’s financial and market performance. 

Operating costs will show you what you’re spending on and where you’re allocating most resources. Plus, you can determine if there’s an opportunity to make changes, grow your business, and increase profits.

Operating costs are crucial, but proper management can benefit your company. You don’t have to scratch your head over operating expenses if you keep a watchful eye and use the right tools to keep your finances in check. Kindly contact one of our experts here if you have any question about Operating Cost in a business.