Every business, from a corner bakery to a tech giant, has one goal in common: maximizing profits. But to get there, you have to master the art of managing operating costs.

These everyday expenses keep your business running, but they can also eat into your bottom line if left unchecked. Understanding what operating costs are and how to control them is crucial for any business owner looking to boost profitability and ensure long-term success.

In this guide, you’ll learn what operating costs are and how to calculate them. You’ll find out about the different types your small business might encounter, plus practical strategies to reduce them.

RELATED ARTICLE — How To Calculate Cash Flow: Key Formulas and Practical Examples

Operating Costs: Definition

Operating costs are the daily expenses that keep your small business running. They include everything from replenishing office supplies, the rent you pay for your workspace, and less obvious costs like depreciation. They show up on your income statement, the financial report that lists your company’s revenues and expenses over a period of time.

So, what are the two main types of operating costs? First, the direct costs, also called cost of goods sold (COGS), are expenses tied directly to making your product or providing your service. This includes things like raw materials or direct labor hours. 

Indirect costs cover expenses like rent, utilities, payroll, and office supplies. In other words, they’re costs that cover operational needs. 

A subset of indirect costs called selling, general, and administrative (SG&A) expenses takes care of costs related to running the business that aren’t directly tied to production. These include administrative salaries, marketing, and office management expenses.

The mix of operating costs can look different depending on your business model. A factory will have high costs for raw materials, utilities, and direct labor. But a consulting firm might spend more on payroll and office rent.

Understanding your operating costs is crucial because they directly impact your bottom line. The lower your operating costs, the more profit you make. That’s why many business owners make reducing these expenses a top priority.

But be careful: Cutting costs too much can backfire. If you skimp on important things like quality materials and skilled workers, it could hurt your business in the long run. The key is finding the right balance between keeping costs low and maintaining the quality that keeps customers coming back.

Types of Operating Costs

Operating costs cover a wide range of expenses, but they don’t include everything. Things like interest payments on loans and investment costs are considered non-operating expenses.

These costs fall into three main categories: fixed, variable, and semi-variable. Let’s break them down.

Fixed Costs

Fixed costs are the consistent core of your operating expenses. They stay the same no matter how much you produce or sell. Think of them as the bills you have to pay even if you don’t make a single sale.

Common fixed costs include:

• Rent for your office or factory space
• Insurance premiums
• Property taxes
• Some utility costs like trash removal
• Security services
• Salaries for permanent staff
• Depreciation

For example, if you’re paying $5,000 a month for rent, that amount doesn’t change, whether you sell 10 products or 1,000.

Variable Costs

Variable costs are the chameleons of your operating expenses. They change based on how much you produce or sell. The more you sell, the higher these costs go.

Examples of variable costs include:

• Raw materials for production
• Shipping fees
• Direct labor tied to production
• Utility bills that fluctuate with usage (like electricity for an office)
• Packaging materials

Let’s say you make custom t-shirts. The more shirts you print, the more ink and blank shirts you’ll need to buy. These are some of your variable costs.

Semi-Variable Costs

Semi-variable costs are a hybrid category. They have a fixed part you’ll pay regardless of your production levels. But there’s also a variable part that changes with your business activity or the size of your business.

Examples of semi-variable costs include:

• Travel expenses (you might have some fixed travel costs, but more trips mean higher costs)
• Equipment maintenance (regular upkeep is fixed, but more use means more repairs)
• Some utility costs (you might have a base rate plus charges for extra usage)

If your business employs anyone else, you’ll also run payroll. Variable employee pay costs include:

• Sales commissions (a base salary plus commission on sales)
• Overtime pay (base wages are fixed, but overtime fluctuates with workload)

Understanding the different types of operating costs is key to managing your business finances. Fixed costs give you a baseline for what you need to earn to keep the lights on. Variable costs help you understand how your expenses will grow as you expand. And semi-variable costs combine elements of both, adding complexity but also flexibility to your cost structure.

FROM ONE OF OUR PARTNERS — Overhead Costs: Examples, Definition, and Types

How To Calculate Operating Costs With the Operating Costs Formula

Knowing how to calculate your operating costs is critical for understanding your financial health. Luckily, it’s a straightforward process that uses information from your income statement.

Here’s the basic formula for calculating operating expenses:

Operating costs = Cost of goods sold (COGS) + Operating expenses

Here’s how to calculate your operating costs:

1. Find your total COGS on your income statement. This includes things like shipping costs, raw materials, and direct labor costs.
2. Locate your operating expenses further down the income statement. This includes things like rent, utilities, payroll, and office supplies.
3. Add these two numbers together.

This simple calculation gives you a clear picture of what it costs to run your business. It’s useful for setting prices, planning budgets, and finding ways to cut costs.

Let’s take a look at how operating costs play out in real businesses. We’ll examine two different operating costs examples to see how their costs break down.

Example 1: Neighborhood Bakery

Imagine a small bakery that specializes in artisanal bread and pastries. Here’s a snapshot of the business’s monthly finances:

• Cost of Goods Sold (COGS). $3,000 for ingredients and packaging
• Operating Expenses. $4,500 for rent, utilities, payroll, and depreciation
• Total Operating Costs. $7,500
• Monthly Revenue. $12,000

Using the operating cost formula, we get:

Operating costs = COGS + Operating expenses = $3,000 + $4,500 = $7,500

If you subtract your operating costs from your revenue, you can calculate your net income. In this example, with total operating costs of $7,500 and revenue of $12,000, the bakery nets $4,500 before accounting for the owner’s salary and taxes.

RELATED ARTICLE — Revenue versus Net Income: How Are They Different?

Example 2: Custom Furniture Manufacturer

Next, imagine a small manufacturer that produces custom wooden furniture. Here are their annual figures:

• COGS: $180,000 for wood, hardware, and direct labor
• Operating Expenses. $210,000, including rent, salaries, utilities, insurance, marketing, office supplies, and depreciation
• Total Operating Costs. $390,000
• Annual Revenue. $450,000

Applying the formula, we get:

Operating costs = COGS + Operating expenses = $180,000 + $210,000 = $390,000

Subtracting the operating costs from the total annual revenue leaves the furniture maker with $60,000 in profit before taxes.

These examples show how operating costs vary significantly across industries. The bakery has higher profit margins but lower overall revenue, while the furniture manufacturer deals with more income and tighter margins. But both businesses need to monitor operating costs to stay profitable.

RELATED ARTICLE — What Is a Good Profit Margin For a Small Business?

6 Tips To Reduce Operating Costs

Trimming your operating costs can boost your bottom line, but it’s critical to approach it carefully. Cutting too deeply or in the wrong areas could hurt your long-term productivity or sales.

Here are some smart ways to lower your operating expenses without compromising your business’s health:

• Embrace Digital Solutions. Automating tasks can save both time and labor costs. This might include accounting, payroll calculation, or inventory management. And modern software can often do the work of several employees, reducing your payroll expenses. Plus, it lets employees focus on high-impact tasks that can’t be automated. 
• Partner With Specialists. Outsourcing tasks like IT support or marketing to experts can be more cost-effective than having full-time staff. This approach can lower your operating expenses while potentially improving service quality.
• Streamline Your Operations. Regularly review your business processes to find and fix inefficiencies. This might involve updating outdated technology, reorganizing your workflow, or addressing busy work that can be automated.
• Conduct Regular Expense Reviews. Schedule periodic reviews of your operating expenses. This habit helps you spot unnecessary spending without compromising growth. It also helps you identify cost-saving opportunities.
• Implement Energy-Saving Measures. Improving your energy efficiency can lead to substantial savings on utility costs. Simple changes like using LED bulbs or programmable thermostats can make a noticeable difference.
• Negotiate With Suppliers. Regularly review and renegotiate contracts with your suppliers. Building strong relationships and being a reliable customer often leads to better rates or terms.

RELATED ARTICLE — Cost Reduction: Strategies to Reduce Business Expenses

Business Expense Tracker

Managing your operating costs starts with accurate expense tracking.

Luckily, tracking expenses has never been easier. Our business expense and receipt tracker lets you scan any receipt, and we capture key info automatically. All your expense data is ready to export into a summary report whenever you need it.