Expense
Encyclopedia of Business Terms and Methods, ISBN 978-1-929500-10-9. Copyright © 2011 by Marty J.Schmidt. Revised 13 January 2012.
The Meaning of Expense, Expense Categories, and Expense Accounts
Expense is an accounting and budgeting term usually referring to something something a company or organization spends money on. More precisely and more broadly, however, an expense is 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. Every expense transaction calls for an impact on an expense category account. The broader definition also covers non cash expenses, such as depreciation expense or bad debt expense.
This item further defines and illustrates major expense terms including cost of goods sold (CGS), Cost of services, cost of sales, selling general and administrative expense (SG&A), along with major expense categories such as::
• Expense Items on the Income Statement
– Income Statement Expense Categories and Examples
– Expense Impact on Gross Profit, Operating Profit, and Net Profit
– Expenses: Example Income Statement
• Expense Accounts in the Accounting System Chart of Accounts
• Budgeting Expense Categories
– Operating Expenses and Operating Budgets
– Capital Expenditures and Capital Budgets
Expense Items 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 and outgoing expenses. The basic income statement equation shows how the statement is "about" revenues and expenses 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
Income Statement Expense Categories and Examples
Expenses and expense category accounts appear under four or five major categories on the income statement:
- Expenses for Cost of goods sold (COGS) (or Cost of sales). These are the expenses directly associated with producing goods or delivering services.
Example may include:
• Direct materials expense 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 expense.
– Depreciation expense of production equipment.
– Other manufacturing / production / delivery overhead.
• Indirect costs of service deliveryCost 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. For companies that sell services rather than manufactured products, the comparable costs of services delivery are reported as Cost of Services. Companies that sell both services and manufactured products report their direct costs for services delivery and product production as Cost of Sales.
In manufacturing companies, CGS generally has three main components: direct labor, direct materials, and manufacturing overhead. (In companies where the products include service delivery, cost of goods sold may instead be called Cost of Sales or Cost of Services, putting the direct and indirect costs of service delivery in this category instead of manufacturing costs).
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 Expenses. These are the expenses for selling, including such things as:
• Store/shop rental, maintenance expense.
• Sales salaries, commissions.
• Advertising expense.
• Depreciation expense for selling assets
(e.g., bar code reading point-of-sale systems). - Operating Expenses - General & Administrative Expenses. 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.
• Expenses for travel and training.
• IT support expenses (when IT supports the entire organization).
• Depreciation expense for Property, Plant & Equipment assets
and other assets not solely dedicated to manufacturing or sales.General and administrative expenses is an an income statement category, for expenses and costs not linked to the production of specific goods, but including general company expenses such as salaries for executives, research, facilities maintenance, and office supplies.
General and administrative expenses are more likely to be listed on the income statement with the term Selling, General and administrative expenses (or SG&A). (in which case selling expenses are also included). These expenses may also be listed on the income statement under "Operating expenses."
As an income statement category, Selling, general, and administrative expenses is sometimes used synonymously with the term Operating expenses. - Financial Expenses (for companies not in a financial industry)
These are expenses 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 expenses for one time events or transactions, or non recurring actions that are not part of the company's normal business operations. These may include expenses from
• Workforce reduction, laying off employees.
• Sale of land, buildings, or real estate.
• Sale or disposal of other significant assets.
• Selling a business.
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Expense Contribution to Gross Profit, Operating Profit, and Net Profit
Knowing which of the above four high level expense categories a given expense item belongs in is important for at least two reasons:
- The expense category determines which expense budget includes this item, and
- The expense category determines which of the several profit calculations on a company's income statement the expense 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 have to be determined by an arbitrarily set allocation percentage.
Operating Expenses (usually classified as Selling, General, and Administrative Expenses, or divided into two categories, "Selling" and
General and Administrative") are subtracted from Sales revenues—along with Cost of goods sold expenses—to produce operating profit and operating margin.
Because Selling, General and Administrative expenses appear below (after) gross profit, they do not not enter the gross margin calculation. For this reason, SG&A expenses are sometimes called "below the line" costs.
Extraordinary item expenses and Financial item expenses 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).
All expenses on the income statement impact, of course, to the company's reported "bottom line" net profit.
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Expenses: Example Income Statement
A example of a typical company's income statement showing the expense categories, and how they contribute to different profits, appears here:
Grande Corporation Gross sales revenues.................33,329 Gross profit.................................10,940 Operating expenses Operating income before taxes............... 3,130 Financial revenue & expenses Income before tax & extraordinary items..... 2,737 Extraordinary items Net Income (Profit).......................... 2,126
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Expense Accounts in the Accounting System's Chart of Accounts
A company's expense 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 the 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 expenses
When funds are paid out to meet an expense, there is a change the balance of the appropriate expense account. In the language of double entry bookkeeping, transactions in the expense category 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 a non-expense category account (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 (Iincreasing 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).
Budgeting Expense Categories
Expense spending is normally planned, authorized, and managed through budgets developed during the budget cycle in the organization's budget process. Most expense 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) are non-capital expenses 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 expenses (such as costs of financing a loan, or one-time costs for closing a plant), and except for capital expenditures (see assets and capital budget). For more explanation of operating expense budgeting and spending, see the encyclopedia entry for Operating budget..
Operating expenses do brings some tax savings. On the income statement, expenses are subtracted from revenues so as to lower income or profit, and that means less tax.
Tax Savings on Expense = Expense x Tax Rate
For 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 on Expense = $600 x 32% = $192
The planning and management of operating expense 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 budgets for a company or organization are especially likely to be organized hierarchically (see the entry budget for examples). A company's overall operating budget, for instance may be subdivided into operating budgets for different departments (Marketing, Engineering, Customer Services, IT Manufacturing, etc). Each Departmental budget may be further subdivided into budgets for different functions (.e.g., Marketing budgets for advertising, for advertising agency expenses, for marketing events, and so on).
Capital Expenditures and Capital Budgets
A capital expenditure (CAPEX) is an expenditure (expense) that contributes contributing value to the property and equipment 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.
Expenditures for capital assets are contrasted with spending that covers operating expenses (OPEX), or purchase investments unrelated to business. Captial expenditures usually do not result in tax savings in the same way that operating expenses do (see the section on operating expenses above). And, Capital spending does not usually enter the income statement in the same way that operating expenses do. Instead, capital assets acquired with capital spending have a book value that is decreased each year (of the asset's depreciable life) by application of depreciation expense.
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. These two kinds of budgets do not overlap: they handle distinctly different spending categories. Capital and operating budgets, moreover, are built through different budgeting 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).
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