Expense is an accounting and budgeting term usually referring to something a company or organization spends money on. More precisely and more broadly, however, expense is defined as a decrease in owner’s equity caused by the using up of assets in producing revenue or carrying out other activities that are part of the entity’s operations.
The broader definition also covers non cash expenses, such as depreciation or bad debt. However, every expense transaction—cash or non cash—calls for an impact on an expense category account.
This article further defines and illustrates expense terms from the income statement and from the budgeting process.
- What is the meaning of expense?
- Where are expense items located on the income statement?
- How do expense accounts appear in the accounting system chart of accounts?
- How are expense items budgeted? What are the important budget categories?
Where are Expense Items located on the income statement?
Expense transactions impact all of the major financial accounting statements, but especially the income statement. The income statement (or statement of operations, for government or non profit organizations) reports financial performance over a period of time, measured in terms of incoming revenues, expenses, and protits. The basic income statement equation shows how the statement is "about" incoming and outgoing funds for the period:
Profit = Revenues – Expenses
Income statements typically include just one or a very few revenue lines, but many expense lines, each corresponding to an expense category account (or group of accounts) from the accounting system's chart of accounts
What are the important income statement expense categories?
Expense category accounts can appear under five major income statement categories.
- Expenses for Cost of goods sold (COGS) or Cost of services or Cost of Sales.
These are the expenses directly associated with producing goods or delivering services. Example may include:
• Direct materials for manufactured goods.
• Direct costs of service delivery (e.g., direct labor costs for service delivery).
• Purchase of finished goods inventory to be sold.
• Direct labor for manufacturing.
• Manufacturing overhead expense.
– Indirect labor.
– Production equipment depreciation expense.
– Other manufacturing / production / delivery overhead.
• Indirect costs of service delivery.
Cost of Goods Sold (CGS) is the total cost of acquiring raw materials and turning them into finished goods. CGS normally does not include costs which apply to the whole enterprise, or to selling, general and administrative expenses. In manufacturing companies, CGS generally has three main components: direct labor, direct materials, and manufacturing overhead.
For companies that sell services rather than manufactured products, the comparable costs of service delivery are reported as Cost of Services. Companies that sell both services and manufactured products may report their direct costs for services delivery and product production as Cost of Sales.
In financial reporting, Cost of goods sold (or Cost of sales, or Cost of services) is a cost category on the income statement, as shown on the example statement below.
- Operating Expenses - Selling.
These are costs for selling, including such things as:
• Store/shop rental, maintenance.
• Sales salaries, commissions.
• Depreciation for selling assets (e.g., bar code reading point-of-sale systems).
- Operating Expenses - General & Administrative.
These are essentially expenses for running the company in its normal line of business, which may include such things as:
• Executive salaries and other wages and salaries for employees.
not engaged in manufacturing or selling.
• Research and development funding.
• The costs of travel and training.
• IT support (when IT supports the entire organization).
• Depreciation for Property, Plant & Equipment assets, and other assets not
solely dedicated to manufacturing or sales.
Categories 2 and 3 above are sometimes combined under the single heading "Selling, General and administrative expenses" (SG&A), Or, these expenses may also appear on the income statement under the single general heading "Operating expenses."
- Financial Expenses (for companies not in a financial industry)
These are costs associated with borrowing funds, or making money from financial investments. These may include.
• Loan origination fees.
• Interest paid on borrowed funds.
- Extraordinary expenses.
These are costs for one time events or transactions, or non recurring actions that are not part of the company's normal business operations. These may include costs of:
• Workforce reduction, laying off employees.
• Sale of land, buildings, or real estate.
• Sale or disposal of other significant assets.
• Selling a business.
How do expenses impact gross profit, operating profit, and net profit?
Knowing which of the above high level income statement categories a given expense item belongs in is important for at least two reasons:
- The category determines which budget includes this item.
- The category determines which of the several profit calculations on a company's income statement the spending item impacts.
Expenses for Cost of goods sold items (such as direct manufacturing labor, or manufacturing overhead) impact are subtracted from sales revenues to produce gross profit and gross margin. (Gross margin is the gross profit expressed as a percentage of net sales.) For companies that use Cost of services or Cost of Sales instead of Cost of goods sold, gross profit and gross margin are derived in the same way.
The income statement shows reported gross profit for the company, but management usually has a high interest in knowing gross profits for individual product lines and individual products, as well. Such information is crucial for effective product management and product strategy decisions, for instance. For product gross profits, actual sales revenues, actual direct materials, and actual direct labor costs can be estimated rather directly. When manufacturing overhead supports multiple products or product lines, however, the overhead costs for specific products may be determined by an arbitrarily set allocation percentage or, alternatively, by an activity based costing approach.
Operating Expenses (usually classified as "Selling, General, and Administrative Expenses," or sometimes appearing in two categories, "Selling" and "General and Administrative") are subtracted from Sales revenues—along with Cost of goods sold—to produce operating profit and operating margin.
Because Selling, General and Administrative expenses appear below (after) gross profit, they do not enter the gross margin calculation. For this reason, the SG&A costs are sometimes called "below the line" costs.
Extraordinary item costs Financial item costs are normally reported below the operating profit line on the income statement (unless the company is in a financial industry, in which case financial expenses may be part of its normal business).
In any case, all expenses on the income statement impact the company's reported "bottom line" net profit.
What are non cash expenses?
Non cash expenses are charges against earnings used solely for the purpose of lowering reported income (thereby lowering taxes). They do not represent actual cash flow.
Non cash expenses are not an income statement
category but rather a kind of cost that can appear in any of the
major categories above. The best known non cash item on the income statement is depreciation expense. Others include amortization and writing off of bad debts.
Example income statement
Expenses are center stage in daily operations, budgeting, planning, and preparing the income statement report.
How do expense accounts appear in the accounting system's chart of accounts
A company's spending is tracked and reported through the keeping of expense accounts.
Accounts are the fundamental building blocks of the organization's accounting system, and the complete list of named accounts for the system is the organization's Chart of accounts. Accounts in the list are organized into five categories, one of which is "Expense" accounts. The chart of accounts for organizations that use double-entry bookkeeping and accounting includes:
A. "Balance Sheet" accounts:
1. Asset accounts: Things of value that are owned and used by the business.
Example: Cash on hand
Example: Accounts receivable
2. Liability accounts: Debts that are owed by the business.
Example: Accounts payable
Example: Salaries payable
3. Equity accounts: The owner's claim to business assets.
Example: Owner capital
Example: Retained earnings
B. "Income Statement" accounts"
4. Revenue accounts: The amounts earned from the sale of goods and services.
Example: Product sales revenues
Example: Interest earned revenues
5. Expense accounts: Costs incurred in the course of business.
Example: Direct labor costs
Example: Advertising costs
When funds are paid out, there is a change the balance of the appropriate expense account. In the language of double entry bookkeeping, transactions in these accounts are nearly always debits, which for these accounts means an increase in account balance (the more that is paid out, the higher the debit balance).
Every debit to an expense account will be accompanied by an equal, offsetting credit transaction with an account in another category (e.g., asset account, or liability account). For instance, the company may purchase office supplies (an expense) with cash (an asset). For the purchase, the bookkeeper will record a debit to an expense account (Increasing the expense account's balance) and at the same time enter a credit to "Cash on hand," an asset account (a credit transaction decreases the balance of an asset account).
See the encyclopedia entry double entry system for more on offsetting debit and credit transactions.
How are expense items budgeted? What are the important budget categories?
Expense spending is normally planned, authorized, and managed through budgets developed during the budget cycle in the organization's budget process. Most of this spending appears either in the organization's operating budget or the capital budget, or sub-categories of these (such as the Marketing budget, or the Manufacturing Budget). Some spending of non-budgeted funds may be necessary, however, which may be classified, for instance, as non budgeted spending (or emergency spending, or supplemental funding).
Operating expenses and operating budgets
Operating expenses (OPEX) represent spending incurred by a company in normal operations: salaries and wages, insurance costs, floor space rental, electricity, computer maintenance contracts, software maintenance contracts, and so on. In brief, almost all routine expenditures a company makes are operating expenses, except for a few special non-operating costs (such as costs of financing a loan, or one-time costs for closing a plant), and except for capital expenditures.
The planning and management of operating cost spending is usually accomplished through the organization's operating budget for normal operations. Operating expenses may be budgeted and accounted for on an annual, quarterly, monthly, weekly or even a daily basis.
Operating expenses bring tax savings for the period they are reported. On the income statement, this spending is subtracted from revenues so as to lower income or profit, and that means less tax.
Tax savings = Expense x Tax rate
instance, a company that takes in revenues of $1000 and which pays an
operating income tax rate of 32% would pay taxes of $320 if it had
no expenses. But if the expenses required to produce the revenue were
$600 during the same period, the 32% tax would be applied only to $400
(That is, $1,000-600), yielding a tax of $128. This is a tax savings is
$198, compared to the same revenues with no expenses:
Tax Savings = $600 x 32% = $192
Capital expenditures and capital budgets
A capital expenditure (CAPEX) represents spending that contributes value to the property and equipment base owned by the business. Capital expenditures usually result in the acquisition of capital assets, which become part of the organization's asset base, carried in asset accounts on the balance sheet.
for capital assets are contrasted with spending that covers
operating expenses (OPEX), or investments unrelated to
the company's main business. Capital expenditures usually do not result in tax savings in
the same way that operating costs do (see the section on operating expenses
above). And, Capital spending does not usually enter the income
statement in the same way that operating costs do. Instead, capital
assets acquired with capital spending have a book value that is decreased each year of the asset's depreciable life through depreciation.
Capital spending is normally planned, decided, and managed through a capital budget. This is one of the two majors kinds of budgets at the top of an organization's budget hierarchy, the other being the operating budget. Capital budgets and operating budgets, are built through different processes, by different managers, and they use different criteria for prioritizing and deciding spending.
Whether or not an expenditure is designated a capital expenditure (CAPEX) or an operating expense (OPEX) will depend what is purchased, what it will be used for, and also upon the country's tax laws. Taxpaying organizations and companies typically use specific criteria that must be met for an acquisition to qualify as "capital," such as a minimum useful life (e.g., one year or more) and a minimum purchase price (e.g., $1,000).