Everything You Need to Know About Operating Cost Formula

Excellent Plastics (not the real name) is a manufacturer of automobile components in Mumbai. Over ten years since its establishment, EP has grown its turnover by 2000%. But their CEO was puzzled as to why they were constantly facing a cash crunch and margins were meager. An expert was called to study the company and suggest remedial steps. The expert returned with his analysis – it was a case of unmonitored operating expenses. 

It was an eye-opener for the CEO and his team. In the euphoria of hyperbolic growth, they had ignored one vital pillar of financial stability – Operating Costs. What is Operating Cost, and how do we use this data to manage our profits better? We shall understand the concept and answer these questions in the following excerpt.

Did you know? The biggest threat to any business is NOT its competitors but complacency.

What Are Costs?

Every business has the following basic financial parameters:

Revenue, which is income generated through sales plus any additional unrelated inflows. 

A cost is the worth of money that has been expended to produce something or provide a service and is therefore no longer available for use in production, research, retail, and accounting. In the case of an acquisition cost, the money spent on the acquisition is considered the cost.

Costs include a wide range and categories, including raw materials, packaging materials, manufacturing costs, marketing costs, overheads, etc. The types of costs are as follows:

• Fixed Costs, 
• Variable Costs, and 
• Semi-Variable Costs. 

Fixed Costs 

Fixed Costs are those which have to be spent on a regular frequency irrespective of production or sales. Factory rent, Salaries, Lease rentals on assets, Insurance, Security, and so on. 

Variable Costs

Variable Costs are those which move up or down in relation to the manufacturing volumes. Raw materials, Packing materials, Transportation costs, some part of Electricity costs, Overtime payments to labour, and so on. 

Semi-Variable Costs

Semi Variable Costs have two components, a fixed component and a variable component. Part of the expenses does not vary with production volumes, whereas some parts move higher or lower in relation to production volumes. The total factory Electricity Bill is an example. Certain minimum lighting and electric consumption will be incurred even if there is no production. 

Similarly, if a certain Dye needs to be changed after manufacturing 1000 components, it acts as a Fixed cost for that batch. But when the batch volume changes, it begins varying. Repairs and Maintenance is also an example of Semi-Variable Costs. 

Also Read: What is Accounting Cycle: Definition and Steps in the Accounting Cycle Process.

What are the Costs of Goods Sold (COGS)?

This is an important concept to be understood. COGS is important information in any financial statement. It is the total of all material costs that are incurred to make the product ready for sale. It is structured as: 

COGS = Opening inventory + Purchases plus Freight In - Closing inventory - Purchase Discounts - Purchase

What is Selling and General Administrative Expenses?

From the time the product is ready until it is sold and payment is collected, the company incurs several expenses. These are Selling and General Administrative Expenses and are often a large part of the total expenses. 

Some examples of SGA are: 

Rent paid, Electricity, Water, Steam and other Utilities, Office stationery, consumables and other supplies, Statutory expenses, Sales and Marketing, including Advertising and Promotion, Salaries and Wages, Insurance premiums, Outsourced Services like Security, Canteen, Housekeeping etc.

What is Gross Profit?

This is the surplus calculated as: 

Gross Profit = Gross Sales Revenue - Cost of Goods Sold

What is Operating Profit?

Operating Profit is the surplus calculated as

Operating Profit = Gross Profit - Operating Expenses. Income Statement

Also Read: What is Double Entry System of Accounting ? Understanding Double Entry System

Operating Cost: The Most Crucial Element

Operating Cost can be defined as the sum of all costs incurred daily to get the resultant saleable output. These are more or less constant in the type of expense incurred, even though the amounts could keep varying.

Operating Cost, as we can see, is very crucial information for management decision-making. By deeply analysing various costs, the Management can draw clear inferences on where cost reductions are possible. By establishing a good costing system, we can even do a product-wise or process-wise analysis of costs. Clear, actionable steps can be taken based on this, and significant savings can be achieved. The Operating Cost Formula, thus, lends itself to dissection and measurement. And only what is measurable can be improved.

The Operating Cost Formula can be written in a simple form as follows: 

Operating Cost = Cost of Goods Sold + Manufacturing Expenses + Marketing and Advertising Expenses + Sales and General Administration Expenses 

Why Is Operating Cost Data Important?

In today's business environment, market forces play a very significant role. Gone are the days when a manufacturer could dictate prices and terms, and buyers had no option but to heed them. Today, competition is present in every industry and service. Competition in the market sets prices, and the seller who does not adapt to the market will soon be extinct. Businesses can make a profit only if they can operate at a cost lower than their revenue. Thus, costs play a predominant role in the viability and growth of any business. 

The world has also grown above subjective judgments and decisions based on gut feeling. Today, with computers capable of handling unimaginable volumes of information at great speeds, authentic data is readily available for decision-making. It is up to business owners and top management to make use of such data and take prudent business decisions. The importance of the Operating Cost Formula thus cannot be underemphasised. 

Using Operating Cost Formula Data

There are several ways this data can be used to derive benefits of cost reduction, improvement in profits, increase in productivity, and the resulting improvement in the work environment. 

A study of the data can reveal in which products we are incurring higher costs (and lower margins). This will enable us to revise our marketing and product mix strategies to get the best out of our investments. 

Comparative processing costs will throw up information on those processes, which eats away at profits. By using scientific process improvement methods like Lean and Six Sigma, we can control wasteful costs, improve efficiencies and change the scenario to a great extent. 

If the analysis shows large chunks of money flowing out in advertising and promotional expenses, we can critically study the same and measure the sensitivity of each channel, media, or strategy. Working on a revised plan can enhance revenue and possibly also help reduce costs in areas that are not producing desired results. 

Cost data on the workforce can show us areas where productivity is low and needs improvement. 

One important factor is collecting data multiple times and at different periods. We should not work on just one set of data but on trends observed in a large data set. This will even out variations in results at different times under different conditions. The data being analysed thus becomes more reliable for taking crucial decisions. 

Let us take an example of what a statement of Operating Cost looks like. 

Computation of Operating Cost: An Example

Let us take a look at the financial statement of Excellent Industries.

All figures in ₹ crores

The Company felt that they were draining too much cash and needed to take quick, effective corrective steps.

They formed a Task Force consisting of members from Accounts, Administration, Purchase, Stores and Sales. This Task Force was entrusted with the challenge of bringing down costs by at least 10%. The Finance Department gave the breakup of the Operating Cost as follows:

All figures in ₹ crores

It highlighted where most of the money was going. A deeper study helped in identifying where savings on costs was under the company's control. This analysis thus throws open a large set of options on which action could be taken to achieve an increase in profits. The Task Force was successful in achieving a saving of 12% of the Operating Cost – A very worthwhile accomplishment by understanding this concept.

Also Read: What are Accounting Principles and Accounting Concepts - Here's a Detailed Overview

Conclusion

Businesses must constantly feel the pulse of their operations. They should be highly sensitive to profitability, expenses, productivity, and employee morale. All of it should be tuned into the market environment. While external conditions can rarely be controlled, internal operations and costs can certainly be monitored. 

Through constant watch, smart businesses will make it a standard practice to innovate methods to reduce costs without compromising on output or quality. Those are the ones who will prosper on a long-term basis and outshine competitors. Constant analysis of Operating costs is thus a very vital tool for any company.

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