written by | October 28, 2022

Everything You Need to Know About Operating Cost Formula

×

Table of Content


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 

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

Total Revenue

₹50,0000

COGS

₹30,0000

Gross Profit

₹20,0000

   

Operating Expenses

 

SG&A

₹30,000

R&D

₹20,000

Total operating expense

 
   

Net Profit

₹15,0000

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

Gross Revenue

 

 

2,000

Operating Expenses

 

 

 

 

Cost of Goods Sold

800

 

 

Marketing & Advertising

400

 

 

General & Administration

200

 

 

Other Operating Expenses

100

 

Total Operating Expenses

 

 

1,500

Operating Income

 

 

500

Other non-operating expenses

 

 

150

Net Profit before tax

 

 

350

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

Cost of Goods Sold

800

Manufacturing Expenses

400

Marketing & Advertising Expenses

200

Sales & General Administration Expenses

100

Total Operating Cost

1,500

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.

Follow Khatabook for the latest updates, news blogs, and articles related to micro, small and medium businesses (MSMEs), business tips, income tax, GST, salary, and accounting.

FAQs

Q: Is Operating Cost analysis part of the statutory audit?

Ans:

No. This is not part of the statutory audit. But many professional organisations include it as part of Internal Management Audit to review the performance on action points of the Operating Cost analysis.

Q: How frequently should Operating Cost analysis be done?

Ans:

Some companies do this on an annual basis. The more frequent the analysis, the better. At the same time, time needs to be given for reviewing the results of the action taken in the previous analysis. Even a quarterly review should be possible if data management and documentation systems are excellent.

Q: At what level in the organisation should Operating Cost analysis be done?

Ans:

Operating Cost analysis will be effective if it is done as a team. The top Management will initiate this, and the Finance Department will provide the data. Analysis should be done by a multidisciplinary team drawn from different functions, including the Production and Commercial Departments, in a participatory manner to arrive at realistic and practical solutions.

Q: Is deep knowledge of Finance required for analysing Operating Costs?

Ans:

Good knowledge of Finance is a great advantage. But not being a Finance professional need not be a handicap. More than Finance, familiarity with various segments of activities that contribute to costs is very valuable. This process involves more management thinking than plain accounting.

Q: How much data is required for a study of Operating Costs?

Ans:

The more data, the better. More than the mere volume of data, the focus should be on collecting data during different periods and situations. A wide variety ensures that the summary of data gathered represents real-life situations.

Q: What are the critical factors in analysing Operating Costs?

Ans:

Listing all expenses in each category is most critical in analysing Operating Costs. A close observation of which costs are making a bigger impact is necessary. This will give us the direction in which cost-reduction efforts should be made.

Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.
×

Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.