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July 25, 2025
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What Are Operating Costs? Everything You Should Know

Understand what operating costs are, how to calculate them, and strategies to manage them for better business profitability.

Operating costs may not be the most exciting part of running a business, but they have a direct impact on how much you actually take home. These are the day-to-day expenses that keep things moving, and if left unchecked, they can quietly drain your profits.

Effective cost management isn’t about cutting corners, it’s about making smart decisions. When you reduce unnecessary spending without sacrificing the quality of your product or service, you free up resources to invest in growth, marketing, and innovation.

Whether you're a freelancer, small business owner, or growing startup, learning how to identify and control your operating costs can make a major difference in your bottom line.

Key Takeaways:

What Are Operating Costs?

Operating costs are the everyday expenses required to keep a business running. From rent and salaries to raw materials and utility bills, these costs directly impact a company's profitability and long-term financial health.

In small business accounting, operating costs are a critical part of calculating cash flow and understanding where money is going. Knowing what falls under these costs and how to manage them helps business owners make informed decisions, reduce wasteful spending, and allocate resources more efficiently.

These costs typically fall into three main categories:

Category Description Examples
Fixed Costs Expenses that remain consistent regardless of business activity Rent, Employee Salaries
Variable Costs Expenses that change based on production or sales volume Raw Materials, Shipping, Utilities
Semi-Variable Costs Costs with both fixed and variable components Phone Bills, Equipment Maintenance

Recognizing these categories makes it easier to track expenses, plan budgets, and find areas for optimization, all of which are key to staying profitable and growing sustainably.

How to Calculate Operating Costs (With Formula)

Understanding how to calculate operating costs is essential for keeping your business financially healthy. Operating costs include all the business expenses required for daily operations, from producing goods or services to keeping the lights on.

To calculate your total operating costs, you’ll need to account for several key components:

  1. Cost of Goods Sold (COGS): These are the direct costs tied to producing your product or service, such as materials and labor.
  2. Salaries and Wages: Include all employee compensation, along with benefits and payroll taxes.
  3. Overhead Costs: These are indirect business expenses like rent, utility costs, insurance, and office supplies.
  4. Other Operational Expenses: Marketing, equipment maintenance, and software subscriptions all fall into this category.

Operating Costs Formula:

Total Operating Costs = COGS + Salaries + Overhead Costs + Other Operational Expenses

Example:
If your business has:

Then your total operating costs would be:
$100,000 + $200,000 + $50,000 + $20,000 = $370,000

Regularly calculating your operating costs not only keeps you in control of your finances, it also helps you track your profitability ratios and spot opportunities to reduce spending without cutting quality. The better you understand your operating costs, the easier it becomes to improve profit margins and support sustainable growth.

To make tracking these expenses easier and more efficient, many businesses turn to digital tools. For example, Tofu’s invoicing app streamlines how you send professional invoices and track payments, giving you clearer insights into your operating income and helping you manage cash flow more effectively.

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Types of Operating Costs

To manage your business efficiently, it’s important to understand the different types of operating costs. These are the everyday business costs that directly affect your bottom line, and they play a key role in bookkeeping, budgeting, and every stage of the accounting cycle.

Operating costs typically fall into three categories: fixed, variable, and semi-variable. Recognizing how each works is essential for effective cost accounting and long-term financial planning.

Fixed Costs

Fixed costs remain constant regardless of how much you produce or sell. They’re predictable and typically recur monthly, making them easier to track in your bookkeeping systems.

Examples: Rent, salaries for full-time staff, insurance premiums, and depreciation.

Variable Costs

Variable costs fluctuate based on your production or sales volume. These expenses rise when business activity increases and fall when it slows down.

Examples: Raw materials, direct labor, packaging, shipping, and sales commissions.

Semi-Variable Costs

Semi-variable (or mixed) costs contain both fixed and variable components. They stay stable up to a point, then change based on usage or volume. A common example is utility costs, which often include a flat base fee plus a usage-based charge.

Examples: Electricity, internet, and phone bills, equipment maintenance.

It's vital to understand the different types of operating costs for good cost management. By sorting your costs into fixed, variable, and semi-variable, you can analyze them better. This helps you make better business decisions and increase your profits.

Operating Costs vs Operating Expenses: What’s the Difference?

When managing your business finances, it’s important to distinguish between operating costs and operating expenses. While they’re often used interchangeably, they refer to different types of spending, and understanding the difference is essential for accurate reporting and smart financial decisions.

Operating costs are the direct, day-to-day expenses required to produce and deliver your product or service. These are closely tied to your core operations, things like raw materials, production labor, and equipment upkeep.

Operating expenses, by contrast, are the broader costs of running your business. They’re not directly tied to production, but they’re still necessary to keep your operations running smoothly. Think of rent, utility costs, marketing, and administrative salaries.

For example, if you run a bakery, the flour and wages for your kitchen staff count as operating costs. But your storefront rent and the bookkeeper’s salary? Those are operating expenses.

Here’s a side-by-side breakdown:

Category Operating Costs Operating Expenses
Nature Directly tied to producing goods or delivering services Support business operations, but not directly tied to production
Examples Raw materials, direct labor, and machine maintenance Rent, utilities, marketing, and administrative salaries

Understanding this distinction improves the accuracy of your financial reports, supports better cost accounting, and helps you track profitability more effectively. When you categorize spending correctly, you gain deeper insights into where your money is going — and where you can cut back or invest more strategically.

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Why Understanding Operating Costs Is Crucial for Profitability

Understanding and managing operating costs is key to boosting your business's profit. It helps you find ways to cut costs without lowering the quality of your offerings.

It's not just about saving money. It's about making smart choices that boost efficiency and competitiveness. Knowing your operating costs well lets you use resources better, invest in growth, and increase profits.

Let's look at a simple example. Imagine you run a manufacturing business. Your costs include raw materials, labor, and overhead. By studying these, you can cut waste, get better deals from suppliers, or improve your production.

Operating Cost Category Monthly Cost Potential Savings
Raw Materials $10,000 10%
Labor $8,000 5%
Overheads $2,000 15%

By managing these costs, you can save a lot. These savings can be used to grow your business and boost profits. This smart approach to cost management is essential for staying ahead in the market.

In summary, knowing your operating costs is crucial for any business wanting to increase its profit. It helps make smart choices, use resources wisely, and grow. By focusing on cost management, businesses can improve their bottom line and stay competitive.

How to Reduce Operating Costs Without Hurting Your Business

Reducing operating costs is one of the most effective ways to increase your operating income and maintain a good profit margin , but it has to be done strategically. Cutting the wrong expenses can hurt productivity or service quality, so the key is to identify savings opportunities that won’t compromise your business operations.

1. Review and Renegotiate Supplier Contracts

Take a close look at the costs associated with your vendors. Are you getting the best rates? Effective contract renegotiation can significantly enhance profitability. For instance, according to Red Bear Negotiation, a mere 1% reduction in procurement costs can lead to over a 4% increase in profits, especially considering that approximately 70% of a company's revenue is typically allocated to suppliers

2. Cut Energy and Utility Costs

Rising utility costs contribute to higher operating expenses. Implementing energy-efficient measures offers substantial savings. Businesses can reduce energy consumption by 31% without affecting output, translating to annual savings of $2 trillion globally.

3. Optimize Your Workspace

If you're paying for more space than you need, consider downsizing or renegotiating your lease. Many businesses save significantly by moving to more cost-effective locations or even going partially remote.

4. Regularly Audit Business Spending

Regular audits of business expenses can uncover significant savings opportunities. For example, companies that proactively manage procurement and renegotiate contracts before auto-renewals can reduce spending by 5–15%. Additionally, audit partners with extensive industry experience deliver higher-quality audits while also offering cost savings to clients in their initial engagements.

5. Invest in Employee Training

While it might seem counterintuitive, smart investments in training can boost productivity and efficiency, ultimately reducing the operating costs tied to errors, rework, or low output.

Final Thoughts: Managing Operating Costs for Long-Term Success

Managing your operating costs isn’t just about cutting expenses; it’s about understanding where your money goes, identifying what drives profitability, and making better financial decisions across your business.

From fixed and variable costs to day-to-day operational spending, staying on top of your numbers is critical. When you have a clear view of your ongoing costs, it becomes easier to maintain a good profit margin, optimize workflows, and improve your bottom line.

But here’s the truth: you can’t manage what you can’t track. One of the most overlooked areas where costs add up and efficiency is often lost is in how you handle invoicing and payment tracking.

That’s where Tofu comes in.

The Tofu Invoicing App helps small business owners cut down on time-consuming admin, reduce manual errors, and get paid faster, all while keeping your financial records clean and professional.

Here’s what Tofu helps you do:

If you're serious about reducing waste, improving cash flow, and growing profitably, the right tools make all the difference. Start using Tofu and turn financial clarity into business confidence.

FAQ

How are a business’s operating costs recorded?

Operating costs are recorded in your accounting system by tracking all day-to-day expenses related to the operation of a business, such as rent, salaries, and utilities.

How are operating costs calculated?

Operating costs are calculated by adding all expenses involved in running the business daily, including fixed costs, variable costs, and semi-variable costs.

What are examples of operating costs?

Examples of operating costs include rent, employee salaries, utility bills, raw materials, and equipment maintenance, essential expenses needed for the operation of a business.

What do variable costs include?

Variable costs include expenses that fluctuate with production or sales volume, such as raw materials, packaging, and commissions.

What do fixed costs include in a business?

Fixed costs include expenses that remain constant regardless of production levels, like rent, insurance, and employee salaries.

What is the difference between operating expenses and capital expenses?

Understanding operating expenses involves recognizing ongoing costs necessary for daily business operations, while capital expenses are one-time purchases for long-term assets like equipment or property.