Using the terms “costs” and “expenses” interchangeably might be ok for everyday conversation, but they’re often recorded differently in a business’s accounts. This can have tax implications, so it’s useful to understand what’s different about them, and why it matters. We’ve set this up so we can smoothly step in with an easy-to-understand explanation.

What are business costs?

There are different types of cost that are important to a business; fixed, variable, and asset costs.

Fixed costs

Fixed costs are things which you don’t have day-to-day control over. You might be able to re-negotiate them from time-to-time, or shop around for a better deal, but on a short-term basis they tend to be just that; fixed. Items typically considered to be fixed costs include:
 

• Rent
• Insurance premiums
• Fixed salaries
• Interest payments on loans or mortgages
• Utility contracts
• Phone contracts
• Maintenance retainers

Variable costs

Variable costs are generally dependent on business activity. That is, the more business you do, the more of these costs you’ll have. For example:
 

• Raw materials
• Hourly paid and piece work labour costs
• Commissions
• Utility and phone bills (as opposed to the cost of contracts)
• Fuel

Asset costs

Assets are things which the business expects to own on a long-term basis. Your asset costs might include things like:
 

• Purchase of business premises
• Machinery
• Vehicles
• Computers and software systems
• Telephone systems

Most of your costs and expenses are included on your profit and loss report because they have a direct impact on your ability to make a profit.

Asset costs are shown on your balance sheet, because this allows you to see what an asset is worth compared to the cost of maintaining and owning it. You get a better idea of its true value that way.

There are also special rules for claiming tax relief on assets. In real-people words this means you might be able to knock some money off your tax bill if you have a limited company which owns assets. Known as capital allowances, it’s worth having a chat with your accountant about them.

Cost of Goods Sold (COGS)

The Cost of Goods Sold (COGS) is sometimes called ‘cost of sales’. This is quite literally what it costs your business to produce the goods or services it sells. Several of the costs we’ve already mentioned above can be included in your cost of sales to some extent, but 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 because it has a direct effect on your gross profit. This is the total amount your business is left with once you deduct the cost of your sales from your income. It helps you keep an eye on those costs, so they don’t go gobbling up your profits.

The first job is to work out what it costs to produce each individual unit. This can be a bit tricky, because some suppliers will give you a discount if you place a massive order so you might end up with weird looking numbers where it costs less to produce more units. We’re going to keep it simple in our example.

 
The next step is to work out the profit you make based on how many units you sell.

So, what are business expenses?

Expenses are what you incur in the day to day running of the business. For tax purposes this can include some items which are also considered as “costs”. Nothing is ever easy, is it?

It’s very useful to keep track of your expenses, and your accountant might shout if you don’t, because businesses pay tax based on their profits. You’ll hear this referred to as ‘claiming expenses’. You don’t actually get the money back from anyone, but you will get tax relief on your expenses, so reducing profits brings your tax bill down. Hurrah and high-fives for that.

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
• Insurance
• Commission
• Advertising
• Maintenance
• Utilities and phone bills
• IT maintenance costs
• Office equipment such as stationery
• Legal expenses
• Accounting expenses
• Rent
• 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, because 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!

Another 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 personal calls are not. We’re obviously massively biased because we make accounting software, but every accountant and business advisor will tell you the importance of recording your business expenses.

The bottom line!

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 costs or expenses.

Learn more about using Pandle to make business accounting easier. Create a free account or use Pandle Pro for £6 a month.

Elizabeth Hughes

A content writer specialising in business, finance, software, and beyond. I'm a wordsmith with a penchant for puns and making complex subjects accessible.