Expenses are the cost of various resources that are consumed in running a business.
In this post, I will explain the most common types of expenses that are encountered by businesses, how to differentiate between them, and what you need to know to classify them correctly in the financial statements.
Following are the main types of expenses:
- Cost of goods sold
- Selling and distribution expenses
- Operating, general and administrative expenses
- Salaries, wages, and benefits
- Rent expense
- Cost of utilities
- Provisions and impairments
- Depreciation expense
- Amortization expense
- Research and development costs
- Printing and stationery expense
- Staff traveling expense
- Repair and maintenance expense
- Insurance cost
- Legal and professional charges
- Communication expense
- Miscellaneous expenses
- Finance cost
- Taxation
Cost of Goods Sold
The cost of goods sold is the cost of manufacturing or acquisition of the goods that have been sold to customers during an accounting period. It is subtracted from the sales revenue to calculate the gross profit in the income statement.
The calculation of the cost of goods sold is pretty straight forward for retail businesses, as you can learn from the example below.
Example
Jim sells imported musical instruments at his store.
Jim can calculate his cost of selling musical instruments during an accounting period as follows:
Value of inventory at the start of the period
Add
Cost of new instruments purchased during the accounting period
Less
Value of inventory unsold at the end of the period
Equals
Cost of goods sold
When calculating the cost of goods sold for a manufacturing business, we need to take into account the cost of all inputs used in the production process.
These include the costs associated with the raw materials and direct labor, as well as indirect expenses such as electricity consumed in the manufacturing process and depreciation expense of the production equipment.
The cost of goods sold does not include any cost incurred on inventory that is unsold at the end of an accounting period, which is why it needs to be subtracted from its calculation.
Example
Cynthia is an expert guitar smith. Each year she hand-crafts some of the finest acoustic guitars for her clients.
Cynthia can calculate her cost of selling guitars during an accounting period as follows:
Value of inventory at the start of the period
Add: Production cost during the period
-Cost of production materials purchased during the period such as wood, strings, polish, and guitar cases.
-Payroll cost of the production assistant.
-Electricity charges relating to the production workshop.
-Rent expense relating to the production workshop.
-Depreciation expense of equipment used in the production of guitars.
Less: Value of inventory unsold at the end of the period
Equals: Cost of goods sold
Selling and distribution expenses
Selling and distribution expenses include any costs that relate to the sales and distribution activities of a business. These include:
- Cost of shipping goods to customers.
- Commission and royalties on sales revenue.
- Salaries and wages of sales and distribution staff.
- Promotion and marketing expenses.
- Operational costs of sales offices such as electricity and rent.
- Operational costs of distribution, such as the cost of fuel used in making deliveries to customers.
- Depreciation of delivery vans and fixtures installed in retail outlets.
Tip
When promotion and marketing expenses are significant, it is more appropriate to show them separately from selling and distribution expenses.
Operating, General & Administrative expenses
This is the default category for any expenses that cannot be directly identified with the cost of sales, selling expenses, finance cost, or taxation.
The following sections describe the common types of costs that are typically included in the operating, general and administrative expenses.
Salaries, wages, and Benefits
Salaries, wages, and benefits expenses include the payroll cost of permanent and temporary employees of an organization for their services during an accounting period.
One thing you need to keep in mind when preparing financial statements of sole traders and partnerships is that the salary of owners is not considered as an expense of the business. Payment to owners are treated as a distribution of profits and are subtracted directly from the equity.
It is also important to remember not to include the salaries of employees involved in the production or sales processes in the operating, general, and administrative costs. The payroll cost of such employees should be included in the cost of sales and selling expenses instead.
Tip
The cost of employees that work on creating a long term asset for the business, such as a building or a website is not expensed immediately in the income statement.
Instead, it is added to the cost of the asset and charged as a depreciation or impairment expense over its useful life.
Rent Expense
The cost of renting property of any kind is charged as a rent expense.
When cash basis of accounting is used, the rent expense for an accounting period is equal to the rent paid during an accounting period.
The calculation of the rent expense on the accruals basis is slightly more complicated as it involves the accountant to track the period of lease that falls within the accounting period rather than just the cash flow.
Tip
The cost of rent relating to production and sales activities are charged to the cost of sales and selling expenses instead of operating, general, and administrative expenses.
If the production and sales activities take place within the same building as the administrative activities of a business, it will be necessary to split the total cost of rent between:
- Cost of sales,
- Selling expenses, and
- Operating, general, and administrative expenses
using an appropriate basis (e.g., covered area).
Electricity & Power
This includes the cost of electricity, natural gas, and the running cost of backup generators.
As with the cost of rent, the portion of electricity and power expense relating to production and sales activities needs to presented in the cost of sales and selling expenses.
Tip
When a business invests in its own source of electricity, through, for example, a power plant, a solar system, or a wind turbine, it will be necessary to capitalize its cost and depreciate it as an electricity and power expense over its useful life.
Provisions For bad Debts and Doubtful Receivables
When a business makes a sale on credit, there is a risk that the customer will never return the amount owed to the business. The same is true, of course, for companies that lend money to others for profit, such as banks.
Whenever a business suspects that it may not recover the full amount of its receivables, it should record the loss immediately in its income statement in line with the prudence concept.
A bad debt expense is recorded for any specific receivables that are unlikely to pay back (e.g., any customers who have filed for bankruptcy).
A provision for doubtful debts is necessary to account for any non-payments that are not yet obvious but can be reasonably expected.
Recording the bad debt expense and the provision for doubtful receivables brings the value of the receivables shown in the balance sheet closer to what is likely to be received by the business in the future.
Example
Amanda is a budding freelance illustrator. At the end of the first accounting period, she has outstanding receivables of $4000 out of which $200 is due from a client that is very unlikely to pay back due to a dispute concerning the work specification.
In the freelance illustration business, it is common for artists not to receive any payment for up to 10 percent of their work.
Amanda should record a bad debt expense of $200 and a provision for doubtful debts of $380 [($4000 - $200) * 10%] on the remaining receivables. Total expense for bad debts and provision for doubtful debts will be $580 ($200 + $380), and the value of receivables in her balance sheet will be $3520 ($4000 - $580).
Depreciation
The cost of a long term asset, such as a building, is not expensed entirely in a single accounting period. Instead, its cost is spread over its useful life in the form of depreciation.
You can calculate depreciation expense by dividing the depreciable amount of an asset (i.e., cost minus its value at the end of its useful life) over its useful life.
Example
A firm of accountants acquires a new office for $100,000.
The office building has an estimated useful life of 20 years at the end of which it is likely to be sold for $80,000.
The building is expected to depreciate evenly over its useful life.
The annual depreciation expense will be $1000, which is calculated by dividing the building's depreciable value ($100,000 - $80,000) with its useful life (20 years).
Amortization
Amortization expense is the equivalent of depreciation for intangible long term assets that do not have any physical form such as software, trademarks, and patents.
Example
Bill hired a web developer to build a website for his consultancy business.
The developer charged $10,000 for the website and estimates it will become obsolete in 5 years.
The annual amortization expense will be $2000 which is calculated by dividing the amortizable value of the website ($10,000) with its useful life (5 years).
Research and Development
Organizations are continually looking for ways to improve their products, processes, and understanding of customers and markets, which is why they are willing to invest substantial sums on research activities.
Under US GAAP, research and development costs are recorded as an expense in the accounting period in which they are incurred.
Printing & Stationery
Examples of costs that are part of the printing and stationery expense include:
- The purchase cost of office stationery
- Printing cost of business documents such as memos, receipts, vouchers, letterheads, etc.
- Cost of photocopies
The cost of printing materials for marketing, such as brochures and pamphlets, is included in the marketing expenses, so do not need to be shown here.
Tip
Printing and stationery expense is an administrative expense for the vast majority of organizations.
An exception to this would be a retailer of stationery supplies or a printing press, in which case you will show these expenses as a part of the cost of sales.
Staff Travelling
Staff traveling expense includes the cost of any travel by the employees that is borne by the employer for attending business meetings, conferences, site visits, etc., that are held outside of their usual workplace.
Repairs & Maintenance
Repair and maintenance expenses help to keep the assets of a business in good shape.
As with depreciation expense, repair and maintenance expenses need to be allocated between the cost of sales, selling expenses, and operating cost depending on where the assets are in use.
Insurance Cost
Organizations need to insure their assets against a range of adversities, such as the outbreak of fire, earthquakes, theft, and diseases.
Insurance cost is not capitalized in the balance sheet because it is a recurring expense that is necessary to preserve rather than enhance an asset’s usefulness.
It is common practice for insurance costs to be paid in advance to the insurance companies, so businesses need to treat it as a prepaid cost that is expensed over the insurance term.
Legal & Professional Charges
Organizations frequently require external help from professionals such as CPAs, lawyers, and consultants to fill the gap between their requirements and the availability of internal resources.
Usually, the cost of hiring external professionals is charged as an expense in the accounting period in which the related services are acquired.
An exception to this rule is where the services are obtained in relation to the acquisition of an asset, in which case its cost is accumulated in the cost of that asset. An example of this is the legal expense incurred on the purchase of a building.
Communication Expense
Examples of costs that are classified as a communication expense are:
- Phone charges
- Cost of internet
- Cost of mailing business correspondence
Miscellaneous Expenses
The expense accounts listed above are usually sufficient to cater for all types of business expenditures.
From time to time, however, you will stumble upon an expense that is too insignificant to create a separate category and which neither fits any of the categories of expenses that are created.
In such cases, it would make sense to compile such expenses under the miscellaneous expenses. An example of a miscellaneous expense is the cost of staff uniforms.
Finance Cost
Finance cost is the cost of borrowing money, which includes the interest charged on bank loans, overdraft fees, and dividends on redeemable shares.
Tip
Payment of dividends on ordinary share capital is not considered as an expense of the company but treated as a distribution to owners.
Taxation
Taxation expense includes any income tax, capital gains tax, and property tax due on the taxable assets and transactions of a business.
Tip
Any tax that is collected by a business on behalf of the IRS, such as the income tax on the salaries of employees that is deducted at source by the employers, is not treated as an expense of the business.
This is because the business is not paying such taxes out of its own resources but from the income that is withheld from others.
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