Business people use two terms – "cost" and "expense" – every day. But what do these two terms mean? Are they just different words for the same concept?
We use the two terms interchangeably in our business conversations, but they have different meanings and applications in business. We'll look at cost and expense –in general, and then as they apply to business accounting and taxes.
Costs and Expenses Compared
First, a general definition of both terms:
Cost is "an amount that has to be paid or spent to buy or obtain something." Cost can be specific, like, "What's the cost of that car?" or it can be a penalty, like "Consider the cost of missing that event."
Notice also that cost implies a one-time event, like a purchase. The term "cost" is often used in business in the context of marketing and pricing strategies, while the term "expense" implies something more formal and something related to the business balance sheet and taxes.
The definition of expense sounds similar to that of cost: "an amount of money that must be spent especially regularly to pay for something." But notice the words "especially regularly."
- the cost of a product is often linked to the price to the producer or seller.
- Expenses show up on your business profit and loss statement.
An expense is an ongoing payment, like utilities, rent, payroll, and marketing. For example, the expense of rent is needed to have a location to sell from, to produce revenue.
You can also consider an expense as money you spend to generate revenue.
- You need to spend money on advertising to get customers and on a phone number to get them to call you
- You need to spend money on rent and utilities if you want to have a retail store
- You need to spend money on a web page to get customers over the internet
There is usually no asset (something of value) associated with an expense. Buying a building is a cost; the cost is the one-time price you pay. Paying interest every month on your mortgage for that building is an expense. Although we use the term "cost" with expenses, they are really just payments.
Costs vs. Expenses in Accounting
Accounting types use the term "cost" to describe several different instances in business situations.
Fixed and Variable Costs. Cost accountants spend there time looking at costs associated with making a product or providing services, to prepare budgets and analyze profits.
Cost of goods sold. The term cost of goods sold refers to the calculation done at the end of an accounting year for businesses that sell products. The cost of goods sold includes several different types of costs:
Direct costs to make and ship products:
- Products bought for resale
- Raw materials to make products
- Packaging and shipping products to customers
- Inventory of finished products
- Direct overhead costs for utilities and rent for a warehouse or factory
Indirect costs like labor, storage costs, and pay of supervisors for the factory or warehouse.
Cost in Accounting
Accountants use cost to refer specifically to business assets, and even more specifically to assets that are depreciated (called depreciable assets). The cost (sometimes called cost basis) of an asset includes every cost to buy, deliver, and set up the asset, and to train employees in its use.
For example, if a manufacturing business buys a machine, the cost includes shipping, set-up, and training. Cost basis is used to establish the basis for depreciation and other tax factors.
The cost of assets shows up on the business accounting on the balance sheet. The original cost will always be shown, then accumulated depreciation will be subtracted, with the result as book value of that asset. All the business assets are combined for the purpose of the balance sheet.
Expenses in Accounting
Expenses in accounting are used to determine profit. The calculation for profit is: Income minus Expenses Equals Profit. Accountants look at two kinds of expenses: fixed and variable.
- Fixed expenses must be paid every month even if there are no sales.
- Variable expenses change with the level of sales.
Keeping track of fixed and variable expenses can be helpful in determining the breakeven point for product pricing. More important, it's a budgeting tool to minimize fixed costs when times get tough.
Cost vs. Expenses and Taxes
Expenses are used to produce revenue and they are deductible on your business tax return, reducing the business's income tax bill. To be deductible, they must be "ordinary and necessary" to the business.
Costs don't directly affect taxes, but the cost of an asset is used to determine the depreciation expense for each year, which is a deductible business expense. Depreciation is considered a "non-cash expense" because no one writes a check for depreciation, but the business can use it to reduce income for tax purposes.
The Bottom Line on Costs vs. Expenses
While there are exceptions, in general, for both accounting and tax purposes:
COSTS are related to buying business assets. They are shown on the business balance sheet. The cost of an asset is usually depreciated (spread over time).
EXPENSES are related to business expenditures over time, and they are shown on the business net income (profit and loss) statement. Most ordinary and necessary business expenses can be deducted on the business tax return.