Expenses are the goods, services and charges that a business incurs as it functions. It has a debit balance in the ledger accounts when it increases and a credit balance when it decreases. The cost of expenses in relation to earned income determines whether the business makes a profit or a loss.
Money spent can be direct, indirect, operating and non-operating. These terms may sound similar and a student may wonder what is the difference between expenses that are direct and operating or indirect and non-operating.
Here is a simple explanation of these 4 terms:
Direct expenses are monies spent that are directly related to the production of goods or carrying out of services that earns an income for the business. This spending is called Cost of Goods that include Inventory, Purchases of goods for resale and the Carriage inwards of them. It is subtracted from the Sales figure to show how much it costs the business to make Gross Profit in the Income Statement.
A sole trader, partnership, and private or public company have to carefully identify the direct expenses to place under this heading in the Income Statement based on the nature of their business. Every business has its own list of direct expenses so a student must not use the Income Statement format of one business and apply it to another. Here are some examples of direct costs in businesses:
- Salon spends on shampoo, dye, gel, hairspray, and wages of hairdressers
- Taxi service spends on gas, repairs, maintenance, auto insurance, and wages of drivers
- Publisher spends on web development, printing of publication, and salaries of journalists
- Restaurant spends on ingredients, bottled drinks, and wages of servers
- Private school spends on printing of handouts, whiteboard markers, and salaries of teachers
A manufacturing company however uses a Manufacturing account to handle direct costs. This is because the majority of money spent is directly related to producing goods that are sold to earn a profit in the business.
Indirect expenses are monies spent to run the overall business but are not directly related to the goods or services that earn an income. This spending is subtracted from the Gross Profit figure to show the Net Profit in the Income Statement.
In different types of businesses, it is easy to identify the indirect costs once the direct costs are already separated. Some expenses may fall under both headings based on the nature of the business.
In a business such as a private school, teachers’ salaries are directly related to the school’s main operation which is educating students. However, salaries of the maintenance staff is indirectly related to the school’s operations which is keeping the surroundings clean.
Here are some examples of costs that are indirect:
- Carriage outwards
- Discount allowed
- Interest paid
- Advertising and Marketing
- Repairs and Maintenance
- Bad debts
Operating expenses cover all direct expenses and some indirect expenses. These costs make the business operate on a daily basis. Most of the expenses in the Income Statement of the business of a sole trader, partnership, and company are operating expenses.
The operating costs list begins at Cost of Sales and ends just before Net Profit. Any one-time costs that have nothing to do with business operations are not listed before the Net Profit figure.
Here are some operating costs and how they make the business function:
- Cash purchases – you spend instant money on goods for resale from suppliers
- Credit purchases – you spend money on goods for resale from suppliers but you owe them for it
- Carriage inwards – you spend money to transport goods for resale from suppliers into your business
- Carriage outwards – you spend money to transport goods for resale to customers out of your business
- Discount allowed – this is treated as an expense because it adjusts the Sales figure that is deducted
- Returns inwards – this is treated as an expense because it adjusts the Sales figure that is deducted
- Rent – you spend money when you pay a landlord for space to run your business for a period
- Repairs – you spend money to fix assets that you use to run your business
- Utilities – you spend money on light, internet, phone and water used to run your business
- Salaries and wages – you spend money on labour provided by your staff
- Insurance – you spend money for protection of a possible eventuality such as fire, flood, accident
- Tax – you spend money on a mandatory contribution to state revenue
Non-operating expenses are costs incurred but are not related to the production of goods, carrying out of services, or the running of the business. These are one-time costs that occur in small businesses occasionally but happen often in large businesses.
Here are some common types of non-operating expenses:
- Interest payments on loans
- Losses from investments
- Losses on sale or write-off of assets
- Inventory write-downs or write-off of unsold inventory that has become obsolete
- Lawsuit settlements
- Restructuring costs to improve competitiveness or business efficiency
- Currency fluctuations in exchange rates that lead to losses
- Natural disasters
- Changes in accounting principles