Operating Costs: How to Calculate and Reduce Business Expenses
Table of Contents
- What Are Operating Costs?
- Operating Costs vs. Operating Expenses
- How to Calculate Operating Costs
- Types of Operating Costs
- Examples of Operating Costs in a Business
- Useful Ratios for Monitoring Operating Costs
- Where Do Operating Costs Appear on Financial Statements?
- How to Reduce Business Operating Costs
- Keep Operating Costs Under Control
- FAQs
Every business has operating costs, the expenses that come with simply keeping things running. Some are obvious, like rent, materials, wages, and insurance. Others, such as software subscriptions, fuel, maintenance, or small recurring fees, are easier to overlook. Knowing what you are spending each month gives you a much clearer picture of whether your pricing is working and where your profit is actually going.
In this guide, we’ll explain what operating costs include, how to calculate them, which expenses are worth watching most closely, and where you may be able to cut costs without making it harder to run your business.
What Are Operating Costs?
Operating costs are the expenses involved in running your business and generating revenue. In the broadest sense, they can include both cost of goods sold (COGS) and operating expenses (OPEX).
- COGS covers the direct cost of producing or delivering what you sell. For a contractor, that might include materials or direct job labor. For a retailer, it can include the cost of inventory sold.
- Operating expenses are the broader costs of keeping the business running, such as rent, insurance, software, marketing, office salaries, and utilities.
Not every business has significant COGS. A freelance writer or consultant may have few direct production costs, while a construction company or manufacturer may spend heavily on labor and materials.
For a broader look at how costs affect your bottom line, see our guide to profitability and cost management.
Operating Costs vs. Operating Expenses
Operating costs and operating expenses are often used interchangeably, but they do not always mean exactly the same thing.
Operating costs can refer to the full cost of running the business, including both direct costs and ongoing overhead.
Operating expenses, or OPEX, usually refer more narrowly to indirect day-to-day expenses that are not directly tied to producing a particular product or completing a specific job.
For example, lumber purchased for a remodeling project may be a direct cost, while the contractor’s office software subscription is an operating expense.
Understanding this difference can make it easier to read an income statement and see where your money is actually going.
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How to Calculate Operating Costs
A common operating cost formula is:
Operating Costs = COGS + Operating Expenses
Here is how to calculate it step by step.
1. Choose a Period
Decide whether you want to calculate costs for a month, quarter, or year. Monthly calculations are often useful for small businesses because they make changing costs easier to spot.
2. Review Your Income Statement
Your income statement, sometimes called a profit and loss statement, summarizes revenue and expenses over a set period.
If you do not use formal accounting reports yet, you can start with your bank records, receipts, payroll records, bills, and expense-tracking system.
3. Identify COGS
Add the direct costs of producing or delivering your products or services.
Depending on the business, this could include:
- materials
- inventory sold
- direct production labor
- supplies used on customer jobs
- certain production or delivery costs
The IRS explains how cost of goods sold is generally calculated for businesses that manufacture products or buy goods for resale. Service businesses may have little or no COGS, depending on how their costs are classified.
4. Identify Operating Expenses
Next, total your ongoing operating expenses. These may include:
- rent
- insurance
- software
- marketing
- administrative payroll
- utilities
- vehicle expenses
- professional fees
- equipment leases
5. Apply the Formula
Suppose a contractor has these monthly numbers:
- Revenue: $20,000
- Direct job labor and materials: $6,000
- Operating expenses: $8,000
The calculation would be:
$6,000 + $8,000 = $14,000 in operating costs
That leaves $6,000 before any additional non-operating costs and taxes.
6. Analyze the Result
The total number is useful, but the trend matters even more. Compare operating costs with revenue and previous months.
If revenue stays flat while operating costs continue to rise, you may need to review your pricing, spending, or efficiency.
Types of Operating Costs
Operating costs can also be grouped according to how they change as your business activity changes.
Fixed Costs
Fixed costs generally stay similar even if you take on more or fewer jobs.
Examples include:
- rent
- insurance
- salaried administrative staff
- software subscriptions
- equipment leases
Variable Costs
A variable cost rises or falls depending on how much work you do or how much you sell.
Examples include:
- materials
- shipping
- sales commissions
- job-specific supplies
- certain hourly labor costs
Semi-Variable Costs
Semi-variable costs contain both a fixed component and a variable component.
A utility bill is a common example. You may pay a basic service charge each month, then pay more as usage increases.
Examples of Operating Costs in a Business
The types of operating costs your business has will depend heavily on your industry.
| Operating cost | Typical category | Example |
| Rent | Fixed | Office, workshop, or storefront |
| Materials | Variable | Lumber, paint, parts, or inventory |
| Insurance | Fixed | General liability or business insurance |
| Utilities | Semi-variable | Electricity, water, internet, or phone |
| Payroll | Fixed or variable | Salaries, hourly labor, or job labor |
| Software | Fixed | Accounting, invoicing, CRM, or scheduling tools |
| Vehicle costs | Fixed or variable | Insurance, fuel, repairs, or leases |
| Marketing | Fixed or variable | Advertising, website costs, or promotions |
| Sales commissions | Variable | Percentage of sales |
| Professional fees | Fixed or occasional | Accounting or legal services |
There is no single average operating cost for a small business. A restaurant, freelance designer, construction company, hotel, and manufacturer all have very different cost structures. It is usually more useful to compare your own costs over time and against relevant industry benchmarks.
Useful Ratios for Monitoring Operating Costs
These ratios help you understand how efficiently your business is turning revenue into profit. Instead of looking at expenses on their own, they show how costs compare with sales and how much money is left at different stages of the business.
| Ratio | Formula | What it tells you |
| Operating expense ratio | Operating Expenses ÷ Revenue × 100 | Shows how much of your revenue is being used to cover operating expenses |
| Gross profit margin | (Revenue − COGS) ÷ Revenue × 100 | Shows how much revenue remains after direct costs |
| Net profit margin | Net Profit ÷ Revenue × 100 | Shows how much profit remains after all expenses |
For example, if your operating expenses are $8,000 and revenue is $20,000, your operating expense ratio is 40%. Tracking these ratios over time can help you see whether costs are rising faster than revenue and whether your pricing is covering the cost of doing business.
You can also use InvoiceFly’s free profit margin calculator to see how changes in pricing and costs affect your margin.
Where Do Operating Costs Appear on Financial Statements?
Operating costs are mainly reflected on the income statement, which summarizes revenue, direct costs, expenses, and profit during a specific period.
COGS is generally deducted from revenue to calculate gross profit. Operating expenses are then deducted as part of determining operating income.
The balance sheet serves a different purpose. It shows what the business owns and owes at a particular point in time rather than summarizing operating expenses for a period.
Keeping accurate expense records is important for both financial management and taxes. The IRS explains that good records can help businesses monitor performance, prepare financial statements, identify income sources, track expenses, and prepare tax returns.
The SBA also recommends maintaining clear financial records and regularly reviewing your business finances so you can make better decisions about spending, cash flow, and growth.
Not every operating expense is automatically deductible. In general, the IRS requires deductible business expenses to be ordinary and necessary for your trade or business.
How to Reduce Business Operating Costs
Reducing operating costs does not mean cutting everything you can. The goal is to eliminate waste while protecting the parts of your business that generate revenue and keep customers happy.
Start with these areas:
- Audit recurring subscriptions. Cancel tools you no longer use and check whether several subscriptions perform the same job.
- Review supplier pricing. Compare vendors periodically and negotiate rates when your purchasing volume increases.
- Track labor carefully. Look for unnecessary overtime, downtime, or scheduling problems rather than simply cutting staff.
- Reduce material waste. Better estimating, inventory control, and job planning can reduce unnecessary purchases.
- Automate repetitive admin. Automation can reduce operating costs when it cuts duplicate data entry or repetitive manual work.
- Review insurance and service contracts. Compare rates before automatically renewing.
- Watch costs monthly. A small recurring increase is easier to address before it becomes a major annual expense.
- Protect revenue-generating spending. Cutting marketing, equipment maintenance, training, or customer service may save money temporarily but create larger problems later.
If operating costs suddenly climb, look at individual categories rather than making across-the-board cuts. A spike in materials, labor, fuel, or subscriptions can point you toward the real problem much faster.
Keep Operating Costs Under Control
Understanding operating costs gives you a clearer picture of what it really takes to keep your business running. By separating direct costs from operating expenses, tracking fixed and variable spending, and comparing expenses with revenue, you can make better decisions about pricing, budgeting, and where to cut back.
The goal is not simply to spend less. It is to make sure the money you spend supports a profitable business. For a deeper look at managing costs and margins together, see our guide to profitability and cost management and learn more about overhead costs.
Create and Send Invoices with Invoice Fly
Whether you’re billing clients weekly, monthly, or per project, Invoice Fly helps you create professional invoices, track payments, and stay organized from anywhere.
FAQs
Operating costs are the expenses a business pays to keep running and generate revenue. Depending on the definition being used, they may include both direct costs such as materials and labor and operating expenses such as rent, insurance, and software.
Common examples include materials, payroll, rent, insurance, utilities, software, marketing, vehicle expenses, equipment leases, and professional fees. The exact mix depends on the type of business.
A common formula is:
Operating Costs = Cost of Goods Sold + Operating Expenses
Add your direct production or service costs to your ongoing operating expenses for the same accounting period.
Operating costs generally exclude expenses that are not part of normal business operations, such as certain financing costs, income taxes, or unusual non-operating losses. The exact accounting treatment depends on the type of expense and financial reporting method.
It depends on the expense. A one-time purchase related to normal operations may still affect business expenses, but major equipment purchases and unusual costs may be treated differently for accounting and tax purposes. When the amount is significant, check the correct treatment with your accountant or tax professional.
