What it means
Every business spends money, but not every payment is an expense. Accounting separates spending that is consumed in running the business today, which is an expense, from spending that buys something lasting, which is an asset.
A coffee machine that will serve the office for five years is an asset, while the coffee beans are an expense. Expenses are recorded under the matching principle, which says costs should appear in the same period as the revenue they helped to create.
That is why a business recognises its insurance cost month by month even if it paid for the full year up front. The unused portion sits on the balance sheet as a prepaid asset until it is used.
Common expense categories include cost of goods sold (the direct cost of producing what was sold), salaries, rent, utilities, marketing, depreciation and interest. Operating expenses are those linked to running the business, while non-operating expenses, such as interest on loans, relate to financing.
Grouping them helps managers see where money is going and which costs move with sales. Expenses are different from cash payments because of timing.
Under accrual accounting an expense is recorded when it is incurred, so a bill received in December for December services is a December expense even if it is paid in January. Depreciation is the clearest example of an expense that involves no cash payment at all in the period.
Managers use expense reports to control costs, compare actual spending with budgets and set prices. They also need to separate fixed expenses, which stay the same regardless of activity, from variable expenses, which rise and fall with volume.
That split is the foundation of break-even analysis and many pricing decisions. Tax adds another layer.
Most jurisdictions allow businesses to deduct genuine business expenses from taxable profit, but the rules on what qualifies vary and some items, such as entertainment, may be limited. Keeping receipts and clear records protects the deduction.
In practice
Real-world examples
Example 1
A bakery buys flour, butter and sugar each week and uses it all in the loaves it sells. These materials are expenses in the week they are consumed, and they feed directly into the cost of goods sold figure.
Example 2
A consulting firm pays $24,000 for a year of insurance in January. It records $2,000 of insurance expense each month and holds the remaining balance as a prepaid asset, which falls month by month.
Example 3
A manufacturer buys a $90,000 machine expected to last ten years. It does not treat the whole $90,000 as an expense in year one; instead it records $9,000 of depreciation expense each year across the machine's life.
Think of it
Expenses are like the costs of running a lemonade stand-the lemons, sugar, cups, and maybe even a permit. You have to spend money to make money.
Formula
Calculation
Net profit = Revenue - Total expenses
Consider Larkspur Design, a fictional studio, with annual revenue of $480,000. Its expenses are cost of sales $210,000, salaries $120,000, rent $36,000, marketing $24,000 and other costs $30,000. Total expenses are $210,000 + $120,000 + $36,000 + $24,000 + $30,000 = $420,000. Net profit is therefore $480,000 - $420,000 = $60,000. Expenses are 420,000 / 480,000 = 87.5% of revenue, leaving a net margin of 12.5%.Case study
Seen in the real world
Cobalt Courier is an illustrative, fictional delivery start-up. In its first year the owner judged success by the bank balance, which looked healthy because customers prepaid for annual contracts.
The accountant pointed out that the cash included money for services not yet delivered, and that several costs, such as vehicle servicing and a large insurance renewal, had been paid late or not yet billed. When all of the year's expenses were recorded in the right period, the apparent cash surplus of $140,000 turned into a profit of only $35,000.
In the illustrative follow-up, the owner switched to monthly accrual-based reporting and compared expenses with budget each month. The change revealed that fuel expenses were running 20% above plan, and a route redesign brought them back into line within a quarter.
Watch out
Common mistakes
- Treating every cash payment as an expense, when buying equipment or repaying a loan does not appear as an expense in the same way.
- Recording an expense only when it is paid, instead of when it is incurred, which misstates profit for the period.
- Mixing personal and business spending, which makes expense records unreliable and can cause tax problems.
Questions
People also ask
What is the difference between an expense and a cost?
A cost is any sacrifice of resources, while an expense is the part of cost that has been used up in earning revenue during the period.
Is depreciation an expense?
Yes, it spreads the cost of a long-lived asset over its useful life, and it reduces profit without any cash leaving the business in that period.
What is the difference between an expense and an expenditure?
An expenditure is the act of spending money or incurring a liability, while an expense is the portion that is recognised in the income statement.
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