Expenses Simplified: What You Need To Know

The spotlight often shines on revenue and profit. Yet, hiding in plain sight of every income statement is a critical factor that can make or break success: expenses. Thoroughly managing them lays the foundation for profit generation and sustainable company growth. 

So, what are expenses, and why do they matter?

What Are Expenses

Expenses are the costs incurred to run and manage operations, generate revenue and make investments. In other words, expenses are outflows of economic resources.

Expenses are deducted from a company’s revenue to calculate its profit. So, if a company generated £12 million in revenue and incurred £5 million in business expenses, its profit would equal £7 million (£12 million – £5 million). 

If a company had more expenses than revenue, it would make a loss – the company spent more than it earned.

How Expenses Are Recorded

In financial accounting, there are two bases for recording expenses:

1. Cash Basis Accounting
2. Accrual Basis Accounting

Cash Basis Accounting

Under cash-based accounting, expenses are recorded when cash is paid, not when the good or service is received. So, if an entity pays for electricity quarterly (every three months), the total bill would be recorded and expensed every third month (when the bill is paid). 

For example, if a company’s electricity bill is £6,000 for the three months ending 31 December, £6,000 would be expensed in December (when the bill is paid).

Accruals Basis Accounting

On the contrary, the accruals accounting system (the system most companies use) requires that an entity record expenses when the benefit is received/consumed, not when cash is paid. 

If an entity uses electricity for three months and pays the bill in the third month, the electricity bill would be recorded equally across the three months.

Using the same example as earlier, if the electricity bill is £6,000 for the three months ending 31 December, £2,000 will be recorded each month-end (October, November and December).

It is worth noting that the company won’t pay £2,000 in these months. £2,000 would be recorded in the company’s accounts monthly, but the bill would be paid in December.

The accruals basis concept only matches expenses to when the entity benefited from them. 

Types of Expenses

Expenses are broadly categorised based on their function, relationship to revenue and overall impact on financial statements.

The three main categories of expenses include the following.

Cost of Goods Sold (COGS)

Also called cost of sales (COS), cost of goods sold represents the direct expenses associated with producing goods or services.

‘Cost of Goods Sold’ is primarily used by companies that make and sell physical goods, while ‘Cost of Sales’ is used by companies that predominantly sell services.

Some common examples of what make up a company’s COGS include:

• Direct material costs – the cost for all the materials and components required for production.
• Direct labour costs – the wages for all employees directly involved in production.
• Direct manufacturing costs – the costs of equipment and facilities used in production.

Costs of goods sold are presented on a company’s income statement and are deducted from revenue to arrive at gross profit.

N.B. Some software and service-based companies have no cost of sales. Therefore, gross profit would be the same as revenue.

Operating Expenses (OpEx)

Operating expenses, often abbreviated as OpEx, are the recurring costs of running an entity’s day-to-day operations. These expenses ensure a business can open its doors day after day and continue serving its customers.

Some common examples of operating expenses include:

• Rent & Utilities –  Office space, electricity, water and internet service bills.
• Marketing & Advertising – Costs for product/service promotions and other related activities.
• Wages & Salaries – Cash and stock-based compensation for employees.

Operating expenses are presented on a company’s income statement and are deducted from gross profit to arrive at operating profit.

Non-Operating Expenses

Non-operating expenses arise from activities unrelated to a company’s core operations but still affect its profit. 

Some common examples of non-operating expenses include:

• Interest Expenses – The borrowing costs on loans and other debt obligations.
• Investment Losses – The losses from poor-performing investments.
• Currency Losses – Losses due to changes in exchange rates.

Since they don’t arise from a company’s core operations, non-operating expenses are presented as separate line items on an income statement, typically after calculating operating profit.

Other Categories of Expenses

Apart from the three categories above, other expense types include:

• Fixed Expenses – Costs that do not change with a change in business production (e.g. rent). 
• Variable Expenses – Costs that fluctuate with changes in production (e.g. direct materials).
• Accrued Expenses – Costs an entity incurs when it consumes a benefit (good or service) but hasn’t paid for it. These expenses are sometimes called ‘expenses owing.’
• Prepaid Expenses – Amounts paid before receiving a benefit (good or service).

Why Expenses Matter

Effective management of expenses is essential for achieving both short-term and long-term success.

Here are some reasons why expenses matter.

Impacts on Profitability

Expenses are deducted from revenue to calculate a company’s profit. Because profit is a primary measure of financial success, companies aim to keep costs to a minimum without negatively affecting their operations.

A trend of declining profitability leads to unsatisfied investors, who may withdraw their funds due to poor company performance. If left unchecked, these high expenses can further run a company into financial hardship and, maybe, bankruptcy.

Performance Evaluation

Detailed expense analysis reveals where a company can be more operationally efficient. 

Detecting high or unnecessary expenses enables companies to streamline operations by reducing/removing costs where possible, investing in cost-saving technologies, negotiating better rates (say, on rent) or finding cheaper alternatives to the materials used in production without sacrificing quality. 

By removing operational inefficiencies, productivity will increase, resulting in lower expenses (and higher profit).

Tax Implications

Certain business expenses are tax-deductible – they reduce a company’s taxable income. Since the corporate tax rate is applied to a company’s taxable income (profit before tax), the lower the taxable income, the lower the tax bill.

Because expenses reduce a company’s taxable income and, hence, its tax bill, individuals might think higher costs may be beneficial. And to a certain degree, it may be – but it’s a delicate dance.

Take the following table as an example.

Both companies generated the same revenue but with different levels of expenses. 

Assuming a 25% corporate tax rate, these differences led to Pattern Group paying considerably less tax than Example Industries (£500k versus £1.25m).

But even though Pattern Group saved £750,000 in corporate taxes (relative to Example Industries), the company is £2,250,000 worse off in net profit. 

This is the delicate dance referred to earlier. Expenses reduce a company’s tax bill, but at what cost?

Factors Affecting Expenses

Business expenses are impacted by several factors, both internally and externally.

Some of these factors include the following.

Location

Location has a significant impact on a company’s expenses, especially rent.

Companies that operate in high-demand areas like city centres often experience higher expenses. For example, office space in central London is appreciably more expensive than office space in smaller towns.

A company’s location also impacts transportation costs, especially for manufacturers and retailers. Companies near suppliers, customers, distribution centres and transportation hubs often face lower logistics costs. 

Inflation

Inflation notably impacts expenses. It increases the costs of goods, services and other resources necessary for business operations.

In manufacturing and retail companies, inflation drives up the costs of raw materials, directly raising the cost of production. Higher production costs reduce a company’s profitability unless selling prices are adjusted upward to offset the higher costs.

Inflation also increases energy costs. Rising energy costs increase electricity and gas expenses for all businesses and are especially felt by companies in high utility consumption industries.

Supply Chain

A company’s supply chain influences the cost of sourcing and the delivery of goods.

A change in supplier pricing affects the cost of raw materials and supplies. If suppliers increase the price of raw materials, a company will face higher material costs and, consequently, higher production costs.

Companies also rely on third parties for product delivery to customers. When issues with these third parties arise, such as delays, companies often bear the brunt of the mishap. Severe delays may result in order cancellations and revenue loss for the company. 

Rounding It All Up!

Expenses represent the costs incurred from doing business. When managed well, they support profitability and efficient operations. When unmanaged, they can undermine financial success.

Expenses fall into categories like Cost of Goods Sold (COGS), operating expenses (OpEx), and non-operating expenses, each impacting profit differently. 

COGS includes direct production costs, while OpEx covers recurring costs like rent and salaries. Non-operating expenses capture costs outside core operations, such as interest expense and investment losses.

Factors like location, inflation and supply chain dynamics significantly impact expenses. By strategically managing costs, companies can improve profitability and operational efficiency and ensure long-term sustainable growth.