Ongoing costs of a business, also known as operating costs, refer to expenses required for the day-to-day administration and maintenance of a business entity.3 min read
1. Definition of Operating Cost
2. What Are the Components of Operating Cost?
3. Fixed Cost
4. Variable Cost
5. Semi-Variable Cost
6. Examples of Operating Costs
Operating cost can be defined as the cost of running the administrative and maintenance functions of a business on a daily basis. Operating cost is an element of a business' operating income as reflected in the financial statements of the organization. It can be expressed as the summation of operating expenses and cost of goods sold. A large part of a business's income goes into its operating costs.
What Are the Components of Operating Cost?
Operating costs can fall into three broad categories, including:
- Fixed cost
- Variable cost
- Semi-variable cost
Fixed Cost
A fixed cost is an operating cost which a company must pay and remains constant irrespective of a company's productivity or performance. An example of a fixed cost is the rent paid for the factory space used by a manufacturing company which must be paid, regardless of the company's productivity or profitability. While a company can find a cheaper factory space, it still has to pay for space to house its equipment and manufacturing processes. Therefore, the cost is fixed.
Examples of fixed costs include overhead costs, such as:
- Office or factory space
- Equipment
- Security
- Insurance
Fixed costs can boost a company's profitability as it increases scalability. If the majority of a company's expenses are fixed, its profit increases with the level of production.
A company whose fixed costs give it economies of scale can spread out the ongoing cost of doing business over the number of unit's produced, effectively reducing the average cost of producing each unit and achieving higher production efficiency.
Variable Cost
Variable costs are expenses that change with the productivity of a company. As the name implies, variable cost increases when production increases and reduce when a company's level of production dips. Variable costs include costs of sourcing for raw materials, electricity bills, water bills, and other utilities.
For example, a food delivery company that sees a surge in demand for its French fries meal requires buying more potatoes to cover the increased demand.
Typically, businesses whose variable costs are higher compared to their fixed costs tend to be more stable as their profitability depends more on sales.
Semi-Variable Cost
The operating costs of a business can also be semi-variable. Semi-variable costs can be considered as costs with elements of fixed and variable costs. While semi-variable costs fluctuate with production levels like variable costs, they are also like fixed costs as a company still needs to pay them when it's not producing.
A common example of semi-variable costs is overtime wages. While the wages a company pays its regular staff is considered fixed cost, any payment for overtime work is considered to be variable cost as it increases and decreases with the company's level of production.
Examples of Operating Costs
The following are examples of the operating expenses of a business:
- Rents and Facilities: Purchasing, leasing, or renting an office or factory space is an ongoing cost of running a business. Companies that conduct their business from office buildings, strip malls, and local shops have to pay for these expenses.
- Utilities: Electricity, water, and heat are also operating costs of a business as you pay for these utilities regardless of your company's productivity or profits.
- Salaries: Your business requires regular and sometimes part-time workers who receive a salary or wage for their contribution to the growth of your company. Salaries are also an ongoing cost of running your business.
- Equipment Maintenance: With time, the equipment you use to produce your goods and deliver services to customers may develop faults. Expenses for periodic equipment maintenance, warranty coverage, or insurance are also operating costs of your business.
- Supplies and Equipment: All businesses, regardless of size, require equipment and supplies to carry out product creation and service delivery.
- Fixtures: These include things such as partitions, signage, paneling, table stands, shelves, lighting, storage cabinets, showcases, and other materials for product display.
- Leasehold Improvements: Companies also require nonremovable installations, such as electrical wiring and plumbing, carpeting, lighting, security systems, HVAC systems, and others.
- Legal Compliance: One of the costs of starting a business is registration of the business as a legal entity with the relevant tax and business regulatory agencies of the local council, state, or country where you intend to operate.
- Marketing and Promotion: Businesses also spend money on marketing and promoting their goods and services on an ongoing basis.
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Legacy costs are company costs associated with health care fees and other benefits for its current employees and retired pensioners. These costs are typically ongoing and will increase the company's spending, while not adding to revenue. Pension plans are a prime example of a legacy cost.
- Legacy costs are corporate expenses for pensions or health care programs.
- Corporations become less competitive as legacy costs increase because these expenses do not contribute anything to revenues, growth, or profits.
- Larger and older corporations typically have the biggest burdens when it comes to legacy costs.
- Many companies are taking steps to reduce legacy costs, such as changing their employee retirement plans from defined-benefit to defined-contribution.
Escalating legacy costs can be a large contributing factor towards limiting a company's competitiveness because such items do not contribute to revenue, growth, or profits. However, while these costs can have a negative impact on a company's bottom line, workers’ rights advocates argue that employers have an ethical obligation to support their employees with these types of funding activities.
Larger, older, and more established companies can sometimes have problems with spiraling legacy costs. That's because they have the most pension and health care liabilities. In the face of these costs, many companies are taking measures to lower legacy costs as much as possible. One example of this can be seen by the trend of companies changing their employee retirement plans from defined-benefit plans to defined-contribution plans.
In 2016, the Citizen’s Budget Commission [CBC], “a nonpartisan, nonprofit organization pursuing constructive change in the finances and services of New York City and State,” published a report titled "The '20-20-20-20' Dilemma: Legacy Costs in the New York City Budget." In the report, the CBC shows that a “giant slice” of the NYC budget is dedicated to legacy costs, which then claimed more than 20% of the annual budget and was projected to grow by 20% to more than $20 billion by 2020.
In this case, legacy costs include pension contributions and retiree health benefits but are also “debt service payments repay[ing] bonds issued for past capital projects.” In CBC’s analysis, the challenges of lowering legacy costs include possible credit downgrades if debt service payments aren’t made. The CBC, of course, supports paying out pensions and points out they are protected by the state constitution, but the commission suggests it's possible for “some infrastructure improvements” to be “funded through current year resources” and that “annual proposals to enhance benefits can be rejected.”
Furthermore, the CBC suggests “bringing retiree health costs in line with those of other state and local governments” by asking retirees to share the cost of health premiums; “reform of union welfare funds” by “consolidating supplementary health care benefits under the city’s health plan”; and eliminating Medicare Part B premium reimbursements, a benefit they claim is “unheard of in the private sector and uncommon even among public employers.” CBC estimates that these budget shifts would save the city up to $1.6 billion by 2020.