What it means
In everyday speech cost and expense mean much the same thing, but in accounting there is a useful distinction. A cost is what you paid to acquire something, and it becomes an expense at the moment its value is consumed in earning revenue, which is why unsold inventory is an asset while sold inventory is an expense.
The costs and expenses block is where readers of an income statement work out how the money was actually spent. Grouping the lines this way lets you see at a glance whether a company is spending most of its money making the product, selling it, or administering itself.
The standard structure runs from most direct to least direct. Cost of revenue comes first, then selling and marketing, then research and development, then general and administrative, with any one-off items such as restructuring charges shown separately so they do not distort the trend.
The point of the discipline is comparability across periods. If sales and marketing is 17.5% of revenue this year against 22% last year, that single change tells you more about the state of the business than almost any absolute dollar figure could.
A common source of confusion is that not every cash payment is an expense and not every expense is a cash payment. Buying a machine is capital expenditure that appears as depreciation over several years, while depreciation itself is an expense with no cash leaving the bank in the period it is recorded.
In practice
Real-world examples.
Example
A board reviewing a quarterly income statement notices total costs and expenses rose 18% while revenue rose 6%. Breaking the block into its components shows the whole increase sat in general and administrative costs after an office move and two senior hires. The board asks for a twelve-month view before approving any further central headcount.
Example
A grant-funded research institute must report costs and expenses split between programme delivery and support functions. Presenting 82% of spending as programme costs and 18% as support helps it satisfy funders who cap administrative overhead at 20%.
Example
A retailer preparing for a bank refinancing reclassifies its store fit-out spend from expenses to capital expenditure, depreciated over eight years. Operating income improves in the current year, but the finance director flags the change explicitly in the notes so the lender is not comparing two different treatments.
Formula
Calculation
Total costs and expenses = cost of revenue + operating expenses + any other operating charges.
Operating income = revenue - total costs and expenses.
Take a company with annual revenue of $12,000,000. Its cost of revenue is $6,600,000, selling and marketing costs $2,100,000, research and development $1,200,000, and general and administrative expenses $900,000.
Total costs and expenses = $6,600,000 + $2,100,000 + $1,200,000 + $900,000 = $10,800,000.
Operating income = $12,000,000 - $10,800,000 = $1,200,000, an operating margin of $1,200,000 / $12,000,000 = 10%.
Gross profit, for context, is $12,000,000 - $6,600,000 = $5,400,000, a gross margin of 45%, so the operating expenses of $4,200,000 consume 35 percentage points of that 45%.Case study
Seen in the real world.
Ridgeway Instruments is an entirely fictional manufacturer used here as an illustrative example. It reported revenue of $12,000,000, total costs and expenses of $10,800,000, and operating income of $1,200,000, giving a 10% operating margin that the management team was reasonably happy with.
The problem was that everything below cost of revenue had been lumped into a single line called overheads. When the finance manager split the $4,200,000 into selling and marketing of $2,100,000, research and development of $1,200,000 and general and administrative of $900,000, the picture changed. Marketing spend was equal to 17.5% of revenue, while research, in a business that competed on technical specification, was only 10%.
The illustrative outcome was a deliberate reallocation over two years: marketing was trimmed to $1,700,000 and research increased to $1,600,000, holding total costs and expenses flat. Nothing about the bottom line moved in year one, but two new product lines emerged from the larger research budget, which the old single-line presentation would never have prompted anyone to consider.
Watch out
Common mistakes.
- Using cost and expense as strict synonyms in financial reporting. A cost sits on the balance sheet as an asset until it is consumed, at which point it becomes an expense on the income statement.
- Judging the block by its total alone. A rising total is perfectly healthy when revenue is rising faster, so always look at each component as a percentage of revenue.
- Burying one-off items such as restructuring or legal settlements inside ordinary operating lines. It makes the year-on-year trend meaningless and tends to erode trust once discovered.
Questions
People also ask.
Where do interest and tax sit?
Below the operating result, because they relate to how the business is financed and taxed rather than to how it operates, which is why operating income is measured before both.
Is capital expenditure part of costs and expenses?
Not directly, since buying a long-lived asset creates an asset on the balance sheet, and only the depreciation of that asset each period appears within costs and expenses.
Why do companies show costs and expenses as percentages of revenue?
Because the ratios make different periods and different sized companies comparable, and they reveal a change in spending discipline far faster than absolute dollars do.
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