Operating expenses are costs related to the business and its management on a daily basis. Total business expenses include the cost of goods sold and the business's operating expenses.
Business expenses are deducted from revenue to calculate operating profit and are reflected in the business's income statement.
Use the following formula to calculate your business's expenses. You will find this information in your business's income statement within your financial reporting package for the specific accounting period.
Business Costs = Cost of Goods Sold + Operating Expenses
From a company's income statement, you can only see the total cost; however, you need to understand the details of what it includes and where it comes from to see where your money has gone, and whether it has been effective and reasonable.
1. Business costs
Businesses must track costs incurred while the business is operating and costs incurred when the business is not operating.
- Because profit is defined as revenue earned by a business minus expenses incurred in its operations, profit can be increased by increasing revenue and decreasing operating expenses. Since cost reduction often seems like an easier and more accessible way to increase profits, managers are often quick to choose this approach.
- However, cutting operating costs too much can reduce a business's productivity and, consequently, its profits. While reducing any specific operating expense will generally increase short-term profits, it can also impact a business's long-term profitability. For example, if a business cuts advertising costs, its short-term profits are likely to improve, as it is spending less on operating expenses. However, by reducing advertising, the business may also reduce its ability to generate new revenue, and future profits could be affected.
- Ideally, businesses should aim to keep operating costs as low as possible while maintaining the ability to increase sales. To achieve this, managers need a thorough understanding of operating costs and how to manage them effectively.
1.1. Cost of goods sold
These are direct costs associated with the production of finished goods, the purchase of goods for resale, or the direct costs of providing services, including the following cost items:
- Direct material costs
- Costs of renting a factory or production facility.
- Wages for production workers and production managers.
- Depreciation costs of machinery and equipment
- Costs of repairing machinery and equipment
- Costs of electricity and water used in the production facility.
- Costs incurred in using the production facility.
1.2. Types of business operating expenses
The operating costs of a business include the following types of expenses:
- Salaries for management staff
- Salaries for the accounting and tax preparation department.
- Salaries for the human resources management department, labor wages, and insurance.
- Salaries for the legal department
- Sales and marketing expenses
- Bank fees
- Travel expenses
- Entertainment and social expenses
- Research and development costs
- Office rental costs
- Office expenses
- The cost of repairing and maintaining office equipment.
- Office electricity and water costs
2. Fixed costs and variable costs
2.1. Fixed Costs
Fixed costs are expenses that do not change with increases or decreases in sales or productivity and must be paid regardless of the business's activity or performance. For example, a manufacturing business must pay rent for its factory premises, regardless of how much it produces or earns. While it may be possible to reduce and minimize rent payments, these costs cannot be eliminated and are therefore considered fixed costs. Fixed costs typically include initial investment costs, property insurance, security guarantees, and equipment installation.
Fixed costs can help achieve economies of scale, because when many of a business's costs are fixed, the business can earn more profit per unit as it produces more units. In this system, fixed costs are spread across the number of units produced, making production more efficient as production increases by reducing the average variable cost per unit. Economies of scale can allow large businesses to sell the same goods as smaller businesses at lower prices.
Economies of scale can be limited in that fixed costs often need to increase with certain standards of production growth. For example, a manufacturing business that increases its production rate over a defined period will eventually reach a point where it needs to increase its factory space to match the increase in product output.
2.2. Variable Costs
Variable costs, also known as variable expenses, include costs that change with production. Unlike fixed costs, variable costs increase when production increases and decrease when production decreases. Examples of variable costs include the cost of raw materials, wages, and electricity. For instance, to increase sales of french fries, a fast-food chain would need to increase the cost of purchasing potatoes from its supplier.
Sometimes, a business may obtain discounts or price reductions when purchasing supplies in bulk, where the seller agrees to slightly lower the cost per unit in exchange for the buyer's frequent bulk purchases. Therefore, this can somewhat mitigate the correlation between increased or decreased output and increased or decreased variable costs for the business.
Volume discounts typically have a relatively small impact on the relationship between production costs and variable costs, and the nature of variable costs as they change with production levels remains unchanged.
Generally, businesses with a high ratio of variable costs to fixed costs are considered less volatile, as their profits depend more on sales. Except for manufacturing and transportation businesses with large fixed-cost investments, most commercial, construction, and service businesses have high variable cost ratios. However, this trend is changing in a competitive environment and with the application of information technology, leading these businesses to invest more in fixed costs to facilitate expansion and control the quality of their services.
2.3. Selling variable costs
In addition to fixed and variable costs, a business's operating costs can also be considered as semi-variable costs (or semi-fixed costs).
These costs represent a mixture of fixed and variable components, and can therefore be thought of as existing somewhere between fixed and variable costs. Partial variable selling costs change with increases or decreases in production, like variable costs, but remain present even when production is zero, like fixed costs. This is the key factor distinguishing partial variable selling costs from fixed costs and variable costs.
An example of a semi-variable cost is overtime pay. Regular wages for workers are generally considered fixed costs, because while a business can reduce the number of workers and paid hours, it will always need a minimum workforce to operate. Overtime payments are generally considered variable costs, because the number of overtime hours a business pays its workers will typically increase when production increases and decrease when production decreases. When wages are paid that include overtime pay, the worker's wages have both fixed and variable components and are therefore considered a semi-variable cost.
3. Cost management and cost reduction solutions
Are you currently using a management style that only tracks business expenses and income without considering the details? If so, now is the time to change that. As your business grows, understanding things like the types of operating expenses will become increasingly important.
Understanding your operating costs allows you to gain insight into how your expenses impact your profits, helping you improve your financial health. Once you understand your costs, you can use the seven methods we've provided to begin cutting expenses and increasing profits. Additionally, you can also refer to... payroll services To gain the most detailed understanding of payroll cost management in a business.
