What Are Operating Costs?
Operating costs are expenses associated with the maintenance and administration of a business on a day-to-day basis. The total operating cost for a company includes the cost of goods sold, operating expenses as well as overhead expenses. The operating cost is deducted from revenue to arrive at operating income and is reflected on a company’s income statement.
Formula and Calculation for Operating Cost
Use the following formula to calculate the operating cost of a business. You will find this information from the firm's income statement that is used to report the financial performance for the accounting period.
Operating cost = Cost of goods sold+Operating expenses
- From a company's income statement take the total cost of goods sold, which can also be called cost of sales.
- Find total operating expenses, which should be farther down the income statement.
- Add total operating expenses and cost of goods sold or COGS to arrive at the total operating costs for the period.
Deciphering Operating Costs
Businesses have to keep track of operating costs as well as the 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 costs. 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 might also reduce its capacity to generate new business and earnings in the future could suffer. Ideally, companies look to keep operating costs as low as possible while still maintaining the ability to increase sales.
Operating Costs Components
While operating costs generally do not include capital outlays, they can include many components of operating expenses including:
- Accounting and legal fees
- Bank charges
- Sales and marketing costs
- Travel expenses
- Entertainment costs
- Non-capitalized research and development expenses
- Office supply costs
- Rent
- Repair and maintenance costs
- Utility expenses
- Salary and wage expenses
Operating costs can include the cost of goods sold, which are the expenses directly tied to the production of goods and services. Some of the costs include:
- Direct material costs
- Direct labor
- Rent of the plant or production facility
- Benefits and wages for the production workers
- Repair costs of equipment
- Utility costs and taxes of the production facilities
A business’s operating costs are comprised of two components, fixed costs and variable costs, which differ in important ways.
Fixed Costs
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 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 eliminate these costs, and so they are considered to be fixed. Fixed costs generally include overhead costs, insurance, security, and equipment.
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.
The economies of scale 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 specified period will eventually reach a point where it needs to increase the size of its factory space in order to accommodate the increased production of its products.
Variable Costs
Variable costs, like the name implies, are comprised of costs that vary with production. Unlike fixed costs, variable costs increase as production increases and decrease as production decreases. Examples of variable costs include raw material costs, payroll, and the cost of electricity. For example, in order for a fast-food restaurant chain that sells French fries to increase its fry sales, it will need to increase its purchase orders of potatoes from its supplier.
It's 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. As a result, the agreement might diminish 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.
However, 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. Volume discounts generally have a small impact on the correlation between production and variable costs and the trend otherwise remains the same.
Typically, 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.
An 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 workforce of some size to function. Overtime payments are often considered to be variable costs, as the number of overtime hours that a company pays its workers will generally rise with increased production and drop with reduced production. When wages are paid based on conditions of productivity allowing for overtime, the cost has both fixed and variable components and are therefore considered to be semi-variable costs.
Limitations of Operating Costs
As with any financial metric, operating costs must be compared over multiple reporting periods to get a sense of any trend. Companies sometimes can cut costs for a particular quarter thus inflating their earnings temporarily. Investors must monitor costs to see if they're increasing or decreasing over time while also comparing those results to the performance of revenue and profit.
Example and Solution.
Operating Costing Problem 1:
Union Transport Company supplies the following details in respect of a truck of 5-tonne capacity:
The truck carries goods to and from city covering a distance of 50 miles each way.
While going to the city freight is available to the extent of full capacity.
Assuming that the truck runs on an average 25 days a month, work out:
(i) Operating cost per tonne-mile, and
(ii) Rate per ton per trip that the company should charge if profit of 50% on freightage is to be earned.
Solution.
Operating Costing Problem 2:
The Kangaroo Transport operates a fleet of lorries. The records for lorry L-14 reveal the following information for September, 1990:
The following information is made available:
A. Operating costs for the month
Petrol Rs.400, oil Rs.170, grease Rs.90, wages to driver Rs.550, wages to khalasi Rs.350.
B. Maintenance costs for the month.
Repairs Rs.170, overhead Rs.60, Tyres Rs.150, Garage charges Rs.100.
C. Fixed costs for the month based on the estimates for the year : Insurance Rs.50, Licence, Tax etc. Rs. 80,
Interest Rs.40, other overheads Rs.190.
D. Capital costs:
Cost of acquisition Rs.54,000
Residual value at the end of 5 years life is Rs.36,000. Prepare a Cost Sheet and performance statement showing:
(a) Cost per day maintained;
(b) Cost per day operated ;
(c) Cost per kilometer;
(d) Cost per hour;
(e) Cost per commercial tonne
Solution.
Operating Costing Problem 3:
Mr. Sohan Singh has started transport business with a fleet of 10 taxis. The various expenses incurred by him are given below:
(a) Cost of each Taxi Rs.75,000.
(b) Salary of Office staff Rs.1,500. p.m.
(c) Salary of garage staff Rs.2,000. p.m.
(d) Rent of garage Rs.1,000. p.m.
(e) Drivers salary (per taxi) Rs.400. p.m.
(f) Road Tax and Repairs per taxi Rs.2,160. p.a.
(g) Insurance premium @ 4% of cost p.a.
The life of a taxi is Rs.3,00,000 km. and at the end of which it is estimated to be sold at Rs.15,000. A taxi runs on an average 4,000 km. per litre of petrol costing Rs.6.30 per litre. Oil and other sundry expenses amount to Rs.10 per 100 km. Calculate the effective cost of running a taxi per kilometer. If the hire charge is Rs.1.80 per kilometer, find out the profit Mr. Sohan Singh may expect to make in the first year of operation.
Solution:
Hire charges earned in the 1st year of operation:
A taxi runs on an average 4,000 km. per month of which 20% it runs empty
i.e., effective running will be 3,000 km. per month.
(i.e., 4,000 – 20% of 4,000)
Hence, total hire charges earned in the 1st year on 10 Taxis = 3,200 x 12 months x 10 Taxis. = 3,84,000 km. at Rs.1.80 = Rs.6,91,200.
Operating Costing Problem 4:
Shanker has been promised a contract to run a tourist car on a 20 km. long mute for the chief executive of a multinational firm. He buys a car costing Rs.1,50,000. The annual cost of insurance and taxes are Rs. 4,500 and Rs.900 respectively. He has to pay Rs.500 per month for a garage where he keeps the car when it is not in use.
The annual repair costs are estimated at Rs.4,000. The car is estimated to have a life of 10 years, at the end of which the scrap value is likely to be Rs.50,000.
He hires a driver who is to be paid Rs.300 per month plus 10% of the takings as commission. Other incidental expenses are estimated at Rs.200 per month. Petrol and oil will cost Rs.100 per 100 kms. The car will make 4 round trips each day. Assuming a profit of 15% on takings is desired and that the car will be on the road for 25 days on an average per month what should he charge per round-trip?
Solution:
Working Notes:
1. Total km. in a month:
One Round Trip = 20 km. outward + 20 km. Inward = 40 km. Total km. = 40 km. x 4 x 25 days = 4,000 km.
2. No. of round trips in a month = 25 x 4 = 100.
3. Petrol & Oil will cost Rs.100 per 100 km. i.e., Re. 1 per one km.
Solution.
Driver’s Commission + Profit = 0.10 T + 0.15 T = 0.25 T.
Total Takings per month = Total Cost + Driver’s Commission + Profit.
T = 6,617 + 0.10 T + 0.15 T.
T = 6,617 + 0.25 T
T – 0.25 T = 6,617
0.75 T = 6,617 or T = Rs. 6,617 x 100/75
T = Rs.8, 822. 67 per month.
Charge per round trip = Rs.8,822.67/100 = Rs.88.23 say Rs.89.
Operating Costing Problem 5:
Mr. X owns a bus which runs according to the following schedule:
(i) Delhi to Chandigarh and back, the same day.
Distance covered: 150 kms. one way.
Number of days run each month: 8
Seating capacity occupied 90%.
(ii) Delhi to Agra and back, the same day.
Distance covered : 120 kms. one way.
Number of days run each month: 10
Seating capacity occupied 85%
(iii) Delhi to Jaipur and back, the same day.
Distance covered: 270 kms. one way.
Number of days run each month: 6
Seating capacity occupied 100%
Passenger tax is 20% of the total takings. Calculate the bus fare to be charged from each passenger to earn a profit of 30% on total taking.
The fares are to be indicated per passenger for the journeys:
(i) Delhi to Chandigarh
(ii) Delhi to Agra
(iii) Delhi to Jaipur
Solution.
