Expense is an action. The action most people try to avoid. Is it true for you? May be yes. Millions of finance professionals across the world are trying to decrease the amount of expense in the income statement. But what if i tell you, increased expense may increase your income also. Let's not be judgmental too early. Many of us have a negative outlook towards the word, expense.
But the reality is, expenses also reflect your capabilities to make investments in your existing businesses or new startups. It would be sounding peculiar and may be a little bit new. Let's see an example to support my opinion. Mr. Hamilton has a fertiliser factory. Now he is looking forward to starting his new factory. What insights do this information have?
- Mr. Hamilton has the financial capabilities to spend on a new factory.
- He can start building a new factory that may cost him a potential amount of money.
- Mr. Hamilton has enough sources of money to spend or invest in new projects.
Is there anything negative in these three insights? No. Then why financial experts, CFO's of different financial or business organizations, try to decrease it? Actually they never try to decrease it. They always try to control it. This is how the basic concept of expense works.
The Concept of Expense
Expense is the cost of the production. With a more clearer outlook, expense is the amount of money any business spends to produce a product or develop a service. As we have discussed in the income section of this series blog posts, that business generates value with its product or services. In this process businesses spend money to develop a valuable product or service. This spendings are Expenses, any spending is a expense for a business if it meets up some certain criteria,
- The spendings should be directly involved to any of the sections of a business. Like production, marketing, transportation etc.
- The spendings should empower the organisation to create more products or services.
- Any spendings that is made to run the business.
For instance Mr. Hamilton, the CEO of Hamilton & Brothers, bought a new SUV financed by an auto financing company. The company Hamilton & Brother has financed the vehicle for its CEO Mr. Hamilton. Though he is the co-owner, president of the board of this organisation as he has not spent his personal money for this vehicle the business is the owner of this SUV and the cost of the vehicle will be recorded as an expense of this business. This expense would be considered as an expense for the following business. Now we dive deep to know about more types of expenses. Here is an important thing to consider, in this article we are talking about expenses. Not Expenditures. While expense is a term more related to finance, expenditure is an accounting term.
Types of Expenses
Effective financial management depends on accurate expense categorization. We primarily categorise expenses as operating or non-operating.
Operating Expenses
These are the essential costs directly tied to the core functions of running the business. They are further classified as variable (fluctuate with production volume) or fixed (remain constant regardless of activity). Common examples of variable operating expenses include cost of goods sold (COGS), selling, general & administrative expenses (SG&A), and depreciation.
Non-Operating Expenses
These expenses arise from activities outside the core business operations. While not directly essential for day-to-day functions, they can still impact the company's financial health. Interest expense, incurred on debt financing, is the most common example of a non-operating expense. Others may include gains or losses from non-core investments or foreign currency exchange fluctuations.
Distinguishing between the two categories is crucial for financial analysis. Operating expenses directly impact a company's profitability, while non-operating expenses provide insights into the overall financial health and risk management strategies.
Example of Operating & Non-Operating Expenses
Here's a breakdown of common expense types categorized by the business function they relate to,
Examples of Operating Expenses
Cost of Goods Sold (COGS): Direct costs associated with producing or purchasing the goods or services the business sells (e.g., raw materials, labor, direct overhead).
Selling, General & Administrative (SG&A): Indirect costs associated with running the business, not directly tied to production (e.g., marketing, advertising, rent, salaries for administrative staff).
Depreciation: Allocation of the cost of a long-term asset (property, equipment) over its useful life.
Variable Operating Expenses
Expenses that fluctuate based on the level of business activity (e.g., production volume, number of customers). Examples include COGS (more materials used with higher production), commissions paid to salespeople (based on sales volume).
Fixed Operating Expenses
Expenses that remain relatively constant regardless of business activity (e.g., rent, salaries for administrative staff, loan payments).
Non-Operating Expenses
Expenses that arise from activities outside the core business operations.
Interest Expense: Cost of borrowing money (e.g., interest on loans, bonds payable).
Other Examples: Gains or losses from non-core investments, foreign currency exchange fluctuations, one-time charges (e.g., restructuring costs, legal settlements).
Impacts of Expenses in Income Statement
Expenses are obvious for a business. Understanding the types of expenses helps finance professionals to control the expenses and ensure maximize outcome from a business. Expenses play a critical role in the Income Statement. Income Statement is a financial document summarizing a company's financial performance over a period. They act as a deduction from the revenue a company generates. Total revenue minus total expenses equals net income, also known as the company's profit or loss. By analyzing expenses, stakeholders like investors and creditors can gain valuable insights. High operating expenses can indicate inefficiencies or a competitive disadvantage, while non-operating expenses can reveal the impact of debt financing or other financial activities outside the core business. Ultimately, effective expense management is crucial for driving profitability and ensuring the long-term financial health of the company.
Proper control over expenses ensures the sustainability of a business. If the expense is more than COGS for a long period of time surely the business will be in loss. It is crucial to understand the timing also. In the initial stage of your business expenses may be higher than the cost of goods sold(COGS), not necessarily indicating that the business is not going in the right direction. Over the time as a business grows it would find the opportunities to control its expenses and maximize the profit.
10 FAQ's About Expenses
There are thousands of question about expenses people asking frequently depending the situations, intents and financial conditions. We have made an collection of the most frequently asked question about expenses from dependable sources like Investopedia, Forbes and Government organization.
What are the two main types of expenses?
Operating Expenses: These are the essential costs directly tied to running the business (COGS, SG&A, depreciation).
Non-Operating Expenses: These expenses arise from activities outside the core business (interest expense, gains/losses from investments).
How do expenses affect my business?
Expenses directly impact your profitability (net income) and overall financial health. Managing expenses effectively is crucial for business success.
What are some common ways to categorize expenses?
Expenses can be categorized by function (COGS, SG&A), variability (fixed or variable), or department (marketing, sales, production).
What is the cost of goods sold (COGS)?
COGS is the direct cost of producing the goods or services a business sells (raw materials, labor, direct overhead). It's subtracted from revenue to determine gross profit.
What are selling, general & administrative expenses (SG&A)?
SG&A includes indirect costs associated with running the business, not directly tied to production (marketing, advertising, rent, salaries for administrative staff).
What is depreciation expense?
Depreciation is the allocation of the cost of a long-term asset (property, equipment) over its useful life. It's a non-cash expense, meaning it doesn't involve an immediate cash outflow.
What is interest expense?
Interest expense is the cost of borrowing money (e.g., interest on loans, bonds payable). It's the most common type of non-operating expense.
What are some other examples of non-operating expenses?
Gains or losses from non-core investments
Foreign currency exchange fluctuations
One-time charges (restructuring costs, legal settlements)
What are some strategies for controlling operating expenses?
Negotiate better rates with suppliers
Improve efficiency in production
processes
Review and optimize staffing levels
Utilize technology
to automate tasks.
Why is budgeting important for expense management?
Are all business expenses tax-deductible?
The IRS allows deductions for ordinary and necessary expenses incurred in carrying on a trade or business. Not all expenses qualify, so consulting with a tax advisor is recommended.
What are some common business tax deductions?
Expenses for COGS, SG&A, depreciation, interest on business loans, and some employee benefits may be tax-deductible.
How can I categorize my personal expenses?
Common personal expense categories include housing, food, transportation, utilities, debt payments, entertainment, and savings.
What are some tips for creating a personal budget?
Track your income and expenses for a month to understand your spending habits. Set realistic spending goals and allocate funds for different.
