What is an Expense?

An expense is defined in the following ways:

 An expense in office supplies uses up the cash (asset)

 A purchase in capital equipment (e.g., a machine or a building)
decreases the book value of the asset over the years through
depreciation expense
 A prepaid expense, such as prepaid rent, is an asset that turns into a
cash expense as the rent is used up each month

A summary of all expenses is included in the income statement as

deductions from the total revenue. Revenue minus expenses equals the
total net profit of a company for a given period.

In the double-entry bookkeeping system, expenses are one of the five main
groups where financial transactions are categorized. Other categories
include the owner’s equity, assets, liabilities, and revenue. Expenses in
double-entry bookkeeping are recorded as a debit to a specific expense
account. A corresponding credit entry is made that will reduce an asset or
increase a liability.

The purchase of an asset such as land or equipment is not considered a

simple expense but rather a capital expenditure. Assets are expensed
throughout their useful life through depreciation and amortization.

Expenses in Cash Accounting and Accrual Accounting

Expenses are recorded in the books on the basis of the accounting system
chosen by the business, either through an accrual basis or a cash basis.
Under the accrual method, the expense for the good or service is recorded
when the legal obligation is complete; that is when the goods have been
received or the service has been performed.

Under cash accounting, the expense is only recorded when the actual cash
has been paid. For example, a utility expense incurred in April but paid in
May will be recorded as an expense in April under the accrual method but
recorded as an expense in May under the cash method – as this is when the
cash is actually paid.

Accrual accounting is based on the matching principle that ensures that

accurate profits are reflected for every accounting period. The revenue for
each period is matched to the expenses incurred in earning that revenue
during the same accounting period. For example, sale commission expenses
will be recorded in the period that the related sales are reported, regardless
of when the commission was actually paid.

Types of Expenses
Expenses affect all financial accounting statements but exert the most
impact on the income statement. They appear on the income statement
under five major headings, as listed below:

1. Cost of Goods Sold (COGS)

Cost of Goods Sold (COGS) is the cost of acquiring raw materials and
turning them into finished products. It does not include selling and
administrative costs incurred by the whole company, nor interest expense
or losses on extraordinary items.

 For manufacturing firms, COGS includes direct labor, direct materials,

and manufacturing overhead.
 For a service company, it is called a cost of services rather than COGS.
 For a company that sells both goods and services, it is called cost of
sales.

Examples of COGS include direct material, direct costs, depreciation

expense, and production overhead.
2. Operating Expenses – Selling/General and Admin
Operating expenses are related to selling goods and services and include
sales salaries, advertising, and shop rent.

General expenses include expenses incurred while running the core line of
the business and include executive salaries, R&D, travel and training, and IT
expenses.

3. Financial Expenses
These are costs incurred from borrowing or earning income from financial
investments. They are expenses outside the company’s core business.
Examples include loan origination fees and interest on money borrowed.

4. Extraordinary Expenses
Extraordinary expenses are costs incurred for large one-time events or
transactions outside the firm’s regular business activity. They include laying
off employees, selling land, or disposal of a significant asset.

5. Non-Operating Expenses
These are costs that cannot be linked back to operating revenues. Interest
expense is the most common non-operating expense. Interest is the cost of
borrowing money. Loans from banks usually require interest payments, but
such payments don’t generate any operating income. Hence, they are
classified as non-operating expenses.

Non-Cash Expenses
The sole purpose of a non-cash expense is to reduce net profit and
eventually, taxes. It is not an income statement category. Depreciation is
the most common type of non-cash expense because it conforms to the
definition that an expense decreases owner’s equity by using up the asset.
Depreciation also results in other non-cash effects such as:

 A debit to a depreciation account increases the account balance

 A credit to a contra asset account like accumulated
depreciation increases the balance of the depreciation account
 On the income statement, the book value of the asset decreases by
the same amount as the accumulated depreciation.

Expenses are income statement accounts that increase the debit side of a
contra account. When the expense is recorded, a corresponding credit is
recorded to an asset or liability.

What is Expenditure?

 Expenditure, on the other hand, can be defined as the amount spent for
a long-term on an asset which gives a long-term benefit like building
expenditure, furniture expenditure, plant expenditure etc.
 In the case of expenditure, the benefits are achieved over the long-term
period which is usually more than one year. The term expenditure is
used related to purchase of fixed assets.
 In accounting books, there are two types of expenditure- Capital
expenditure and Revenue expenditure. Capital expenditure is the one
which is done to purchase or increase the value of fixed assets.
 For example purchase of building, land, plant is termed as capital
expenditure. Revenue expenditure is the expenditure whose benefit will
be received after the complete accounting year. Examples of revenue
 expenditures are cost of goods sold or repairs and maintenance
expenses.

Expense vs Expenditure Infographics

Here are the top 7 differences between Expense vs Expenditure

Expense vs Expenditure Key Differences

The key differences between Expense vs Expenditure are as follows –
 While both the terms – Expense vs expenditure are used in accounting
to refer to the costs done by the organization but both are different.
Expenses are those costs which are incurred to earn revenues whereas
expenditures are those costs which are incurred to purchase or increase
the value of the fixed assets of the organization.
 Expenses are those which are incurred for a short-term basis and
expenditures are incurred for a long-term period.
 Expenses have an effect on the financial statements of the company as
they are recorded as the costs incurred to earn revenues. Expenditures
are not recorded in the financial statements and generally, they don’t
have any effect on the financial statements of the company.
 Expenses are done by a company so that it can function properly on a
daily basis whereas expenditure is done by a company to establish itself
so that can start proper operations.
  Expenses are generally anticipated by the company and take place
multiple times whereas expenditures are not so much anticipated costs
and generally occurs once in the time period.
 Examples of expense are salary paid, rent etc. Examples of expenditure
are payments made to purchase new land or building for business,
equipment etc.

Expense vs Expenditure Head to Head Differences

Now, let’s have a look at the head to head differences between Expense vs
Expenditure

Basis Expense Expenditure

Expenditure is the cost

Expenses are those costs
Meaning of the which is spent on
which are incurred to earn
terms purchase or growth of
revenues.
fixed assets.

Expense affects the Profit Expenditure does not

Effect on and Loss statement of a have any implication on
Financial company as they appear the financial statements
Statement as costs incurred to earn and is not usually
revenue. recorded.
 An expense is generally for Expenditure is usually
Term short-term costs of the long-term costs of the
organization. organization.

Number of times An expense is incurred Expenditure is incurred

suffered multiple times. once in a time period.

Expenditure is done for

An expense is done for
Capital and Revenue
general expenses.
Purpose of expenditure. Expenditures
Expenses are done by an
spending are done by an
organization so that it can
organization to establish
run on a day to day basis.
it so that it can operate.

Purchase of new land,

Salary paid, rent paid,
Examples purchase of new plant for
wages etc are expenses.
business etc are examples.

Expenditures are not

Expenses are high and
Expectation expected in that frequent
very frequently expected.
manner.
 Conclusion

Both the terms expense vs expenditure though used widely in the accounting concepts
differ from each other. While expense refers to short-term costs incurred by the

company expenditures refer to the long-term costs incurred by the company for its
establishment and operations. Both the terms are valuable in the accounting equation

since both have specific contributions and meanings. While expense has a direct effect
on the profit and loss statement of a company and is recorded as the costs incurred to

generate revenues expenditure does not directly affect the financial statements of the
company and are not recorded.

Revenue vs. Expenses

Revenue is money your company earns from conducting business. If you owned an ice-
cream stand, for instance, revenue is what you get from customers who buy ice cream.
Expenses are the costs you incur to generate that revenue. The ingredients you buy to
make the ice cream, the wages you pay your employees, the rent and utilities you pay
for your stand – these are all expenses.

To remain viable, a company's revenue must exceed its expenses.

Income Statement and Operating Profit

Revenue and expenses appear on your company's income statement. Revenue minus
expenses equals your operating profit – the profit your company made in its business.
Revenue and expenses are distinct from "gains" and "losses," which represent money
made or lost on the sale of company assets or other activities outside the day-to-day
operations of the company. When an ice-cream shop sells an ice-cream cone, for
example, the money it gets is revenue.

But when that shop sells, say, a piece of equipment it no longer needs, any profit it
makes from the sale is a gain. That's because the company is in business to sell ice
cream, not equipment. Gains and losses appear on the income statement separate from
revenue and expenses.

Revenue Expenditure:

Definition and Explanation:

All the expenditures which are incurred in the day to day conduct and administration of
a business and the effect-of which is completely exhausted within the current
accounting year are known as "revenue expenditures". These expenditures are
recurring by nature i.e. which are incurred for meeting day today requirements of a
business and the effect of these expenditures is always short-lived i.e. the benefit
thereof is enjoyed by the business within the current accounting year. These
expenditures are also known as "expenses or expired costs." e.g. Purchase of goods,
salaries paid, postages, rent, traveling expenses, stationery purchased, wages paid on
goods purchased etc.

This expenditure is incurred on items or services which are useful to the business but are
used up in less than one year and, therefore, only temporarily increase the profit-making
capacity of the business.

Revenue expenditure also includes the expenditure incurred for the purchase of raw
material and stores required for manufacturing saleable goods and the expenditure
incurred to maintain the- fixed assets in proper working conditions i.e. repair of
machinery, building, furniture etc.

Examples:

Following are the examples of revenue expenditure.

1. Wages paid to factory workers.

2. Oil to lubricate machines.
3. Power required to run machine or motor.
4. Expenditure incurred in the ordinary conduct and administration of business, i.e.
rent, , carriage on saleable goods, salaries, wages manufacturing expenses,
commission, legal expenses, insurance, advertisement, free samples, postage,
printing charges etc.
5. Repair and maintenance expenses incurred on fixed assets.
6. Cost of saleable goods.
7. Depreciation of fixed assets used in the business.
 8. Interest on borrowed money.
9. Freight, cartage, octroi duty, transportation, insurance paid on saleable goods.
10. Petrol consumed in motor vehicles.
11. Service charges to motor vehicles.
12. Bad debts.

Difference Between Expense vs Expenditure

Expense vs Expenditure – In simple words, expenses are those costs which

are incurred to earn revenues whereas, expenditure is the cost which is spent
on purchase or growth of fixed assets.
In this article, we look at Expense vs Expenditure in detail.

What is the Expense?

 An expense can be defined as that cost which is paid or given in

exchange for something of value. That something can be produced or
services. When this product or service costs a great deal it is expensive
and when something does not cost a great deal it becomes inexpensive.
In the world of accounting, the word expense has a particular meaning.
 We can define expense a remittance of cash from an individual or an
organization to another individual or organization. In other words, an
expense is a situation in which an existing asset is utilized for payment
or a liability happens. If we see this from the point of view of accounting
equation expenses decrease the owner’s assets.
 International Accounting Standards Board defines expenses as the
gradual reduction in economic benefits during the accounting time
 period in the form of remittances or outward cash flows or exhaustion in
the number of assets or sustains liabilities that end up in reducing the
owner’s equity. So we can sum up expenses as outflows or using up of
assets as part of operations of a business to generate sales/revenue.

Expense definition
An expense is the reduction in value of an asset as it is used to generate revenue. If
the underlying asset is to be used over a long period of time, the expense takes the
form of depreciation, and is charged ratably over the useful life of the asset. If the
expense is for an immediately consumed item, such as a salary, then it is usually
charged to expense as incurred. Common expenses are:

 Cost of goods sold - (COGS) (cost to make the product or goods or give service)
 Rent expense
 Wages expense
 Utilities expense

If an expenditure is for a minor amount that may not be consumed for a long period
of time, it is usually charged to expense at once, to eliminate the accounting staff
time that would otherwise be required to track it as an asset.

Under cash basis accounting, an expense is usually recorded only when a cash
payment has been made to a supplier or an employee. Under the accrual basis of
accounting, an expense is recorded as noted above, when there is a reduction in the
value of an asset, irrespective of any related cash outflow.

The purchase of an asset may be recorded as an expense if the amount paid is less
than the capitalization limit used by a company. If the amount paid had been higher
than the capitalization limit, then it instead would have been recorded as an asset
and charged to expense at a later date, when the asset was consumed.

The accounting for an expense usually involves one of the following transactions:
 Debit to expense, credit to cash. Reflects a cash payment.

 Debit to expense, credit to accounts payable. Reflects a purchase made on credit.

 Debit to expense, credit to asset account. Reflects the charging to expense of an

asset, such as depreciation expense on a fixed asset.

 Debit to expense, credit to other liabilities account. Reflects a payment not involving
trade payables, such as the interest payment on a loan, or an accrued expense.

Under the matching principle, expenses are typically recognized in the same period
in which related revenues are recognized. For example, if goods are sold in January,
then both the revenues and cost of goods sold related to the sale transaction
should be recorded in January.

An expense is not the same as an expenditure. An expenditure is a payment or the

incurrence of a liability, whereas an expense represents the consumption of an asset.
Thus, a company could make a $10,000 expenditure of cash for a fixed asset, but the
$10,000 asset would only be charged to expense over the term of its useful life.
Thus, an expenditure generally occurs up front, while the recognition of an expense
might be spread over an extended period of time.

Expense management is the concept of reviewing expenses to determine which ones

can be safely reduced or eliminated without having an offsetting negative impact on
revenues or on the development of future products or services. Budgets and
historical trend analysis are expense management tools.

Revenue Expenditure

During the normal course of business, any expenditure incurred of which benefit is
received during the same accounting period is called revenue expenditure. These
expenses help a business sustain its operations and may not result in an increase in
revenue.

Examples of such expenses are wages, rent, power, bad debts, depreciation, telephone,
printing, cost of goods (to be sold), freight, maintenance of fixed assets, etc.
Unlike capital expenditure, these expenses are relatively small & recurring in nature.
Sometimes referred as revex these are used for meeting daily requirements of a
business, therefore, they are short-term i.e. the benefit received is consumed by the
business within the same accounting year.

Revenue Expenditure in Financial Statements

It is shown on the debit side of trading account & Income statement, the accounting
treatment for both revex and capex is done differently.

All expenses shown on debit side of the below Trading and Profit & Loss account are
revenue in nature.
The amount transferred to trading and P&L account should only be to an extent to
which goods or services have been consumed. For example, cost of goods (to be sold) is
a revenue expenditure, however, only the cost of goods actually sold in current
accounting period should be transferred to the trading account.

When Revenue Expenditures are not regarded as

Revenue Expenditures?
There are some items of expenditure which are revenue by nature, yet they are not
regarded as revenue expenditure. Such expenditures may be divided into two groups:

1. Deferred revenue expenditure

2. Capitalized revenue expenditure

1. Deferred Revenue Expenditure:

This is a revenue expenditure, the benefit of which is not confined to one accounting
year - it extends to future accounting year or years also. However, this expenditure does
not result in the acquisition of any fixed asset. For example, heavy advertisement
expenditure is incurred on introduction of a new product in the market. This is a revenue
expenditure in nature and the benefit is enjoyed by the business over a number of years,
but no asset of permanent nature is acquired. A portion of this expenditure is treated as
revenue expenditure chargeable in the current accounting year and the remaining
portion is temporarily treated as capital expenditure and shown on the Asset side of the
Balance Sheet. Below are a few examples of such expenditure:

(a) Expenditure incurred to the formation of a joint stock company i.e. Preliminary
Expenses.

(b) Expenditure on research and experiment connected with the introduction of a new
product.

(c) Heavy expenditure on advertisement for marketing a new product.

(d) Heavy expenditure on repairs to property.

(e) Expenditure on removal of business from one place to another place.

2. Capitalized Expenditure:

Some expenditures although of revenue nature basically, are directly connected with
fixed assets and spent directly on the acquisition of fixed assets. Such expenditures are
added to the cost of assets and are called "Capitalized Expenditures". For example, we
buy a second-hand plant for $50,000. This is undoubtedly a capital expenditure. A
further sum of $5,000 is spent on its repair and overhauling in order to bring the plant
into proper working order. Expenditure on account of repair and overhauling, although
revenue by nature, will be treated as Capital Expenditure in this case and will be debited
to plant account not to Repairs A/c. Thus, a revenue expenditure which increases the
utility or productive capacity of an asset, is treated as capitalized expenditure. Below are
a few examples of such expenditure:

(a) Expenditure on installing an asset. i.e. installation charges.

(b) Expenditure on repair to property, if the production capacity or utility of the property
is increased. It may, however, be noted that sometimes a new asset may require some
repair after its purchase but before it is installed and put into operation. Cost of such
repair, although it may not increase the production capacity of the asset, will be treated
as a capitalized expenditure.

(c) Expenditure incidental to purchase of fixed assets, e.g. freight, clearing charges,
customs duty, carriage, octroi duty, import duty on assets purchased.

(d) Expenditure on removal of old property.

(e) Cost of repair to second-hand assets: Repair is a revenue expenditure. But the cost of
repair after buying a second-hand asset to bring them into proper working condition is
treated as Capitalized Expenditure.

(f) Wages: It is a revenue expenditure but if paid for installation of a machine or plant,
then it is treated as a capitalized expenditure.

(g) Legal Charges: Legal charges i.e. lawyer's fee, court fee in connection with the
purchase of asset of permanent nature are regarded as capital expenditure.

(h) Interest: Interest paid is generally a revenue expenditure. But in some industries like
iron & steel, cement industry etc., a concern has to wait for a long period before it starts
operation. Interest for such period on capital and loan is treated as capital expenditure.

Note:
From the above discussion, the distinction between 'deferred revenue expenditure' and
'capitalized expenditure' may be noted. The amount of deferred revenue expenditure is
generally heavy and it is spread over a number of years. But capitalized expenditure is
added in full to the cost of concerned asset, whatever may be the amount of
expenditure. Hence there is no question of apportioning the expenditure over a number
of years.
Example:

State with reasons whether the following should be considered as deferred revenue
expenditure or capitalized expenditure.

1. Preliminary expenses paid in the formation of a company.

2. Heavy advertisement expenses paid to introduce a new product in the market.

3. Wages paid for the installation of a machinery.

4. Carriage paid on the purchase of a machinery.

5. Cost of overhauling and painting a second-hand truck newly-purchased.

6. Research and experimental expenses to introduce a new product.

Solution:

No. Nature of Expenditure Reason

1. Deferred revenue expenditure. At the time of formation of a company certain

expenses are incurred which are revenue by
nature e.g. cost of preparing documents,
registration fee, cost of stamp etc. Such
expenditures are large in amount and it will be
logical to spread such expenditures over a
number of years.

2. Deferred revenue expenditure. It is ordinarily a revenue expenditure. But if heavy

advertisement expenses are paid to introduce a
new product, then, the benefit will be received
for a number of years, so it is treated as deferred
revenue expenditure.

3. Capitalized expenditure or This expenditure is regarded as a part of the cost

capital expenditure. of machinery, so it is regarded as a capitalized
expenditure.
 4. Capitalized expenditure. Carriage paid on machinery is also regarded as
an additional cost of the machinery, therefore,
treated as a expenditure.

5. Capitalized expenditure. Cost of overhauling and painting is incurred to

bring the second-band truck into proper working
order, so it is regarded as capitalized
expenditure.

6. Deferred revenue expenditure. The benefit of this expenditure will be enjoyed

for many years, so it is regarded as a deferred
revenue expenditure.

Note: Both deferred revenue expenditure and capitalized expenditure are shown on the
asset side of the Balance Sheet.

Capital Expenditures:

Definition and Explanation:

An expenditure which results in the acquisition of permanent asset which is intended lo

be permanently used in the business for the purpose of earning revenue, is known as
capital expenditure. These expenditures are 'non-recurring' by nature. Assets acquired
by incurring these expenditures are utilized by the business for a long time and thereby
they earn revenue. For example, money spent on the purchase of building, machinery,
furniture etc. Take the case of machinery-machinery is permanently used for, producing
goods and profit is earned by selling those goods. This is not an expenditure for one
accounting period, machinery has long life and its benefit will be enjoyed over a long
period of time. By long period of time we mean a period exceeding one accounting
period.

Moreover, any expenditure which is incurred for the purpose of increasing profit earning
capacity or reducing cost of production is a capital expenditure. Sometimes the
expenditure even not resulting in the increase of profit earning capacity but acquires an
asset comparatively permanent in nature will also be a capital expenditure.

It should be remembered that when an asset is purchased, all amounts spent up to the
point till the asset is ready for use should be treated as capital expenditure. Examples
are: (a): A machinery was purchased for $50,000 from Karachi. We paid carriage $1,000,
octroi duty $500 to bring the machinery from Karachi to Lahore. Then we paid wages
$1,000 for its installation in the factory. For all these expenditures, we should debit
machinery account instead of debiting carriage A/c, octroi A/c and wages A/c. (b): Fees
paid to a lawyer for drawing up the purchase deed of land, (c): Overhaul expenses of
second-hand machinery etc. (d): Interest paid on loans raised to acquire a fixed asset
etc.

Examples:

1. Purchase of furniture, motor vehicles, electric motors, office equipment, loose

tools and other tangible assets.
2. Cost of acquiring intangible assets like goodwill, patents, copy rights, trade
marks, patterns and designs etc.
3. Addition or extension of assets.
4. Money spent on installation and erection of plant and machinery and other fixed
assets.
5. Wages paid for the construction of building.
6. Structural improvements or alterations in fixed assets resulting in an increase in
their useful life or profit earning capacity.
7. Cost of issue of shares and debentures (certain expenditures are incurred by the
companies when share and debentures are issued).
8. Legal expenses on raising loans for the purchase of fixed assets.
9. Interest on loan and capital during the construction period.
10. Expenditures incurred for the development of mines and plantations etc.
11. Money spent to bring a second-hand asset into working condition.
12. Cost of replacing factory building from an old place to a new arid better site.
13. Premium given for a lease.

Difference between Capital Expenditure and Revenue

Expenditure:

Revenue Expenditure Capital Expenditure

1. Its effect is temporary, i.e. the benefit 1. Its effect is long-term, i.e. it is not
is received within the accounting year. exhausted within the current accounting
year-its benefit is received for a number of
years in future.
2. Neither an asset is acquired nor the 2. An asset is acquired or the value of an
value of an asset is increased. existing asset is increased.

3. It has no physical existence because it 3. Generally it has physical existence except

is incurred on items which are used intangible assets.
by the business.

4. It is recurring and regular and it 4. It does not occur again and again. It is
occurs repeatedly. nonrecurring and irregular.

5. This expenditure helps to maintain 5. This expenditure improves the position of

the business. the business.

6. The whole amount of this expenditure 6. A portion of this expenditure

is shown in trading P & L A/c or (depreciation on assets) is shown in
income statement. trading & P & L A/c and the balance is
shown in the balance sheet on asset side.

7. It does not appear in the balance 7. It appears in the balance sheet until its
sheet. benefit is fully exhausted.

8. It reduces revenue (profit) of the 8. It does not reduce the revenue of the
business. concern. Purchase of fixed asset does not
affect revenue.

Example:

State with reasons whether the fallowing items of expenditure are capital or revenue.

(i) Wages paid on the purchase of goods.

(ii) Carriage paid on goods purchased.

(iii) Transportation paid on machinery purchased.

(iv) Octroi duty paid on machinery.

(v) Octroi duty paid on goods.

(vi) A second-hand car was purchased for $7,000 and $5,000 were spent for its repairs
and overhauling.

(vii) Office building was whitewashed at a cost of $3,000.

(viii) A new machinery was purchased for Rs.80,000 and a sum of Rs.1,000 was spent on
its installation and erection.

(ix) Books were purchased for $50,000 and $1,000 were paid for carrying books to the
library.

(x) Land was purchased for $1,00,000 and $5,000 were paid for legal expenses.

(xi) $50,000 were paid for customs duty and freight on machinery purchased fromJapan.

(xii) Old furniture was repaired at a cost of $500.

(xiii) An additional room was constructed at a cost of $15,000.

(xiv) Damages paid on account of the breach of contract to supply certain goods.

(xv) Cost of replacement of an old and worn out part of machinery.

(xvi) Repairs to a motor car met with an accident.

(xvii) $10,000 paid for improving a machinery.

(xviii) Cost of removing plant and machinery to a new site.

(xix) Cost of acquiring the goodwill of an old firm.

(xx) Cost of redecorating a cinema hall.

(xxi) Cost of putting up a. gallery in a cinema hall.

(xxii) Compensation paid to a director for loss of his office.

(xxiii) Premium paid on the redemption of debentures.

(xxiv) Costs of attending a mortgage.

(xxv) Commission paid on issue of debentures.

(xxvi) Cost of air-conditioning the office of the director of a company.

(xxvii) Repairs and renewal of machinery.

(xxviii) Cost of acquiring patent rights and trade marks.

(xxix) Compensation paid to workers for termination of their services.

(xxx) Compensation paid to a person injured by company's car.

(xxxi) Expenditures incurred on alteration in windows ordered by municipal authorities.

(xxxii) Painting expenditures of a newly-constructed factory.

(xxxiii) Expenditures incurred on renewal of patent.

(xxxiv) Expenditures on replacement of a slate roof by a glass roof.

(xxxv) $10,000 spent on dismantling, removing and reinstalling machinery and

fixtures.

(xxxvi) legal expenses incurred in an income tax appeal.

Solution:
Sr. Nature of Reasons
No. Expenditure

Wages A/C is (i) Revenue Wages paid on goods purchased and a

debited. expenditure revenue expenditure because goods
purchased are meant for resale. It is recurring
by nature as goods are purchased repeatedly
in a business.

Carriage A/c is (ii) Revenue The carriage paid on purchases is a revenue

debited. expenditure. expenditure because goods purchased are
meant for resale and whenever goods are
purchased carriage is paid to bring the goods
to the godown of the business.
Machinery A/c is (iii) Capital A machinery purchased is useless until it is
debited instead expenditure. brought to the business. As machinery is a
of fixed asset and transportation paid is an
transportation additional cost to the machinery, so it is a
A/c. capital expenditure.

Machinery A/c is (iv) Capital Octroi duty paid on machinery is also an

debited instead expenditure. additional cost to the machinery, If it is not
of octroi duty paid, the machinery cannot be taken to the
A/c business, so it is a capital expenditure.

Octroi duty A/c (v) Revenue Octroi duty paid on goods is a revenue
is debited. expenditure. expenditure because goods mean saleable
goods. It is recurring and is paid repeatedly
whenever goods are purchased.

For both (vi) Capital A second-hand car is a fixed asset as it "can be

expenditures expenditure. used for many years and its utility does not
motor car A/C is diminish in one year, so it is a capital
debited expenditure. But it is useless if it is not made
good to work, so the amount spent on its
repair and overhauling is also a capital
expenditure.

White washing (vii) Revenue Whitewashing of a building is necessary for its

A/c is debited. expenditure. maintenance and because of this expenditure
the profit earning capacity of the business has
not increased, so it is a revenue expenditure.

Machinery A/c (viii) Capital Machinery is a permanent asset of the

debited for all expenditure. business and can be used for many years but it
expenditure. will benefit to the business until it is installed
and erected at a proper place. So amount
spent on purchase of machinery, on its
installation and erection is capital expenditure.
For bath (ix) Capital Fixed asset "Books" has been acquired and can
expenditures expenditure. be used for many years. Cost of carrying books
Books is regarded as a part of purchase price of the
A/c is debited. books, so it is a capital expenditure.

Land A/c is (x) Capital Land purchased is a fixed asset. All expenses'
debited. expenditure. connected with its acquisition are regarded as
a part of its purchase price.

Machinery A/c is (xi) Capital Machinery is a fixed asset. All expenses

debited. expenditure. connected with its import from Japan are
regarded as a part of its purchase price, So it is
capital expenditure.

Repair A/c is (xii) Revenue Value of furniture does not increase as a result
debited. expenditure. of
its repair -- it is simply kept in a proper
working condition.

Building A/c is (xiii) Capital This is an addition to a fixed asset and as a

debited. expenditure. result of this expenditure the value of the
building has increased, so it is a capital
expenditure.

Damages A/c or (xiv) Revenue In this case the goods have not been supplied
general expenditure. by the business to the customer according to
expenses is the contract between them. The customer
debited. claimed damages which the business paid. It is
a usual thing that happens in ordinary course
of trading, so it is a revenue expenditure.

Repair and (xv) Revenue A worn out part of the machinery is simply the
maintenance Expenditure. cost of repair and maintenance of fixed asset.
A/c The value and profit earning capacity of the
is debited. machinery has not increased in any way, so it
is a revenue expenditure.
Repair to car (xvi) Revenue Cost of repair to a motor car does not increase
A/c is debited. Expenditure the value of the car, it is simply incurred to put
back the car into working condition, so it is a
Revenue expenditure.

Machinery A/c is (xvii) Capital Cost has been incurred to 'improve (h

debited. expenditure. machinery. It increases the value and profit
earning capacity of the machinery, so it is
capital expenditure.

Plant and , (xviii) Capital Plant and machinery have been removed to a
Machinery A/c is expenditure. new site in order to increase their profit-
debited. earning capacity, so cost of removal is a capital
expenditure.

Goodwill A/c is (xix) Capital Goodwill is an intangible asset and it will

debited. expenditure. benefit to the business for many years. So cost
of acquiring goodwill (using the name of an
old firm) is always a capital expenditure.

Re-decoration (xx) Revenue Generally a cinema hall is decorated regular

'A/c or expenditure. and re-decorating cost is a recurring
Maintenance expenditure Moreover, it will not add to the
A/c is debited. capacity of the hall, so it is a revenue
expenditure.

Cinema hall A/c (xxi) Capital As a gallery has been put up in the cinema
or Building ' expenditure. hall, it increases the capacity of the hall, which
debited. in turns enhances the profit-earning capacity
of the business, therefore, the cost is treated
as a capital expenditure.

Expense A/c is (xxii) Revenue Compensation paid to the director of a

debited. expenditure. company ,for the loss of his office is a revenue
expenditure because the company will get the
benefit of this expenditure only for one year.
 (xxiii) Capital By issuing debentures, money is borrowed
expenditure. from the public for a long period of time and
is used in the purchase of fixed assets or on
the expansion of the business, therefore,
premium paid is a capital expenditure.

(xxiv) Capital Mortgage means a deed showing that the

expenditure. money has been borrowed (loan raised) by
mortgaging assets as collateral security. The
assets will remain mortgaged with the lender
until the loan has been repaid. So the assets
have been utilized for raising loan and the
costs attending the mortgage is, therefore, a
capital expenditure.

(xxv) Capital Debentures are considered as borrowed

expenditure. capital and are used for the acquisition of fixed
assets such as machinery etc., therefore,
commission paid on issue of debentures is a
capital expenditure.

(xxvi) Capital By making the office of the director, air-

expenditure. conditioned, the efficiency of the director will
increase and it will last for many years, so cost
of air-conditioning is a capital expenditure.

Repair A/c is (xxvii) Revenue Annual repair and renewal of machinery is

debited. expenditure. necessary to keep it in a proper working
condition, therefore, this expenditure is
considered as a revenue expenditure.

(xxviii) Capital Patents and trade marks are intangible assets,

expenditure. the benefit of, which is received for many
years, so cost of acquiring these assets is a
capital expenditure.
(xxix) Capital By terminating inefficient workers, the
expenditure. business will run more economically and
profit-earning capacity of the business will
increase, so compensation paid to them is a
capital expenditure.

(xxx) Revenue It happened in the ordinary course of business,

expenditure. so, compensation paid to the injured person is
a revenue expenditure.

(xxxi) Revenue This expenditure will add nothing to the value

expenditure. of the building and will have no effect on the
profit-earning capacity of the business, so it is
a revenue expenditure.

(xxxii) Capital Amount spent on painting a new factory is

expenditure. regarded as a part of the cost of factory
building, therefore, it is a capital expenditure.

(xxxiii) Revenue If patent is renewed annually, then it is a

Expenditure. revenue expenditure as it has been incurred in
the ordinary course of business.

(xxxiv) Capital As a slate roof is replaced by a glass roof, it

expenditure. will increase the efficiency of the building and
therefore, it is a capital expenditure.

(xxxv) Revenue Amount of $10,000 spent on dismantling

Expenditure removing and re-installing machinery an
fixtures will be treated as revenue expenditure.
may be treated as deferred revenue
expenditure item and spread over a number of
years.

(xxxvi) Revenue This expenditure has been incurred in the

Expenditure ordinary course of the business being expense
 o carrying on the business, therefore, it is a
revenue expenditure.

Principles for making distinction between Capital

Expenditure and Revenue Expenditure:
We have no hard and fast rule for distinguishing capital expenditure from revenue
expenditure because, the same item of expenditure may be treated as capital, revenue
or deferred revenue depending upon the circumstances.

For example, to a machinery dealer purchase of machinery is a revenue expenditure,

while machinery purchased for manufacturing goods is a capital expenditure. In the
same way, wages are generally a revenue expenditure, but wages paid for the
installation and erection of a machinery is a capital expenditure. However, generally the
following principles are followed to make a distinction between capital expenditure and
revenue expenditure.

1. Any expenditure that benefits the business for several accounting years, is
regarded as a capital expenditure; any expenditure that benefits the business
only for one accounting year is considered a revenue expenditure.

2. Any expenditure which is not incurred repeatedly and regularly (non-recurring)

is a capital expenditure, while any expenditure which is incurred again and
again (recurring ) is a revenue expenditure e.g., motor car is not bought again
and again, but petrol required to drive it is to be bought at regular intervals.

3. Any expenditure incurred to improve the concern or to increase the profit-

earning capacity of the concern is a capital expenditure. On the other hand,
expenditure incurred to keep the activities of a concern going, is revenue
expenditure.

4. Expenditure incurred after buying second-hand asset to bring it into proper

working order is a capital expenditure.

5. Expenditure incurred on the purchase and installation of a new asset is

regarded as capital
 expenditure.

6. 6. Any expenditure incurred on the extension or addition to an existing asset is

considered as a capital expenditure.

Classifying expenses

Accounting Basics and Expenses

Generally accepted accounting principles (GAAP) dictate how small business owners
must account for the earnings and expenses of their business for financial reporting
purposes only. Although some principles are more complex than others, a firm grasp of
some basic accounting concepts, particularly with reporting expenses, is a way to
increase your comfort level with the accounting obligations of your business.
Basic Revenue Recognition

Because your expenses will reduce the revenue your business earns, learning the basics
of revenue recognition is essential. The fundamental concept of GAAP is that you only
record revenue once the business fully performs its obligations under a contract,
thereby providing it with a legal claim for the collection of funds. For example, if you
operate a service business, you don't report any revenue on your books until you
complete all services for a client. However, once you do, you can record the revenue
even before the customer pays the invoice, provided you use accrual rather than cash
accounting methods, which most businesses do.
Expense Reporting Basics

The same recognition principle applies to the recording of expenses on your books.
Under GAAP, the recording of an expense doesn't relate to its actual payment; rather,
you record it at the time you become legally liable for its payment. To illustrate, suppose
you use a business credit card to purchase office supplies. You record the expense at the
time you make the purchase rather than waiting until you pay the credit card bill. This is
because your liability to the credit card company accrues at the time you make the
purchase.
Depreciation Expense

Depending on the type of small business you operate, depreciation can be a substantial
expense on your income statement. Depreciation is different from other expenses you
report in that depreciation doesn't represent a liability of the business to make cash
payment. Instead, it represents a portion of the price the business pays to purchase
assets and equipment that are useful to the business for many years. For example, if you
operate a food delivery business, it's likely that you will purchase a vehicle for use in the
business. However, because the vehicle will last for many years, you must claim a
portion of the price as depreciation expense each year.
Calculating Depreciation

Unlike the tax rules that apply to depreciation deductions, GAAP allows business owners
to estimate the useful life of each asset the business purchases for purposes of
calculating depreciation. The basic way for a small business to calculate depreciation is
using the straight line method. The annual depreciation expense will equal the purchase
price minus the salvage value (the price the business can sell the asset for at the end of
its useful life) divided by the number of years you estimate the asset will be useful. A
benefit to calculating depreciation this way is that the expense is the same each year for
the asset.

Types of Expense Accounts

Keeping accurate accounting records is an important part of running a successful small
business. In addition to protecting your business in case of an audit, organized records
help provide a picture of the financial health of your business. A business can have
expenses that range from payroll to advertising, as well as the myriad expenses that
come with producing a product, you can typically classify them into a few broad
accounting categories.
Operating Expenses: The Cost of Keeping the Lights On

Essentially, operating expenses are any costs you incur while operating your business
not directly attributable to the manufacture of your product. For example, payroll is a
common operating expense, as you must pay your employees to help you make or sell
your product. Other common examples include advertising, computer expenses,
packaging materials, maintenance costs, utility expenses and the cost of your
accountant or attorney. On an expense report, operating expenses are often subdivided
into categories such as fixed and variable expenses, or into selling, general and
administrative expenses.
Cost of Goods Sold: The Cost of Producing Goods and Services

The cost of goods sold category includes all of the expenses your business incurs in the
production of goods. For example, if you pay to acquire raw materials used to create a
product that your business intends to sell, that constitutes part of your cost of goods
sold. The cost of goods sold calculation can get tricky because it does include the cost
of labor used in the direct production of your product.

While general salaries fall under the category of operating expenses, workers who
physically construct your product for you are considered to be part of your cost of
goods sold. According to the IRS, this categorization typically only applies to mining and
manufacturing businesses. To compute your cost of goods sold, assess the cost of your
product inventory at the beginning of the year, add in any costs used to produce your
product, and subtract your year-end product inventory.
Taxes and Other Expenses: The Cost of Doing Business

Taxes have their own accounting category, and depending on the type and location of
your business, it can be an extensive one. Your business might owe taxes on the federal,
state and local levels. If you have employees, also include payroll taxes in this category.
If your company sells a product, you might owe sales and excise taxes that you should
have collected from your customers. If your business owns property, any property taxes
you pay also fall into this classification.
Everything Else: The Cost of Borrowing Money

Other non operating expenses is a catch-all category for common expenses that do not
fall into any other clearly defined category. Capital expenditures, such as the money you
use to buy your office building, are considered non operating expenses, as are any
interest payments you make on company loans. If you take a loss on the sale of any
 business properties, that falls under the heading of a non operating expense. Litigation
costs are also considered non operating expenses.

Natural expense classification

Natural expense classification refers to the reporting of expenses by the nature of each
type of expense. An example of natural expense classification is to report expenses in the
following manner:

 Compensation expense

 Compensation is a cash or non-cash payment made in exchange for services

rendered. Compensation can include base pay, bonuses, commissions, merit pay, and
tip income. It can also include ancillary or deferred payments, such as stock options,
vacation pay, pension benefits, free parking, and medical insurance. Compensation
levels are based on regional salary surveys; a periodic review of these surveys
ensures that an employer sets compensation packages at competitive levels, in order
to retain employees. Compensation is also based on performance, so that top-level
performers can receive significantly greater pay than mid-range performers.
 In a service business, compensation is typically the largest expense incurred by the
employer. It is still a significant expense even in businesses that do not require a
significant amount of employees.
 Compensation is subject to a variety of taxes and withholdings, including Social
Security and Medicare.

 Depreciation expense
 Insurance expense
 Office supplies expense
 Travel and entertainment expense
 Utilities expense

This reporting treatment varies from the alternative of reporting expenses by function,
such as:
 Accounting department expense

 Engineering department expense

 Marketing department expense

 Selling department expense

The natural expense classification is more likely to be used in smaller companies that do
not have formal departmental reporting structures.

Misclassification of Expenses in an Accounting System

Your accounting system is the key to understanding what's happening in your business.
It's also vital to tax return preparation and other government compliance obligations.
That’s why getting things right is essential. Unfortunately, mistakes can happen, whether
you use a cloud-based or desktop accounting system. Understanding what can go
wrong and how it can impact you is important. Even more important is knowing how to
correct accounting errors and avoid future ones.

How accounting errors can occur

The integrity of the information in your accounting system is only as good as the
information you enter. This means including an expense in the appropriate account,
applying the correct description or code, and entering the correct amount.

Unfortunately, misclassification can result in two ways: simple mistakes or erroneous

account assignment. Here are a few errors to look for when reviewing accounting
reports.

 Capital assets misclassified as expenses: Misclassifying expenses, which should be

labeled as a depreciable asset is one common reporting error. Asset purchases such
as furniture and equipment may need to be depreciated over a certain number of
years. Thus, the entire cost cannot be deducted in the year of purchase.
 Misreported startup costs: Business startup costs are another expense classification
challenge. Some costs must be amortized over a certain period, while others may be
expensed as incurred. The tax and accounting treatment for startup costs can be
complex. Consider conducting additional research and seek expert advice.
 Expense assigned to incorrect business entity: If more than one line of business is
tracked in the accounting system, expenses can sometimes be associated with the
wrong income-producing product or service.
  Expenses assigned to the wrong account number: This may be the result of data
entry errors or lack of knowledge by the person inputting expenses. Know
your industry standards for proper categorizing.
 Data entry errors: Check for extra digits or transposition. These errors can usually
be spotted when a double entry system is used, as accounts will not balance.
The impact of misclassification errors

Errors may be minor or substantial. Either way, they can have serious consequences:

 Incorrect expense reporting can distort a company's computed operating profit

margins or could result in over-reporting of income.
 Misclassification or failure to include business expenses may result in the failure to
report a deductible expense.
 Increased costs associated with error correction. Correcting classification mistakes on
the back end is time-consuming for employees already busy with year-end reporting.
 Late payment fees and interest owed when expenses slip through the cracks. When
misclassification errors are discovered later in the accounting cycle, invoices may be
past due and result in additional fees and interest.
 Improper matching of income and expenses. Misclassified expenses may cause
incorrect reporting for companies using accrual accounting. Expenses should be
properly matched with the income they generate. If expenses are classified in the
wrong month or year, this will not happen as it should.
How to avoid misclassification

Being careful with your financial information is the first line of defense in ensuring that
expenses are properly classified. But there are other steps you can take to avoid
misclassification.

READ MORE:

 Accounting Software: 5 Advantages of a Pay-As-You-Go System

 Train staff on correct data entry. Make sure employees entering expenses into your
accounting system understand your accounts and descriptions. If you use a cloud
accounting system, there is some built-in expertise with respect to assigning
expenses to the correct accounts.
 Do a periodic review of entries. Some misclassifications may be easy to spot because
the description won't match the item. You may also want to compare numbers from
last year with this year's entries to detect any differences that don't make sense. You
may want your accountant to periodically review your accounts to make sure that
 they appropriately reflect the expenses you incur and comply with generally
accepted accounting principles.
 Check for differences between the budget and actual expenses. Your budget may show
a certain amount of money is to be spent on a particular item or activity, but the
entry doesn't match up. Comparing your actual expenses to the amount you
budgeted can help you discover a misclassification (or at least an explanation for the
differences).
 Adopt best practices. Set deadlines for data entry and reconciliation so that errors are
found quickly and can easily be corrected.
Fixing problems
Some accounting errors can be fixed by simply making or changing an entry. For
example, a company's payment to an independent contractor for $500 was not entered
in the books. This error can be fixed by making the appropriate entry. Some corrections
in expense classification may trigger a change in accounting method for tax purposes,
requiring you to file a request for a change in accounting method. Other errors may
have ripple effects (e.g., you may need to restate previous financial statements).

If you experience misclassification problems or want to avoid them entirely, it's always
advisable to work with experts who can ensure that your accounting systems are
working well and your numbers are correct.

Overhead - definition
Overhead is those costs required to run a business, but which cannot be directly
attributed to any specific business activity, product, or service. Thus, overhead costs
do not directly lead to the generation of profits. Overhead is still necessary, since it
provides critical support for the generation of profit-making activities. For example,
a high-end clothier must pay a substantial amount for rent (a type of overhead) in
order to be located in an adequate facility for the sale of clothes. The clothier must
pay overhead to create the proper retail environment for its customers. Examples of
overhead are:

 Accounting and legal expenses

 Administrative salaries
 Depreciation
 Insurance
 Licenses and government fees
 Property taxes
 Rent
 Utilities

Overhead costs tend to be fixed, which means that they do not change from period
to period. Examples of fixed overhead costs are depreciation and rent. Less
frequently, overhead varies directly with the sales level, or varies somewhat as the
activity level changes.

The other type of expense is direct costs, which are those costs required to create
products and services, such as direct materials and direct labor. Overhead and direct
costs, when combined, comprise all of the expenses incurred by a company.

A business should set its long-term product prices at levels that account for both its
overhead costs and direct costs. Doing so allows it to earn a profit on a long -term
basis. However, it is is possible to ignore overhead costs for the pricing of special
one-time deals, where the minimum price point only has to exceed the relevant
direct costs.

Similar Terms

Overhead is also known as burden or indirect costs. A subset of overhead is

manufacturing overhead, which is all overhead costs incurred in the manufacturing
process. Another subset of overhead is administrative overhead, which is all
overhead costs incurred in the general and administrative side of a business.

Administrative overhead
Administrative overhead is those costs not involved in the development or
production of goods or services. This is essentially all overhead that is not included
in manufacturing overhead. Examples of administrative overhead costs are the costs
of:

 Front office and sales salaries, wages, and commissions

 Office supplies

 Outside legal and audit fees

 Administration and sales office lease

 Administration and sales utilities

 Administration and sales telephones

 Administration and sales travel and entertainment

Administrative overhead is considered a period cost; that is, the benefit of this
type of cost does not carry forward into future periods.

Similar Terms

Administrative overhead is also known as general and administrative overhead.

Manufacturing overhead
Manufacturing overhead is all indirect costs incurred during the production process.
This overhead is applied to the units produced within a reporting period. Examples
of costs that are included in the manufacturing overhead category are:

 Depreciation on equipment used in the production process

 Property taxes on the production facility

 Rent on the factory building

 Salaries of maintenance personnel

 Salaries of manufacturing managers

 Salaries of the materials management staff

 Salaries of the quality control staff

 Supplies not directly associated with products (such as manufacturing forms)

 Utilities for the factory

 Wages of building janitorial staff

Since direct materials and direct labor are usually considered to be the only costs
that directly apply to a unit of production, manufacturing overhead is (by default) all
of the indirect costs of a factory.

Manufacturing overhead does not include any of the selling or administrative

functions of a business. Thus, the costs of such items as corporate salaries, audit and
legal fees, and bad debts are not included in manufacturing overhead.

When you create financial statements, both generally accepted accounting

principles and international financial reporting standards require that you assign
manufacturing overhead to the cost of products, both for reporting their cost of
goods sold (as reported on the income statement), and their cost within the
inventory asset account (as reported on the balance sheet). The method of cost
allocation is up to the individual company - common allocation methods are based
on the labor content of a product or the square footage used by production
equipment. it is also possible to use multiple allocation methods. Whatever
allocation method used should be employed on a consistent basis from period to
period.

Related Terms

Manufacturing overhead is also known as factory overhead, production overhead,

and factory burden.

Fixed Cost
What Is a Fixed Cost?
In management accounting, fixed costs are defined as expenses that do not change
as a function of the activity of a business, within the relevant period. It must be paid by
an organization on a recurring basis, even if there is no business activity. Although
fixed costs can change over a period of time, the change will not be related to
production.
As an example of a fixed cost, the rent on a building will not change until the lease
runs out or is re-negotiated, irrespective of the level of activity within that building.
Examples of other fixed costs are insurance, depreciation, and property taxes.
Fixed costs tend to be incurred on a regular basis, and so are considered to be
period costs. The amount charged to expense tends to change little from period to
period.

When a company has a large fixed cost component, it must generate a significant
amount of sales volume in order to have sufficient contribution margin to offset the
fixed cost. Once that sales level has been reached, however, this type of business
generally has a relatively low variable cost per unit, and so can generate outsized
profits above the breakeven level. An example of this situation is an oil refinery,
which has massive fixed costs related to its refining capability. If the cost of a barrel
of oil drops below a certain amount, the refinery loses money. However, the refinery
can be wildly profitable if the price of oil increases beyond a certain amount.

Conversely, if a company has low fixed costs, it probably has a high variable cost per
unit. In this case, a business can earn a profit at very low volume levels, but does not
earn outsized profits as sales increase. For example, a consulting business has few
fixed costs, while most of its labor costs are variable.

VARIABLE COSTS

Variable costs change directly with the output – when output is zero, the variable cost
will be zero. The total variable cost to a business is calculated by multiplying the total
quantity of output with the variable cost per unit of output.

A common example of variable costs is operational expenses that may increase or

decrease based on the business activity. A growing business may incur more operating
costs such as the wages of part-time staff hired for specific projects or a rise in the cost
of utilities – such as electricity, gas or water.

Unlike fixed expenses, you can control your variable expenses to leave room for profits.

What Is the Difference Between Fixed Cost and Variable Cost?

Meaning
Fixed Costs: In accounting, fixed costs are expenses that remain constant for a period
of time irrespective of the level of outputs.
Variable Costs: Variable costs are expenses that change directly and proportionally to
the changes in business activity level or volume.

Incurred when
Fixed Costs: Even if the output is nil, fixed costs are incurred.
Variable Costs: The cost increases/decreases based on the output

Also known as
Fixed Costs: Fixed costs are also known as overhead costs, period costs or
supplementary costs.
Variable Costs: Variable costs are also referred to as prime costs or direct costs as it
directly affects the output levels.

Nature
Fixed Costs: Fixed costs are time-related i.e. they remain constant for a period of time.
Variable Costs: Variable costs are volume-related and change with the changes in
output level.

Examples
Fixed Costs: Depreciation, interest paid on capital, rent, salary, property taxes,
insurance premium, etc.
Variable Costs: Commission on sales, credit card fees, wages of part-time staff, etc.

Variable Costs vs Fixed Costs

The table below summarizes the key difference between fixed and variable
costs:

Variable Cost Fixed Cost

Definition Costs that vary/change Costs that do not change

depending on the company’s in relation to production
production volume volume

When Total variable costs increase Total fixed cost stays the
Production same
Increases

When Total variable costs decrease Total fixed cost stays the
Production same
 Variable Cost Fixed Cost

Decreases

Examples Direct Materials (i.e. kilograms Rent

of wood, tons of cement)

Direct Labor (i.e. labor hours) Advertising

Insurance

Depreciation

Example #1 – Fixed vs Variable Costs

The following table shows various costs incurred by a manufacturing

company:

Cost Variable Fixed

Depreciation of executive jet x

Cost of shipping finished goods to customers x

Wood used in manufacturing furniture x

Sales manager’s salary x

Electricity used in manufacturing furniture x

Cost Variable Fixed

Packing supplies for shipping products x

Sand used in manufacturing concrete x

Supervisor’s salary x

Advertising costs x

Executive’s life insurance x

Example #2

Let’s say that XYZ Company manufactures automobiles and it costs the
company $250 to make one steering wheel. In order to run its business, the
company incurs $550,000 in rental fees for its factory space.

Let’s take a closer look at the company’s costs depending on the company’s
level of production.

Number of Total
Variable Cost per Total Fixed
Automobiles Variable
Steering Wheel Cost
Produced Cost

1 $250 $250 $550,000

500 $250 $125,000 $550,000

Number of Total
Variable Cost per Total Fixed
Automobiles Variable
Steering Wheel Cost
Produced Cost

1000 $250 $250,000 $550,000

1500 $250 $375,000 $550,000

Applications of Variable and Fixed Costs

Classifying costs as either variable or fixed is important for companies because

by doing so, companies can assemble a financial statement called the
Statement/Schedule of Cost of Goods Manufactured (COGM). This is a
schedule that is used to calculate the cost of producing the company’s
products for a set period of time.

The COGM is then transferred to the finished goods inventory account and
used in calculating the Cost of Goods Sold (COGS) on the income statement.

By analyzing variable and fixed cost prices, companies can make better
decisions on whether to invest in Property, Plant, and Equipment (PPE). For
example, if a company incurs high direct labor costs in manufacturing their
products, they may look to invest in machinery to reduce these high variable
costs and incur more fixed costs instead.

These decisions, however, also need to consider how many products are
actually being sold. If the company invested in machinery and incurred high
fixed costs, it would only be beneficial in a situation where sales are high
enough so that the overall fixed costs are less than the total labor costs would
have been had the machine not been purchased.

If sales were low, even though unit labor costs remain high, it would be wiser
to not invest in machinery and incur high fixed costs because the high unit
labor costs would still be lower than the overall fixed cost of the machinery.
The volume of sales at which the fixed costs or variable costs incurred would
be equal to each other is called the indifference point. Finally, variable and
fixed costs are also key ingredients to various costing methods employed by
companies, including job order costing, process costing, and activity-based
costing.

Why Is It Important to Distinguish Between Fixed Costs and

Variable Costs?
As a small business owner, it is vital to track and understand how the various costs
change with the changes in the volume and output levels. The breakdown of these
expenses determines the price level of the services and assists in many other aspects
of the overall business strategy. These costs are also the primary ingredients to various
costing methods employed by businesses including job order costing, activity-based
costing and process costing.

1. BREAK-EVEN ANALYSIS

The knowledge of the fixed and variable expenses is essential for identifying a profitable
price level for its services. This is done by performing the break-even analysis (dollars
at which total revenues equal total costs)

Volume needed to break even = fixed costs / (price – variable costs)

The equation provides not only valuable information about pricing but can also be
modified to answer other important questions such as the feasibility of a planned
expansion. It can also give entrepreneurs, who are considering buying a small business,
information about projected profits. The equation can help them calculate the number of
units and the dollar volume that would be needed to make a profit and decide whether
these numbers seem credible.

2. ECONOMIES OF SCALE

An understanding of the fixed and variable expenses can be used to identify economies
of scale. This cost advantage is established in the fact that as output increases, fixed
costs are spread over a larger number of output items.

Both fixed costs and variable costs contribute to providing a clear picture of the overall
cost structure of the business. Understanding the difference between fixed costs and
variable costs is important for making rational decisions about the business expenses
which have a direct impact on profitability.
Most Common Examples of Fixed Cost

#1 – Depreciation
It is a fixed cost as it is incurred with the same value over the life of the asset.
It does not vary.

#2 – Amortization
Amortization is used to lower the cost value of intangible asset a period of
time. It also includes repayment of a loan. For example, suppose ABC
Corporation spends $50,000 to acquire a patent that will expire in 5 years. It
should be amortized over the five years before it expires. Amortization
expense of $10,000 will be incurred as a fixed cost in books.

#3 – Insurance
This is a periodic premium paid under the agreement of policy. For example,
the cost of insuring the factory building is a fixed cost irrespective of the
number of units produced within the factory.

#4 – Rent Paid
Rent paid for the space that is used to conduct the business is a fixed cost.
This amount is not dependent on the performance of the company. Even for a
retail shop, rent is fixed and is not dependent on the number of sales.

#5 – Interest Expense
Interest Expense against any borrowings like bonds, loan, convertible debt
or lines of credit from banks and financial institutions is fixed costs also known
as debt expenses.
#6 – Property Taxes
The government imposes a property tax on business and it’s a fixed cost
based on the cost of its assets in total. It’s paid once a year.

#7 – Salaries
Irrespective of hours worked, salaries are the fixed compensation paid to
employees of the company. The rent and salary paid to every employee of
companies every month remain fixed and can be considered as fixed cost
example

#8 – Utility Expenses
This is the cost of the use of various utilities like the cost of electricity, gas,
phone bills, internet bills, telephone bills, etc. are fixed costs at large.

#9 – Advertising and Promotional Expense

Marketing is a major expense in any small business budget. A wide range of
expenses such as print and broadcast ads, brochures, marketing campaigns,
catalogs, etc. comes under advertising budget and activities such as
giveaways, contests, and focus groups and surveys come under promotional
activity. The expense dollar amount can vary from quarter or year but it
represents a fixed cost.

#10 – Equipment Rental

There is equipment used for an extended period of time in various units of
production and rental is paid on such equipment. Such equipment rental is
fixed in nature and incurs fixed costs.
#11 – Legal Expenses
The expenses incurred in legal proceedings and regulations formation of the
company are fixed in nature and hence are fixed costs.

Conclusion

Fixed expenses are an important component of a business. It is very important

in business to project profit and to calculate the break-even point. At the
initial stage of business, it should be kept lower as businesses income will be
low. A business will certainly take some time for establishment and get
customers. Fixed expenses will typically differ based on the business.
Businesses that are largely dependent on people rather than physical assets
will not have many fixed assets. Some of the business is like website design,
tax preparation, etc. On the other hand, companies, where physical assets are
required at large, will have high fixed assets such as airlines, auto
manufacturers, etc. We can also conclude that fixed costs are not relevant for
production decisions.

What Is an Accrued Expense?

An accrued expense, in accounting, is an expense that is recognized on the books
before it has been paid. Because accrued expenses represent a company's
obligation to make future cash payments, they are shown on a company's balance
sheet as current liabilities; accrued expenses are also known as accrued liabilities.
An accrued expense is only an estimate, and likely will differ from the supplier’s
invoice scheduled to arrive at a later date.

Following the accrual method of accounting, expenses are recognized when they
are incurred, not necessarily when they are paid.
Understanding Accrued Expense
An example of accrued expense is when a company purchase supplies from one
of its vendors but has not yet received an invoice for the purchase. Other forms
of accrued expenses include

interest payments on loans,

warranties on products or services received, and
taxes;
all of which have been incurred or obtained, but for which no invoices have been
received nor payments made. Employee commissions, wages, and bonuses are
accrued in the period they occur although the actual payment is made in the
following period.

When a company accrues (accumulates) expenses, its portion of unpaid bills also
accumulates.

Accrued expenses are the opposite of prepaid expenses. Prepaid expenses are
payments made in advance for goods and services that are expected to be
provided or used up in the future.

While accrued expenses represent liabilities,

prepaid expenses are recognized as assets on the balance sheet.

Accrued Expense in Action

A company pays its employees' salaries on the first day of the following month
for services received in the prior month. So, employees that worked all of
November will be paid in December. If on December 31, the company’s income
statement recognizes only the salary payments that have been made, the accrued
expenses from the employees’ services for December will be omitted.

Because the company actually incurred 12 months’ worth of salary expenses,

an adjusting journal entry is recorded at the end of the accounting period for the
last month’s expense. The adjusting entry will be dated December 31 and will
have a debit to the salary expenses account on the income statement and a
credit to the salaries payable account on the balance sheet.
When the company’s accounting department receives the bill for the total
amount of salaries due, the accounts payable account is credited. Accounts
payable is found in the current liabilities section of the balance sheet and
represents the short-term liabilities of a company. After the debt has been paid
off, the accounts payable account is debited and the cash account is credited.

KEY TAKEAWAYS

 Accrued expenses are recognized on the books when they are incurred, not
when they are paid.
 Accrual accounting provides a more accurate financial picture than cash
basis accounting.
(I) Direct & Manufacturing Expenses

These expenses are directly related to Trading and Manufacturing activities of

the business. These expenses are also called as primary expenses e.g. wages,
factory expenses etc.

(II) Indirect Expenses

1. Operating Expenses

Operating expenses are those expenses which are incurred by the enterprise in
the normal conduct of the business operations. These are expenses which are
incurred for running the business smoothly and efficiently. These are further
divided into three types viz

(A) Office and Administration Expenses

This group of operating expenses includes the expenses incurred for the
administration of the enterprise. Such as Office staff salary, office rent,
depreciation on office furniture, telephone expenses, directors fees etc.

(B) Selling and Distribution Expenses

Selling and distribution expenses are incurred for the purpose of increasing or
maintaining the sales of the enterprise and for distributing the goods which are
sold e.g. salaries to salesman, advertisement & publicity, depreciation on
delivery van, bad debts etc.

(C.) Finance expenses

The finance expenses include all the expenses incurred for arranging or raising
the finance of the company e.g. cash discount to customer, Bank charges etc.

(2) Non operating expenses

Non operating expenses are those expenses which are not concerned directly
with conduct of the business. These expenses are not regular expenses e.g.
loss on sale of fixed assets, penalty fine for the breach of law, preliminary
expenses written off etc.

(3) Interest

It includes Interest on Debenture, bonds, loan from banks, financial institute,

public deposits and short term loans.
Operating Income

Operating income of any business is that income which is earned by it in the

normal course of its operations. The most important source of operating
income of any business is Gross Profit and discount or commission on purchase

2. Non Operating Income

Non operating income is the income of an enterprise which is not earned in the
ordinary course of business. It is extraordinary income which may not be
regular e.g. interest on loans given or debenture purchased, dividend on
investments, profit on sale of fixed assets, bad debts recovered etc.

What are Accounts Expenses?

An expense in accounting is the money spent, or costs incurred, by a business

in their effort to generate revenues. Essentially, accounts expenses represent
the cost of doing business; they are the sum of all the activities that result in
(hopefully) a profit.

It is important to understand the difference between “cost” and “expense”

since they each have a distinct meaning in accounting. Cost is the monetary
measure (cash) that has been given up in order to buy an asset. An expense is
a cost that has expired or been taken up by activities that help
generate revenue. Therefore, all expenses are costs, but not all costs are
expenses.

What is an Expense?

An expense is defined in the following ways:

 An expense in office supplies uses up the cash (asset)

 A purchase in capital equipment (e.g., a machine or a building)
decreases the book value of the asset over the years through
depreciation expense
 A prepaid expense, such as prepaid rent, is an asset that turns into a
cash expense as the rent is used up each month
 A summary of all expenses is included in the income statement as deductions
from the total revenue. Revenue minus expenses equal the total net profit of a
company for a given period.

In the double-entry bookkeeping system, expenses are one of the five main
groups where financial transactions are categorized. Other categories include
the owner’s equity, assets, liabilities, and revenue. Expenses in double-entry
bookkeeping are recorded as a debit to a specific expense account. A
corresponding credit entry is made that will reduce an asset or increase a
liability.

The purchase of an asset such as land or equipment is not considered a simple

expense but rather a capital expenditure. Assets are expensed throughout
their useful life through depreciation and amortization.

What Are Allowable Business Expenses for Your Small Business?

As a small business owner, you may run on a tight budget. Your business
expenses might add up fast between equipment, inventory, overhead, and
payroll. Luckily, many of your business expenses are tax-deductible.

Although you might get help from a user-friendly accounting software,

accounting terms can encompass a wide variety of items. Get back
to accounting basics by reviewing what constitutes an allowable business
expense.
What are allowable business expenses?
Business expenses refer to costs incurred or money spent while operating a
business. There are hidden costs of running a business, as well as the
traditional expenses that you incur. To deduct an expense, the Internal
Revenue Service (IRS) says the item bought must be ordinary to your industry.
The expense must also be necessary to run your business.
Let’s say you own a hair salon. At your salon, you offer washes, cuts, and
colors. You dry your customers’ hair as a part of these services, but one of
your hair dryers breaks.
 You buy a new hair dryer. You could consider the new hair dryer a deductible
business expense. This is because a hair dryer is an ordinary tool in a salon.
Having a hair dryer is also a necessary part of your services.

The IRS allows 100% small business tax deductions for many general business
expenses. General business expenses could include:
 supplies
 employee wages
 rent paid for office space
 lease payments on warehouse space
 fuel cost
 utility payments
 equipment maintenance
Some expenses are not tax deductible. These expenses are either not ordinary
and necessary to running your business, or are already claimed in another tax
filing.

Non-deductible expenses include:

 Cost of Goods Sold (COGS) – You deduct COGS from your gross receipts to
find your gross profit for the year. You cannot deduct COGS again as a
business expense.
 Capital assets – You have to pay some large expenses over a long period of
time. A business expense is entirely used up within one year.
 Personal expenses – You do not make personal expenses to run your business.
Personal expenses are unrelated to your business expenses and cannot be
deducted.

Dividing expenses
Sometimes you buy something that you use for both your business and your
personal life. When this occurs, you may divide the expenses.
You might consider costs of entertaining a client ordinary and necessary for
your business. But, for bookkeeping purposes, these expenses are only 50%
deductible.

Here is an example of dividing your expenses. You might buy a cell phone to
use for your business. Half of your calls are made to clients. The other half of
your calls are personal.

In this case, you consider 50% of the cost of the cell phone a business
expense. The cell phone is ordinary and necessary for your business. You
consider the other 50% of the cost of the cell phone a personal expense.
Personal expenses are not deductible.

Classification of Expenditure: Direct and Indirect

Expenses

Here we detail about the classification of expenditure i.e. direct and

indirect expenses.
Direct and Indirect Expenses:

It is usual to distinguish the total expenditure into two categories—

direct and indirect. Direct expenditure is that which can be
conveniently allocated to a particular job or product or unit of service.

For example, when a book is printed it is rather easy to know how

much money has been spent on the paper used and also on wages paid
to the workers who were engaged in composing the matter, proof
reading and machining the book.

Making of some blocks can also be put down to that book. Such are the
instances of direct expenditure. But in addition to these expenses,
there will be a number of other expenses which will be incurred not for
the sole purpose of the book but for the benefit of all the work which is
going on. For example, the building is used for all the work done.

Therefore, it is not easy to say what exact amount out of rent is to be

allocated to the book. Similarly, the wages of clerical labour,
supervisory staff, etc. cannot be easily allocated. Such expenses are
known as indirect expenditure and it can be defined as that
expenditure which cannot be conveniently allocated to a particular
product or a job or a unit of service and which is incurred for the
benefit of output generally.

The distinction between direct and indirect expenses turns largely on

convenience. We can find out the share of an article in large number of
expenses incurred, but the time and money spent on this may be out of
all proportion to the benefits obtained.

We may obtain reasonably, correct figure of cost by treating such

difficult cases as indirect. Also, the nature of the business will
determine what is Direct Cost and what is Indirect Expenses. In case
of big contracts, for example, almost one entire expenditure is direct,
while in a firm manufacturing a large variety of articles, most of the
expenditure, apart from materials and labour, will be indirect.
Direct Expenditure is made up of:
(1) Direct Materials;

(2) Direct labour; and

(3) Direct Expenses or Charges

Indirect Expenditure can be classified into:

(1) Works or Factory Expenses;

(2) Office and Administrative Expenses; and

(3) Selling and Distributive Expenses.

Direct Materials:
Materials which directly enter the product and from a part of finished
product are direct materials. These can be identified in the product
and can be measured and directly charged to the product. Examples of
direct materials are timber in furniture making, cloth in dress making
and pig-iron in foundry.

Indirect Materials:
Materials which are used for maintenance and repair of machinery,
the running of service department, spare and components, packing
materials etc. are indirect materials. These do not normally form a
part of the finished product.

Direct Labour:
Labour is treated as direct if it can be conveniently allocated to
different jobs or products, etc. If we know how much time a worker
spent on each of the various jobs he undertook during a particular
period, his wages would be treated as direct. Thus wages of workers
put on definite jobs or products will be direct.

Indirect Labour:
Wages which cannot be allocated to different jobs or products are
treated as indirect labour. Indirect wages are a part of factory
expenses. Wages paid to watch and ward staff, repair gangs,
supervisor, etc. are indirect.

Other Direct Expenses or Charges:

Expenses which can be allocated conveniently to a unit of cost (other
than direct materials and direct labour) are called other direct
expenses or charges. Carriage on materials bought for particular job (if
not included in the cost of materials) will be direct charge. Royalty
paid on the basis of quantity of goods produced is another example of
direct expenses.

Manufacturing (Works or Factory) Expenses or Overheads:

The term manufacturing include ail operations and process starting
from the receipt of raw materials and ending with storage of finished
good. All expenses incurred in these operations and process, other
than direct materials, direct labour and other direct expenses are
classified as manufacturing or works expenses. Some examples are
depreciation on plant and machinery, depreciation on works building,
insurance charges and repair of plant machinery and factory building,
power consumption coal and other fuel charges.
Thus all expenses incurred inside a factory and for the benefit of
manufacture as such will be included in factory expenses.

The following are some of the items so included:

1. Wages paid to indirect workers such as watch and ward staff, repair
gangs, foremen etc.

2. Works manager’s salary and fees paid to directors devoting their

attention to production problems.

3. Work’s canteen and welfare activities.

4. Contribution to Employees’ State Insurance Corporation and

Provident Funds.

5. Cost of indirect materials, carriage inward on such materials,

materials of small value.

6. Buying and store-keeping expenses including value of normal

losses.

7. Factory rent and rates, insurance and repairs of factory premises

and plants, etc.

8. Power and fuel (coal, gas, electricity, etc.) factory lighting.

9. Depreciation on plant and machinery, factory premises, etc.

Office and Administrative Overheads:
All expenses relating to general administration (not connected with
production or sales) will be included in ‘Office and Administrative
Overheads’.

The usual items comprised in these overheads are as

following:
1. Salaries of the general manager, finance manager, the accountants,
the secretary and their staff, clerks etc.

2. Office rent and rates and repairs and depreciation of office premises
and office equipment’s. Power used by office equipment’s.

3. Insurance of office premises and equipment’s.

4. Fees of directors (other than those connected with sales or

production)

5. Telephone, telegrams and postage, printing and stationary.

6. Legal charges, Audit fees, Bank charges etc.

Selling and Distribution Overheads:

Selling expenses are expenses of seeking to create and stimulate
demand and of securing orders. Distribution expenses are expense
incurred in moving the goods from the company’s go-downs to the
customer’s premises. Selling and distribution expenses form no part of
the cost of production but a considerable proportion of the price of the
product is taken up by them.
The usual items included are selling and distribution
expenses are as follows:
1. Salaries of the sales manager and his staff including his office staff
and his salesmen.

2. Travelling expenses and commission payable to salesmen.

3. Advertising and showroom expenses including rent and lighting.

4. Printing of catalogues and price lists and general stationary.

5. Rent of finished goods godowns and their repairs, etc.

6. Bad debts, legal charges for recovery of debts.

7. Packing and carriage outwards, insurance in transit.

8. Fees of sales directors.

9. Depreciation, repairs and running expenses of delivery vans.

10. Telephone and postage, etc. of sales department.

11. Subscriptions to mercantile agencies and trade journals.

In small concerns office expenses and selling expenses may be
grouped together.

The total of the Direct Expenditure—Direct Materials, Direct Labour

and Direct Expenses— is known as Prime cost or Flat Cost.

Prime cost plus Works or Factory Expenses is known as Works Cost or

Manufacturing Cost or Factory Cost.

Works Cost plus Office and Administrative Cost is called Gross or

Office Cost or Cost of Production.

Cost of Production plus Selling and Distributive Expenses is Cost of

Sales. This differs from Selling Price. Selling Price is equal to Cost of
Sales plus Net Profit (or minus loss).

Conversion Cost:
The sum of direct wages, direct expenses and factory expenses is
known as conversion cost.
These terms should be carefully noted and their misuse
avoided. For convenience, the various costs of a
manufacturing concern are given ahead:

The under mentioned definitions given by the CIMA, London should

also be noted.

Prime Cost:
“The aggregate of direct materials cost, direct wages (direct labour
cost) and valuable direct expenses”.

Direct Materials Cost:

“Materials cost which can be identified with and allocated to cost
centres or cost units”.

Direct Expenses: “Expenses which can be identified with and allocated

to cost centres or cost units”.

Production Cost:
“The cost of the sequence of operations which begins with supplying
materials, labour and services and ends with primary packing of the
product”.

Cost of Sales:
“The cost which is attributable to the sales made”.

Total Cost:
“The sum of all costs attributable to the unit under consideration”.

Expenses Excluded from Costs:

The total cost of a product should include only those items of expenses
which form part of cost of production and which are charged against
profit. Item of expenses which are appropriation or apportionment of
profit should not form a part of the costs.

These are:
(i) Income Tax,

(ii) Dividend to shareholders,

(iii) Commission to partners, managing agents etc.

(iv) Capital losses,

(v) Interest on capital (under certain circumstances),

(vi) Interest paid on debentures, and (vii) Capital expenses

Direct and indirect business expenses

You can categorize expenses by direct and indirect expenses. Both direct and
indirect expenses have to be necessary and ordinary for you to deduct them.

Direct expenses are specifically related to producing the good or service you
sell. Direct expenses are usually 100% deductible. Examples of direct expenses
include raw materials and wages.

Indirect expenses help you operate your business. Examples of indirect

expenses include rent and utilities. Indirect expenses are deductible based on
a percentage.

Indirect expenses are a large factor when you run your business from home.
For this reason, accounting for small business may include these types of
expenses frequently. You find the percentage to deduct by comparing your
home’s total square footage to the space you use for business in your home.

Operating Expense
The next section of the income statement focuses on the operating expenses that arise
during the ordinary course of running a business. Operating expense consists of salaries
paid to employees, research and development costs, legal fees, accountant fees, bank
charges, office supplies, electricity bills, business licenses, and more.

The general rule of thumb is that if an expense doesn't qualify as a cost of goods sold,
meaning it isn't directly related to producing or manufacturing a goods or services, it
goes under the operating expense section of the income statement. There are several
categories, the biggest of which is known as Selling, General, and Administrative
Expense, but we'll get to that in a few pages.
Whether you are a new investor trying to study a company's annual report and 10K, or a
business owner examining your operations or considering buying or starting a new
undertaking, understanding the role of operating expenses is vital to your success.

The biggest challenge to controlling operating expenses is a risk known as agency cost.
It is the inherent conflict between owners and managers. Those that work in the
business are always going to want nicer offices, more secretaries, better facilities, faster
computers, free lunches, or whatever else they can imagine. These are easier to control if
you have a small business but your options are limited if you own shares in a large
corporation.

You'll also find that some companies purposely chose to run higher expense ratios than
their competitors. One major, well-known bank makes an intentional choice to run 10%
to 15% higher operating expenses, and thus lower profit margins, to keep the branches
fully staffed. They believe that by making banking as convenient as possible and
avoiding long lines, the improved customer service will cause more of their clients to
keep a larger portion of their household's accounts with them. Their goal is to eventually
become a one-stop shop so that you can do your banking, manage your credit cards,
open a brokerage account, or get insurance, all on an integrated statement. Only you, as
the investor, can decide whether you think the plan is intelligent and the higher
operating expense are worth it.

In general, you want to work with managements that strive to keep operating expense
as low as possible while not damaging the underlying business.

Operating Expenses(OPEX)
What are operating expenses?

Definition of Operating Expenses

Operating expenses are the costs that have been used up (expired) as part of a
company's main operating activities during the period shown in the heading of
its income statement.
Examples of Operating Activities
Examples of a retailer's main operating activities involve the buying and selling of
merchandise or goods. Therefore, the retailer's income statement will report the
following operating expenses:
 Cost of goods sold. These costs are reported as operating expenses on the income
statement because of the matching principle: The cost of the merchandise that is sold
is being matched with the revenues from selling the goods.
 Selling, general and administrative expenses (SG&A). These costs are reported as
operating expenses on the income statement because they pertain to operating the
main business during that accounting period. These costs are expenses because they
may have expired, may have been used up, or may not have a future value that can
be measured.
Some authors define operating expenses as only SG&A. In other words, they do not
include the cost of goods sold as an operating expense. Such a definition will be
deficient when measuring a company's operating income. Clearly, the calculation of
operating income cannot omit the cost of goods sold.

List of Operating Expenses

Operating expenses are the expenses which are incurred by the business in the
normal course of its operations. Operating Expense includes cost related to the
production of goods, however, finance cost such as the interest expenses is always
excluded from the operating expenses as they are not related to the day to day
operations of the business.

Other costs that are excluded from the operating cost include auditor fees, debt

replacement cost, bank fees etc.

Every company always tries to reduce the burden of operating expenses as much as

possible because this is one of the deciding factors of the firm’s ability to compete with
its competitors.

The list of Operating Expenses is sub-divided into two parts – Selling, General and
Admin Expense (SG&A) and Costs of Goods Sold.ing Expense under SG&A Expenses

These costs are part of operating expenses because they are incurred due to the main
business activities. These expenses include telephone expense, traveling expense, utility

expense, sales expense, Rent, repair & maintenance, bank charges, legal expenses, office
supplies, insurance, salaries and wages of administrative staff, Research expenses etc.
Below is the list of 13 Operating expenses that come under Selling, General and Admin

costs.
#1- Telephone Expenses

These are the cost incurred on landline or mobile phones. Generally, monthly bills are
payable for them. Many Companies also reimburse their employees for their telephone

expenses. Depending upon the company policy telephone expenses are charged to
Profit and loss account.

#2 – Travelling Expenses
These are the expenses which are paid by the company for their staff during their official

visit. The staff can travel to meet customers, for some supplies or any other event. In
such a case either company pays staff expense directly or reimburses the staff after their

visit. These expenses are charged in the P&L as traveling expense.

#3 – Office Equipment and Supplies

These are the expenses which are incurred for the purpose of purchasing office supplies
used on a day to day basis in the office. For example, pen, papers, clippers etc.

#4 – Utility Expenses
The expenses which are related to payment of utility bills of the company like expenses

of water and electricity that generally are used for the daily operating activities are the
utility expenses and are charged to the profit and loss account of the company.

#5 – Property Tax
The property tax paid by the company on its properties forms the part of the operating

expenses of the company.

#6 – Legal Expenses

These operating expenses which are incurred for using the legal services by the
company. These are charged in the profit and Loss account of the company under the

head legal expenses.

#7 – Bank Charges

The fees charged by the banks for the general transactions going in the business are
known as the bank charges. For example transaction charges for cheque fees etc.

#8 – Repair and Maintenance Expenses

The Repair and maintenance operating expense on the asset used for production like

repairing requirements of machines, or the vehicles in the company.

#19 – Insurance Expenses

The expenses which are incurred for taking insurance of health care, general insurance
of staff and fire insurance are to be charged to the profit and loss account under the

head insurance expenses.

#10 – Advertising Expenses

This operating expense related to the promotion and advertising forms part of the
operating expenses of the company as they are done for increasing the sales. The same

however does not include the trade discount which the company gives to its customers.
#11 – Research Expenses

This type of operating expenses which are incurred for research of the new products are
treated as revenue expenses and should not be capitalized. These are charged to Profit

and Loss account

#12 – Entertainment Expenses

The entertainment expenses incurred for the sales and related support activities forms
the part of the operating expenses of the company.

#13 – Sales Expenses

This operating expenses that are incurred for the purpose of increasing sales are part of

the sales expenses. For example, a discount on sales and the sales commission expenses
etc.

List of Operating Expense under COGS

Cost of the Goods Sold is the Costs which are incurred for the Goods or products sold

by the organization during a specific time period. The cost which is considered while
calculating the cost of goods sold refers to the cost which is directly attributable to

goods or products sold by the company. This includes cost related to direct labor, direct
overheads, and direct material. The cost should be matched with corresponding

revenues which the entity has recognized in the income statement.

Below is the list of 6 Operating expenses that come under Cost of Goods Sold.

#1 – Freight in Cost
Freight-in is the shipping cost which buyer has to pay for purchasing the merchandise

when terms are the FOB shipping point. The expense related to freight-in is considered
as part of the cost of merchandise and in case if the merchandise is not yet sold then

the same should be considered in the inventory.

#2 – Freight out Cost

Freight out is the cost of transportation which is associated with the delivery of the
goods from the place of the supplier to customers and the same should be included

within cost of the goods sold classification in the income statement.

#3 – Product Cost

These are the costs which are incurred to make the product in the condition to sell it to
customers. The product cost includes cost related to direct labor, direct overheads and

direct material
#4 – Rental Cost

Rental Cost which is paid for the properties used for providing the support related to
the production. The Salaries, wages, and other benefits are given to the staff related to

the production of goods.

#5 – Depreciation Expenses

The reduction in the value of the asset due to wear and tear while using at the time of
production is the depreciation expense and forms the part of the cost of goods sold.
#6 – Others Costs

These are incurred which is directly attributable to production form part of the cost of
goods sold.

Operating Expense Examples

The following examples of operating expense discuss most common expenses

in the income statement. In simple terms, operating expense (Opex) refers to
the money spent on running the business operations of the company
smoothly. Generally referred to as “OPEX Cost”, and is the primary concern for
the management of the company to reduce the same without affecting the
product quality and to stay ahead of the competitors. Operating Expense is
the Sum total of all the expenses excluding the cost of goods sold, interest,
taxes and non-cash expenses like depreciation and amortization to the income
statement.
Below are the top 15 most examples of operating expenses (OPEX) –
1. Salaries paid to the Employees
2. Rent
3. Insurance
4. Utility Bills
5. Office Admin Expense
6. Repairs & Maintenance
 7. Printing & Stationary
8. Property Taxes
9. Direct Material Cost
10. Advertising Cost
11. Entertainment Cost
12. Travel Cost
13. Conveyance
14. Telephone Expense
15. Selling Expenses
Let us discuss each one of them in a bit more detail

Most Common Examples of Operating Expense (OPEX))

Compensation related examples of operating expenses (OPEX)
 Salaries – Salaries paid to the employees of the company and is one of
the most critical expenses for any company being fixed in nature. It
includes gratuity, pension, pf, etc.
 House Rent Allowance: It refers to the allowance given by the
employer to the employee to stay in a house on rent. It forms part of the
CTC to the employee and can be claimed from the company.

Office Related Examples of Operating Expense (OPEX)

These are the day to day expenses of the company to run the business
operations smoothly and includes the below mentioned:
 Rent: It refers to the rentals paid to the landlord for using the premises
for business use. Generally incurred on a monthly basis and is a fixed
cost for the company.
 Insurance: It refers to the amount paid to the Insurance company for
the group insurance of the employees for any kind of medical
emergency. Since this expense is incurred for the benefit of the
employees it’s an operating expense for the company to keep them
motivated by providing safety and security.
 Utility Bills: It refers to electricity, internet charges, mobile bills, etc
paid. It is a monthly expense and normally fixed in nature.
 Office Admin Exp: It refers to the daily admin expense of the premises
like stationary, petty cash, conveyance, transport, cleaning charges, etc.
 Repairs & Maintenance: It refers to the periodic maintenance of the
fixed assets, plant & machinery and furniture and fixtures of the
company to keep the same in good condition.
 Printing & Stationary: This is a routine exp incurred on a daily basis in
the office premises on printing of documents etc.
 Property Taxes: It refers to expenses paid to the authorities for owning
the property and using it for commercial use.
 Direct Material Cost: It refers to the purchases of direct materials
required to make the product and finally sell the same to the end user.
Since its a direct major cost in the product, it is unavoidable and has to
be paid on an ongoing basis.
Sales & Marketing Expenses Related Operating Expense (OPEX)
It refers to the expenses incurred in order to generate business for the
company and to expand its existing operations. It includes the following :
 Advertising Cost: Cost incurred to market the company’s product on
social media or tv channels. Its an operating cost for the company to
stay in business and compete with the peer groups efficiently.
 Entertainment Cost: Cost incurred for the welfare of the employees to
keep them entertained.
 Travel Cost: Cost incurred to travel from one place to another for the
top executives of the company with regards to the business
requirements.
 Conveyance: It refers to the reimbursement paid to the staff for day to
day office travel.
 Telephone Exp: It refers to the expenses paid to the service provider for
the use of the internet and mobile phones of the employees in the
company.
 Selling Expenses: This refers to the cost incurred for selling the product
of the company to the end users via various means. It may include
printing of booklets, arranging seminars or events to make the people
aware of the benefits of the product.

Conclusion

Operating expenses form a major component for analyzing the financial

position of the company and compare them with peers. A low operating
expense ratio gives the company the strength to expand and grow in the
future.
 In the initial stages of the company, the opex will be very high since the
company has just started its operations by spending heavily on
infrastructure, human capital, and marketing expenses. Gradually this
ratio starts declining when the company is able to generate revenues on
a larger scale.
 However, in the case of a liquidity crisis in the company, the opex plays
a vital role in decision making since the departments with higher opex
cost is been closed and those with lower opex cost are been continued.

Cost of Sales vs. Operating Expenses

Companies incur and record costs in running the day-to-day operations of the business.
These costs are separated into two categories—Cost of Sales and Operating Expenses.

Cost of sales may also be called cost of services and cost of goods sold. Operating
expenses are also known and SG&A—sales, general and administrative expenses.
Companies also have non-operating costs that do not belong in these two categories. If
your company buys fixed assets or buys another company, those are investing costs. If

you pay back a loan, the principle amount is a financing cost; only the interest is an
operating cost. Paying dividends to shareholders is a financing cost. Our focus is the

operating costs of the business.

What is the difference between cost of sales and

operating expenses?
Cost of sales or cost of goods sold represent the costs involved in making and delivering
your company’s product or service to a customer. For example, if you make and sell a
physical product, the raw materials, labor (including benefits to factory workers), factory

costs like utilities and equipment, factory management overhead, shipping costs, etc. are
included in cost of goods. For a service company, the salaries of the service providers

and any other cost associated directly with providing the service is a cost of sales.
Operating or SG&A expenses can be considered as the overhead to run the company.

Think of these as the ongoing costs just to be in business. These are costs for marketing,
sales, information technology, human resources, accounting, legal and administrative.

These functions are very important, but the people in these departments perform a
support function in the business. They are not directly involved in making your product

or service. Their services are not what your customer is buying.

Why are cost of sales and operating expenses separated?

These costs are separated for management and analysis purposes. Your company makes
money by selling its product or service. Separating these costs allows a company to

understand what it is costing to produce and deliver its products or services. Knowing
these costs helps determine what those products need to be sold for to make enough

‘gross profit’ on each sale to cover the company’s operating expenses and leave a
sufficient ‘net profit.’

Separating the costs makes it easier to see where the problems are if net profit is too
low. Managers can look at the data to answer 1) are we not selling enough; 2) are we

not charging enough; 3) is it costing too much to make the product; or 4) is our
overhead too high?

For owners of small to medium sized companies, the more your company grows, the
further removed you are from day-to-day operations. Having your costs properly

allocated is essential so that you can understand what is going on in the business.
Especially if profit is too low, the cost separation will allow you to see where the

problem is occurring.
Operating Expense
What Is Operating Expense?
An operating expense is an expense a business incurs through its normal
business operations. Often abbreviated as OPEX, operating expenses include
rent, equipment, inventory costs, marketing, payroll, insurance, step costs, and
funds allocated for research and development. One of the typical
responsibilities that management must contend with is determining how to
reduce operating expenses without significantly affecting a firm's ability to
compete with its competitors.

Operating Expenses
Understanding Operating Expense
Operating expenses are necessary and unavoidable for most businesses. Some
firms successfully reduce operating expenses to gain a competitive advantage
and increase earnings. However, reducing operating expenses can also
compromise the integrity and quality of operations. Finding the right balance
can be difficult but can yield significant rewards.

The Internal Revenue Service (IRS) allows businesses to deduct operating

expenses if the business operates to earn profits. However, the IRS and most
accounting principles distinguish between operating expenses and capital
expenditures.

KEY TAKEAWAYS

 Operating expenses are incurred in the regular operations of business

and include rent, equipment, inventory costs, marketing, payroll,
insurance, and funds allocated for research and development.
 Operating expenses are necessary and mandatory for most businesses.
Capital Expenses
Abbreviated as CAPEX, capital expenses are purchases a business makes as an
investment. Capital expenditures include costs related to acquiring or
upgrading tangible and intangible assets. Tangible business assets include real
estate, factory equipment, computers, office furniture, and other physical
capital assets. Intangible assets include intellectual property, copyrights,
patents, trademarks, et. al.

Capital Expenses vs. Operating Expenses

The IRS treats capital expenses differently than operating expenses. According
to the IRS, operating expenses must be ordinary (common and accepted in the
business trade) and necessary (helpful and appropriate in the business
trade). In general, businesses are allowed to write off operating expenses for
the year in which the expenses were incurred; alternatively, businesses
must capitalize capital expenses/costs. For example, if a business spends
$100,000 on payroll, it can write off the entirety of that expense the year it is
incurred, but if a business spends $100,000 buying a large piece of factory
equipment or a vehicle, it must capitalize the expense or write it off over time.
The IRS has guidelines related to how businesses must capitalize assets, and
there are different classes for different types of assets.

Operating Expense vs. Non-operating Expense

By contrast, a non-operating expense is an expense incurred by a business
that is unrelated to the business' core operations. The most common types of
non-operating expenses are depreciation, amortization, interest charges or
other costs of borrowing. Accountants sometimes remove non-operating
expenses to examine the performance of the business, ignoring effects
of financing and other irrelevant issues.

Operating Expenses on Income Statements

An income statement tracks the income and expenses of a company over a
certain period to provide an image of its profitability. Income statements
typically categorize expenses into six groups: cost of goods sold; selling,
general, and administrative costs; depreciation and amortization;
other operating expenses; interest expenses; and income taxes. All these
expenses can be considered operating expenses, but when determining
operating income using an income statement, interest expenses and income
taxes are excluded. (For related reading, see "Different Types of Operating
Expenses")

Non-Operating Expense
What is a Non-Operating Expense?
A non-operating expense is a business expense unrelated to the core
operations. The most common types of non-operating expenses are interest
charges and losses on the disposition of assets. Accountants sometimes
remove non-operating expenses and non-operating revenues to examine the
performance of the business, ignoring effects of financing and other irrelevant
issues.

KEY TAKEAWAYS

 A non-operating expense is an expense incurred from activities

unrelated to core operations.
 Non-operating expenses are deducted from operating profits and
accounted for at the bottom of a company's income statement.
 Examples of non-operating expenses include interest payments or costs
from currency exchanges.
Understanding Non-Operating Expense
Non-operating expense, like its name implies, is an accounting term used to
describe expenses that occur outside of a company's day-to-day activities.
These types of expenses include monthly charges like interest payments on
debt but can also include one-off or unusual costs. For example, a company
may categorize any costs incurred from restructuring, reorganizing, costs from
currency exchange, or charges on obsolete inventory as non-operating
expenses.

Non-operating expenses are recorded at the bottom of a company's income

statement. The purpose is to allow financial statement users to assess the
direct business activities that appear at the top of the income statement alone.
It is important for a business' future outlook that its core business operations
generate a profit.

Examples of Non-Operating Expense

Most public companies finance their growth with a combination of debt and
equity. Regardless of the allocation, any business that has corporate debt also
has monthly interest payments on the amount borrowed. This monthly
interest payment is considered a non-operating expense because it does not
arise due to a company's core operations.

If a company sells a building, and it is not in the business of buying and selling
real estate, the sale of the building is a non-operating activity. If the building
sold at a loss, the loss is considered a non-operating expense.

Recording Non-Operating Expense

When looking at a company's income statement from top to
bottom, operating expenses are the first costs displayed just below revenue.
The company starts the preparation of its income statement with top-
line revenue. The firm's cost of goods sold (COGS) is then subtracted from its
revenue to arrive at its gross income. After gross income is calculated, all
operating costs are then subtracted to get the company's operating profit, or
earnings before interest, tax, depreciation, and amortization (EBITDA). Then,
after operating profit has been derived, all non-operating expenses are
recorded on the financial statement. Non-operating expenses are subtracted
from the company's operating profit to arrive at its earnings before
taxes (EBT). Taxes are then assessed to derive the company's net income.

Selling expense | Sales expense

Selling expense (or sales expense) includes any costs incurred by the sales
department. These costs typically include the following:

 Salesperson salaries and wages

 Sales administrative staff salaries and wages

 Commissions

 Payroll taxes

 Benefits

 Travel and entertainment

 Facility rent / showroom rent

 Depreciation
 Advertising

 Promotional materials

 Utilities

 Other departmental administration expenses

If the marketing function is merged into the sales department, then a number of
additional marketing costs may be included in the preceding list, such as the costs of
developing advertising campaigns, the artwork costs incurred to develop promotional
materials, and social media expenditures.

The proportions of costs incurred can vary dramatically by business, depending upon
the sales model used. For example, a customized product will require considerable in-
person staff time to obtain sales leads and develop quotes, and so will require a large
compensation and travel cost. Alternatively, if most sales are handed off to outside
salespeople, commissions may be the largest component of selling expense. An Internet
store may have few direct selling costs, but will incur large marketing costs to advertise
the site and promote it through social media.

There are varying treatments of selling expenses. Under the accrual method of
accounting, you should charge them to expense in the period incurred. Under the cash
basis of accounting, you should charge them to expense when paid.

You would normally report selling expenses in the income statement within the
operating expenses section, which is located below the cost of goods sold. However,
under a contribution margin income statement format, you would be justified in
reporting commissions within the variable production expenses section of the income
statement, since commissions usually vary directly with sales.

How Are Selling Expenses Figured Out Monthly?

Selling expenses, often called cost of goods sold, refer to costs and purchases needed to create
products or deliver services for which consumers pay your small business money. The difference
between sales revenue and sales expenses determine gross profit, from which overhead is
deducted to calculate net profit. Most businesses figure out selling expenses monthly, but it can
also be done weekly or quarterly.
Defining Cost of Goods Sold

Your selling expenses are all costs that vary with sales activity. For example, a company that
manufactures bolts spends more on raw materials and labor when producing 10,000 units
compared to producing 5,000. However, salespeople work 40 hour weeks, so their salaries are
paid regardless of sales level for a period. A cleaning business uses detergents, sponges and
cloths to provide services, so the products consumed in a month contribute to selling expenses.
COGS may include raw materials, direct labor, packaging and shipping.
Calculating Direct Labor

For many businesses, direct labor is the largest component of producing goods and services.
Direct labor refers only to those employees who work directly, and only counts the hours on
which employees engage in activities related to goods and services sold. For example, a worker
may spend four hours in the morning printing customer work in a photo shop, then work four
hours answering customer calls. Only the worker's time printing is direct labor. Regular hours,
shift premiums, overtime hours, payroll tax and other benefit costs are included in the direct
labor expense.
Inventory and Material Costs

Most businesses use inventory as a basis for calculating material COGS. The basic formula is:
beginning inventory + purchases - ending inventory = COGS. This equation suits some
businesses, but others that store an inventory of finished goods prior to selling may use a
variation called change in inventory accounting. The equation is essentially the same, but it
looks at inventory increases and decreases. Its formula is: purchases + inventory decrease -
inventory increase = COGS. The change in accounting method may be used in a company with
an extensive product line or to total results from a number of locations or departments.
Changing inventory costs and cost flow may also affect inventory COGS calculations.
Miscellaneous Direct Costs

Any expense that varies with sales volume could be considered part of the selling expense.
Packaging materials are one example, and shipping may also be variable. There is some
 discretion, however, since one truck, partially filled, may cost the same when completely filled.
Similarly, a company that uses delivery routes that make stops daily, regardless of sales volume,
would count shipping as a fixed expense.
The Income Statement

Monthly selling expenses are usually communicated as part of an income statement, which can
vary in complexity, but includes the basic sections of revenue and expenses. Single-step income
statements include only revenue and expenses. Multiple-step income statements are more
common, and include COGS as a separate line item. A common format for such an income
statement is: * Sales * Selling expenses (COGS) * Gross Profit * Operating expenses
(overhead) * Net Profit (loss) Other income, such as interest on investments or rental income,
adds to the net profit to calculate net income.

General and administrative expense

General and administrative expense is those expenditures required to administer a
business, and which are not related to the construction or sale of goods or services.
This information is needed to determine the fixed cost structure of a business.
Examples of general and administrative expenses are:

 Accounting staff wages and benefits

 Building rent

 Consulting expenses

 Corporate management wages and benefits (such as for the chief executive officer
and support staff)

 Depreciation on office equipment

 Insurance

 Legal staff wages and benefits

 Office supplies

 Outside audit fees

 Subscriptions

 Utilities

Another way of describing general and administrative expenses is any expense that
will still be incurred, even in the absence of any sales or selling activity.

General and administrative expense is generally not considered to include research

and development (or engineering) expenses, which are usually aggregated into a
separate department.

General and administrative expenses appear in the income statement immediately

below the cost of goods sold. They may be integrated with selling expenses (in
which case the cluster of expenses is known as selling, general and administrative
expenses), or they may be stated separately.

There tends to be strong cost-reduction pressure on general and administrative

expenses, since these costs do not directly contribute to sales, and so only have a
negative impact on profits. However, many of these expenses are fixed in nature,
and so can be fairly difficult to eliminate in the short term.

A company that has a strong, centralized command-and-control management

system in place is likely to spend much more on general and administrative
expenses than a business that has a decentralized organizational structure, and
which therefore does not require extra staff to control the activities of subsidiaries.

Selling, General & Administrative Expense - SG&A

What Does Selling, General & Administrative Expense - SG&A Mean?
Reported on the income statement, it is the sum of all direct and indirect selling
expenses and all general and administrative expenses of a company.

Direct selling expenses are expenses that can be directly linked to the sale of a specific
unit such as credit, warranty and advertising expenses. Indirect selling expenses are
expenses which cannot be directly linked to the sale of a specific unit, but which are
proportionally allocated to all units sold during a certain period, such as telephone,
interest and postal charges. General and administrative expenses include salaries of
non-sales personnel, rent, heat and lights.

Investopedia explains Selling, General & Administrative Expense - SG&A

High SG&A expenses can be a serious problem for almost any business. Examining this
figure as a percentage of sales or net income compared to other companies in the same
industry can give some idea of whether management is spending efficiently or wasting
valuable cash flow. For example, in the television industry businesses that depend on
a great deal of advertising must carefully monitor their marketing expenses. A good
management team will often attempt to keep SG&A expenses under tight control and
limited to a certain percentage of revenue by reducing corporate overhead (i.e. cost-
cutting, employee lay-offs).

Expenses

A company needs to spend money to make money, and these outflows from making
and selling its products or providing and selling its services represent a company's
expenses. Companies' expenses are usually grouped into similar categories.

Cost of Sales. Cost of sales (also known as cost of goods sold--COGS--or cost of
services) represents all of the expenses directly incurred in creating the goods or
services that a company sells. Examples include raw materials, items purchased for
resale, the cost of running a factory, and labor. If it cost Best Buy $9 to acquire the DVD
that you purchased, that $9 is considered a cost of sales. The steel and rubber Harley-
Davidson HOG had to purchase to make its motorcycles would also be grouped into
cost of sales.

Selling, General, and Administrative Expenses. Selling, general, and administrative

expenses (also known as "SG&A") consist of several types of costs. Selling expenses are
those expenses incurred in attempting to create sales for the company. Examples
include marketing expenses and compensation for sales staff. General and
administrative expenses, meanwhile, represent most overhead costs of operating a
company's business. Costs related to a company's human resources and finance
departments and costs related to its office buildings are examples of general and
administrative expenses.
Depreciation and Amortization. When a company purchases an asset that the
company intends to use over a period of time, such as a piece of factory equipment or a
building, the asset's entire cost isn't immediately expensed on the income statement.
Instead, the company expenses the asset gradually over the estimated useful life of the
asset. This expense represents the building's or equipment's normal wear and tear over
time, and is referred to as depreciation expense.

Amortization is similar to depreciation, except amortization relates to intangible assets,

or assets that do not have a physical presence, such as a brand name. Oftentimes,
depreciation and amortization are already included in the other expenses mentioned
above, so you may not see them listed separately on the income statement. However,
the statement of cash flows, one of the other key financial statements, has depreciation
and amortization amounts (sometimes combined) disclosed.

Selling General and Administrative Expenses (SGA)

SGA expenses consist of the combined payroll costs (salaries, commissions, and travel
expenses of executives, sales people and employees), and advertising expenses a
company incurs. High SGA expenses can be a serious problem for almost any business.
A good management will often attempt to keep SGA expenses limited to a certain
percentage of revenue. This can be accomplished through cost-cutting initiatives and
employee lay-offs.

There have been several cases in the past where bloated selling, general and
administrative expenses have literally cost shareholders billions in profit. According to
Roger Loweinstein, in the 1980's, ABC (later merged with CAP Cities, then bought by
Disney) was spending $60,000 a year on florists, as well as providing stretch limos and
private dining rooms for its executives. It was the shareholders who were footing the bill.
(On a related note: at the same time these ABC executives were squandering
shareholders' capital, they were artificially padding earnings by selling the original
Jackson Pollack and Willem de Kooning paintings the network owned!)

SGA Expenses and Fixed vs. Variable Cost Structure

There is a big difference between a company that has a variable cost structure and one
that has a fixed cost structure. A company with high fixed expenses is said to have high
operating leverage because the company loses money up to a break-even point and
then makes a lot of profit beyond that level. A perfect example is a McDonald's
franchise. Due to the high initial investment in land, building, cooking equipment,
restaurant seating, fixtures, and other costs, you may have to do, say, $800,000 to
$1,000,000 or more to breakeven. Beyond that point, your costs are covered so you
generate far higher profits. That's why a business can fail if sales fall from $2,000,000 to
$800,000, even though it is still a decent size by small business standards.

A variable cost structure is one in which the selling, general and administrative expenses
keep pace with sales. Think of a furniture importer that has almost no expenses except
for a 15% commission paid to independent road salesmen. If sales fall, costs fall in line,
protecting the business and shareholders. Companies with highly variable cost
structures are said to have low operating leverage.

It is worth noting that depreciation and amortization expenses are noncash expenses.
For more information about noncash revenue and expenses, read the section on accrual
accounting later in this lesson.

Other Operating Expenses. Other operating expenses represent all other expenses
related to a company's primary operations not included in the above categories. Often,
nonrecurring costs or accounting gains are included here. Pay close attention to these
items. Some companies abuse these "one-time" accounting events to the point where
they become annual events. Also, they frequently include items such as restructuring
charges, which are costs incurred to close a factory or lay off part of the workforce, for
example. They may also include asset write-offs or write-downs, which often suggest
that management may have paid too much for a particular asset or invested too much
in an unprofitable business.

Interest Income and Interest Expense. In order to raise funds for the purchase of
assets used to run the business, a company may issue debt (i.e., borrow money). In most
cases, the company is required to pay interest on these obligations. Conversely, when a
company has more cash than it currently needs for operating its business, it may invest
this excess money. These investments often earn interest or investment income. On the
income statement, you may see interest expense and interest income listed separately
or lumped together as net interest expense or net interest income.

Taxes. Just as you pay taxes to Uncle Sam, most companies do, too. For companies that
make a profit, taxes are an expense on the income statement.

Goodwill and other Intangible Asset Amortization Charges

You already learned what goodwill was in Investing Lesson 3 - How to Analyze a Balance
Sheet. A quick reminder in case you forgot: Goodwill is used to show the price in excess
of the assets one business pays when it acquires another business. If that sentence
scared you, calm down and let me explain. Say your pizza parlor wants to buy a
competitor's pizza shack. Anything you pay in excess for the current value of the assets
such as real estate, food equipment, appliances, tables, chairs, or other goods, gets put
on your balance sheet as goodwill. For more than one hundred years, small business
owners often refer to goodwill as "blue sky".

In the past, companies were required to charge a portion of goodwill to the income
statement, reducing reported earnings. The theory made sense on the surface: If you
bought any asset, you had to depreciate it so why, then, wouldn't you have to do the
same when you bought an entire company?

For all intents and purposes, these goodwill charges were ignored by the investor
because, unlike buying assets that were needed to operate, acquiring a competitor or
merger likely increased your profits if done wisely. The goodwill charges were causing
managers to report lower earnings, which was against the accounting goal of providing
an accurate picture of economic reality.

Changes in the Accounting Rules for Goodwill

In June 2001, the Financial Accounting Standards Board (FASB), the folks who make
accounting rules in the United States by determining GAAP, changed the guidelines, no
longer requiring companies to take these goodwill and amortization charges. Instead,
the company was required to periodically determine, through cash-flow analysis and
other means, whether the goodwill was impaired. In practical terms, this meant that the
goodwill would sit on the balance sheet forever unless something happened to the
acquired business that caused management to realize they overpaid. In the event they
did overpay, they would record a goodwill expense on the income statement, causing
reported profits to fall. The goodwill "asset" could then be removed from the balance
sheet.

The one exception to this new goodwill policy was intangible assets that do not have
indefinite lives, such as patents. These will need to continue to be amortized off as an
expense because when the patent expires, it is effectively worthless so it would be
misleading to list it on the balance sheet as an asset. In simple terms, if the pizza shack
you bought had a licensing agreement with a local sports team that ran out in five years,
you would have to continue to charge that asset off on the income statement until it
reached $0 at the end of the five years.

The most important thing for you to know when you look at goodwill is that it is a non-
cash charge. That means that if a company has a goodwill expense of $10 million, not a
penny is coming out of headquarters in most cases because it is just representing a loss
that has already occured. If the pizza shack you bought went bankrupt three years from
now after the building burned to the ground, you would record a goodwill charge and
your profits will be lower. The money you spent for the building was paid out three
years before when you bought the place, not when the goodwill charge hit the income
statement.

Depreciation and Amortization

There are two different kinds of depreciation an investor must grapple with when analyzing
financial statements. They are accumulated depreciation and depreciation expense. Each is
unique, though new investors often confused them. In order to understand why they are
important and how they work, we must discuss the terms individually.

Depreciation Expense
According to a major brokerage firm, “Depreciation is the process by which a company
gradually records the loss in value of a fixed asset. The purpose of recording
depreciation as an expense over a period is to spread the initial purchase price of the
fixed asset over its useful life. Each time a company prepares its financial statements, it
records a depreciation expense to allocate the loss in value of the machines, equipment
or cars it has purchased. However, unlike other expenses, depreciation expense is a
"non-cash" charge. This simply means that no money is actually paid at the time in
which the expense is incurred.”

An Example of Depreciation Expense

To help you understand the concept, let’s look at an example of depreciation expense:

Sherry’s Cotton Candy Company earns $10,000 profit a year. In the middle of 2002, the
business purchased a $7,500 cotton candy machine that it expected to last for five years.
If an investor examined the financial statements, they might be discouraged to see that
the business only made $2,500 at the end of 2002 ($10k profit - $7.5k expense for
purchasing the new machinery). The investor would wonder why the profits had fallen
so much during the year.

Fortunately, Sherry’s accountants come to her rescue and tell her that the $7,500 must
be allocated over the entire period it will benefit the company. Since the cotton candy
machine is expected to last five years, Sherry can take the cost of the cotton candy
machine and divide it by five ($7,500 / 5 years = $1,500 per year). Instead of realizing a
one-time expense, the company can subtract $1,500 each year for the next five years,
reporting earnings of $8,500. This allows investors to get a more accurate picture of how
the company’s earning power. The practice of spreading-out the cost of the asset over
its useful life is depreciation expense. When you see a line for depreciation expense on
an income statement, this is what it references.
This presents an interesting dilemma. Although the company reported earnings of
$8,500 in the first year, it was still forced to write a $7,500 check, effectively leaving it
with $2500 in the bank at the end of the year ($10,000 profit - $7,500 cost of machine =
$2,500 remaining).

The result is that the cash flow of the company is different from what it is reporting in
earnings. The cash flow is very important to investors because they need to be ensured
that the business can pay its bills on time. The first year, Sherry’s would report earnings
of $8,500 but only have $2,500 in the bank. Each subsequent year, it would still report
earnings of $8,500, but have $10,000 in the bank because, in reality, the business paid
for the machinery up-front in a lump-sum. This is vital because if an investor knew that
Sherry had a $3,000 loan payment due to the bank in the first year, he may incorrectly
assume that the company would be able to cover it since it reported earnings of $8,500.
In reality, the business would be $500 short.* There have been cases of companies going
bankrupt even though they were reporting substantial profits.

This is where the third major financial report, the cash flow statement, comes into an
investor's analysis. The cash flow statement is like a company’s checking account. It
shows how much cash was spent and generated, at what time, and from which source.
That way, an investor could look at the income statement of Sherry’s Cotton Candy
Company and see a profit of $8,500 each year, then turn around and look at the cash
flow statement and see that the company really spent $7,500 on a machine this year,
leaving it only $2,500 in the bank. The cash flow statement is the focus of Investing
Lesson 5.

Accounting for Depreciation Expense in Your Income Statement Analysis

Some investors and analysts incorrectly maintain that depreciation expense should be
added back into a company’s profits because it requires no immediate cash outlay. In
other words, Sherry wasn’t really paying $1,500 a year, so the company should have
added those back in to the $8,500 in reported earnings and valued the company based
on a $10,000 profit, not the $8,500 figure. This is incorrect (honestly, I'm being polite -
it's idiotic). Depreciation is a very real expense. Depreciation attempts to match up profit
with the expense it took to generate that profit. This provides the most accurate picture
of a company’s earning power. An investor who ignores the economic reality of
depreciation expense will be apt to overvalue a business and find his or her returns
lacking. As one famous investor quipped, the tooth fairy doesn't pay for a company's
capital expenditure needs. Whether you own a motorcycle shop or a construction
business, you have to pay for your machines and tools. To pretend like you don't is
delusional.
Selling Expenses Vs. Administrative Expenses
Selling and administrative expenses are both part of the selling, general and
administrative (SG&A) expenses a company uses to operate. These operating
expenses don't include the cost of goods sold (COGS). Even though they are part of the
same income statement category, breaking these subcategories down gives business
leaders insight for cost control measures. Companies look at the selling expenses in
comparison to other administrative expenses to determine if the company is properly
utilizing resources for staff and marketing.
Define Selling Expenses

Whenever a product or service is sold, there are expenses related to the activities
generating sales revenues. To be considered a selling expense, the cost must be a
direct expense, such as a sales representative's salary, commission, benefits, travel
and any accommodations in line with the sale. This is determined at the point of sale.
Implementation and fulfillment of the sale are not considered a selling expense.

For example, if a company sells solar panels, the selling expense is not the cost of the
production of the solar panel nor the installation of the solar panel. It is strictly the costs
involved with the person who drives to a neighborhood and spends the day knocking on
doors until he gets someone to buy the panels. That salesman's salary, commission,
mileage and parking fall under selling expenses.
Define Administrative Expenses

Income statements lump general and administrative costs into one category. General
and administrative expenses are all the expenses not associated with selling and not
associated with making the product. These expenses include the overhead to run the
main office, marketing, executive and support staff, and any distribution costs.

For example, the same solar panel company has general administrative expenses in the
form of central office rent, administrative staff and installation employees. Utilities,
insurance, office supplies and management-related expenses are considered general
and administrative expenses.
COGS Are Not Selling Expenses

An expense not factored into the selling or administrative expenses is the COGS. The
COGS are all the expenses paid in the creation of the product sold. These include
manufacturing plant leases, and employees and supplies used to make the products
sold. Keeping COGS in check requires buying supplies in bulk, finding efficient labor
and being able to get the product to the warehouse without delay for a reasonable price.

For example, a company that sells the solar panels has a manufacturing plant that
makes them in Taiwan. The costs of the lease, labor and supplies to make the solar
panels are the COGs. Even the freight and shipping costs to get the solar panels to the
U.S. warehouse is considered part of the COGS. The delivery to the customer is
considered part of the distribution cost, which is part of the general and administrative
expenses.
Importance of Differentiation

Good managers understand how each of these expense categories affects the overall
profitability of the company. When sales are down, the manager must consider where
money is being spent and if it is being spent in places it doesn't need to be.
Implementing cost controls might mean making administrative expenses more lean by
cutting back on auxiliary staff while redirecting marketing efforts. Adjustments may also
be made to COGS in an effort to reduce product costs and increase the profit margin.

An efficiently run company maximizes production and sales output in relation to

operating expenses, both of which include the sales and administrative costs. When
output exceeds what the sales team is selling, either production needs to be slowed or
changes must be made to generate more sales and reduce overhead until the company
finds an operating balance point. Business leaders then implement strategies while
monitoring progress.