In accounting, expenses are the costs a business incurs to keep things running. They include everything from the rent on your office space to the software subscriptions that power your team. Expenses represent the money spent or liabilities incurred while you earn revenue.
Below, we’ll explain the main categories of expenses, how they are recorded in accounting, and how they affect an income statement.
What’s in this article?
- What are the main categories of expenses?
- How are expenses recorded in accounting?
- Why is accurate expense tracking important?
- What is the difference between fixed and variable expenses?
- How do expenses affect the income statement?
What are the main categories of expenses?
Expenses fall into different categories, depending on the purpose of the payment. Businesses log these categories separately within accounting systems to clarify how they are spending money. Here are the main expense categories.
Cost of goods sold (COGS): This is the direct costs of producing or delivering your product or service. For a bakery, COGS would include the cost of ingredients such as flour and sugar; for a software company, it might include cloud hosting fees. COGS is tied directly to your sales, and it affects your gross profit.
Operating expenses: These cover the day-to-day costs of running your business (e.g. salaries, office supplies, marketing, utilities). Operating expenses are necessary, but they’re not directly tied to the production of goods or services.
Non-operating expenses: These are costs unrelated to your core business activities. For instance, if your business has a one-off legal settlement or makes interest payments on a loan, those would be considered non-operating expenses.
Depreciation and amortisation: These are non-cash expenses that reflect wear and tear on tangible assets or the gradual reduction in the value of intangible assets (such as patents and trademarks). They help spread the cost of long-term investments over time. Depreciation and amortisation can be classified as either operating or non-operating expenses, depending on how the asset relates to core business activities.
How are expenses recorded in accounting?
All expenses are recorded for accounting purposes to clarify your business’s spending and ensure you’re calculating appropriate tax obligations. For accurate records, hold on to all receipts, invoices, or contracts; they prove the expense happened and explain why, which is helpful in the event of audits and when you file taxes or reconcile records later.
Here’s how to accurately record your expenses:
Categorise: Figure out what each expense is for and which category it belongs to. Whether you’re paying for software, stocking up on supplies, or covering travel costs, determine whether the cost factors into operating expenses, COGS, or something else.
Log: Record the expense in your accounting system. If you’re using double-entry accounting (which most businesses do), you’ll debit the expense account (increasing your expenses) and credit the payment account. For example, if you spend £500 on advertising, you’d debit “advertising expense” with £500 and credit “cash” (or “accounts payable”) with £500.
Reconcile and review: At the end of the month (or quarter), compare your recorded expenses to your bank statements and receipts. You should also regularly review your income statement to see how your expenses are affecting your profitability. A regular review can help you spot trends, control spending, and make more strategic decisions about where to allocate resources.
Why is accurate expense tracking important?
Accurate expense tracking provides financial clarity that can inform business decisions. Here are some more details:
Tracking profitability: Careful expense tracking shows your actual profitability. The only way to know whether your revenue is truly outpacing your costs is to log every expense.
Reviewing costs: Expense tracking can signal where you’re paying more than you should be. This can guide your decisions on whether to renegotiate vendor agreements or reduce spending on underperforming initiatives.
Preparing for taxes: Clear expense records can help you claim the tax deductions you’re entitled to and avoid costly mistakes. They also make the filing process and audits much easier to handle.
Setting budgets: Expense tracking helps you detect cost patterns (such as peaks during certain months or spending on specific projects) and anticipate expenses before they hit. Identifying these patterns can help you plan for how to cover high-cost periods and ensure you have enough left for bills, payroll, and other necessary expenses.
Planning for growth: Accurate expense tracking shows you what it costs to run your business today. It gives you a baseline to forecast future costs as you plan for growth.
What is the difference between fixed and variable expenses?
Fixed expenses are regular, recurring expenses, while variable expenses change depending on your production. By distinguishing between fixed and variable expenses, you can better control costs, plan for growth, and respond to changes in your business.
Fixed expenses
These costs stay consistent no matter how much your business produces or sells. They’re predictable and recurring. Examples include expenses such as rent, salaries for full-time staff, insurance, and subscriptions. If you run a coffee shop, the rent for your space would be a fixed expense.
Fixed expenses provide stability in your budget. However, they can be challenging to manage when revenue is low, since they don’t decrease automatically during slower periods.
Variable expenses
These costs fluctuate based on your business activity – specifically, how much you’re producing or selling. Variable expenses are tied directly to the volume of your business operations: the more you grow, the higher these expenses tend to be. Examples might include expenses for items such as raw materials, shipping costs, sales commissions, and utilities (which can increase with more production or office activity). Using the example of running a coffee shop, the cost of coffee beans and milk would be variable expenses.
Variable expenses scale with your business, which can make them flexible. However, they’re harder to predict, so they require close monitoring to avoid unexpected peaks in costs.
How do expenses affect the income statement?
Expenses directly affect your business’s profitability. On the income statement, expenses are subtracted from revenue to determine your net income (or net profit). When expenses rise without a corresponding increase in revenue, they decrease profits. For example, an increase in marketing costs or supplier prices will reduce your profits if they are not offset by higher sales.
By reviewing how expenses change over time, you can pinpoint inefficiencies, unnecessary costs, or areas where spending is too high relative to the value it creates. Every business aims to balance expenses and revenue growth. The income statement can tell you whether you’re achieving that balance – or if costs are too high.
Here’s one example of how expenses factor into a net profit calculation. Assume your income statement looks like this:
Revenue: £500,000
COGS: £200,000
Gross profit: £300,000
Operating expenses: £150,000
Operating income: £150,000
Non-operating expenses: £50,000
Net income: £100,000
Here, the sum of your expenses (COGS, operating, and non-operating) are subtracted from overall revenue to determine your net income.
£500,000 - (£200,000 + £150,000 + £50,000) = £100,000 Net Income
The content in this article is for general information and education purposes only and should not be construed as legal or tax advice. Stripe does not warrant or guarantee the accuracy, completeness, adequacy, or currency of the information in the article. You should seek the advice of a competent lawyer or accountant licensed to practise in your jurisdiction for advice on your particular situation.