In business the terms “costs” and “expenses” are commonly used interchangeably and, whilst this is fine in everyday conversation, it’s good practice to define the difference when we’re talking about a business situation.
The reason for this is that costs and expenses are recorded differently in a business’s accounts and, in some cases, have different tax implications.
So, getting into the mindset of using the terms costs and expenses correctly will help you no end when it comes to bookkeeping. It will also give you a clearer understanding of how your business is performing and how you might improve its profitability.
Here we’ll look at the main difference between costs and expenses and give some examples of each. We’ll also look at how to record them and what is allowable against tax.
What are business costs?
There are different types of cost that are important to a business; fixed, variable, and asset costs.
The best way to think of what is meant by fixed costs, is to think of them as anything which you don’t have daily or weekly control over. So, for example, items that could be considered as fixed costs could be:
- Property rental
- Insurance premiums
- Fixed salaries
- Interest payments on loans or mortgages
- Utility contracts
- Phone contracts
- Maintenance contracts
Variable costs are generally those that are dependent on business activity – that is, the more business you do, the more of these costs you’ll have, for example:
- Hourly paid and piece work labour costs
- Utility and phone bills (as opposed to the cost of contracts)
Asset costs can also fall into the term fixed costs, but it’s worth differentiating what it means, because they are treated differently for tax purposes.
Generally, an asset cost is anything that is intended to be held for at least 2 years and can include:
- Purchase of business premises
- Computers and software systems
- Telephone systems
It can be slightly confusing as to what is an expense and a cost as many of the items we’ve described as “costs” are actually included in your profit and loss accounts as “operating expenses”.
Don’t worry about this too much though, as this is more important for analysing how your business is performing than it is for accounting purposes.
The most important thing to understand is the difference between asset costs, which are shown on your balance sheet, and other costs, which directly affect your profit and loss.
It’s also important to understand which costs are directly linked to “Cost of Goods Sold” (COGS).
Cost of Goods Sold (COGS)
Another term for COGS is ‘Cost of Sales’. Several of the costs mentioned above can be included in COGS to some extent.
Essentially, these are the direct cost of producing the goods or services that the business sells. It’s important to understand that COGS doesn’t include costs or expenses incurred in the day to day running of the business.
The reason it’s important to understand what can be included in COGS is that it has a direct effect on the calculation of gross profit. In our example, Widget & Co. is a business which manufactures widgets (of course!).
|The raw material cost (including inward shipping) of a widget:||£100|
|The direct labour cost purely in the production of the widget:||£20|
|Cost of Goods Sold per widget is the raw material cost plus the direct labour cost:||£120|
|The company sells 1,000 widgets at £200 each, revenue:||£200,000|
|Cost of Goods Sold (1,000 units x £120 cost per widget):||£120,000|
|Gross Profit (Revenue minus Cost of Goods Sold):||£80,000|
For most businesses the costs of selling the goods or services are not included in COGS as they are part of the day-to-day operations of the business and are recorded as ‘Operating Expenses’.
This is a highly simplified example and when the goods are considered to be ‘sold’ depends on the type of accounting model that you’re using:
- Cash basis: The goods are considered to be sold once the cash is received
- Accrual basis: The goods are considered to be sold when the sale is invoiced
So, what are business expenses?
Expenses are generally expenditure which you incur in the day to day running of the business and, for tax purposes, can include some items that are also considered as “costs”.
The other main difference is that expenses will always be used to reduce the net profit of the business. This is where an expense incurred solely for use in the business is recorded, and offset against the income to reduce the net profit. It’s useful, because businesses pay tax based on their profits, so reducing the profits brings the tax bill down.
Some costs, such as those used to buy fixed assets like property or major machinery, are treated differently and show on the balance sheet, rather than the profit and loss account.
What can be classed as a business expense?
The scope of what can be considered business expenses is wide but includes:
- Staff costs, including pensions and health insurance
- Advertising costs
- Maintenance costs
- Utility and phone bills
- IT maintenance costs
- Office equipment such as stationery
- Legal expenses
- Accounting expenses
- Travel and subsistence (although the cost of travelling to and from your normal place of work is not an allowable expense)
- Entertaining for business purposes
Identifying and showing business expenses
Sole traders and unincorporated businesses aren’t legally separate to their business in the way that the owner of a limited company is.
This means it’s particularly important to distinguish what is a business expense as opposed to a personal expense, as it’s too easy to blur the lines. So, if you travel for work and claim mileage, make sure you have a robust system for recording your miles!
An example might be where a mobile phone is used partly for business and also for personal use. The monthly cost of business calls is a legitimate expense, but any personal calls are not. Similarly, where a vehicle is used for personal and business use, only the business proportion of the vehicle’s costs is a legitimate business expense.
Expenses are generally shown on the profit and loss account as ‘Operating Expenses’. So, to take the example of Widget and Co. again, assuming all their expenses total £30,000:
|Gross Profit (Revenue minus Cost of Goods Sold):||£80,000|
|Net profit (Gross profit minus operating expenses):||£50,000|
The bottom line!
As you can see, correctly recording all your business’s costs and expenses correctly can affect the amount of tax that you pay. And there’s more – producing and analysing financial reports can also give invaluable insight into how the business might be made more profitable by, for example, reducing variable costs or expenses.