There was a question that caused quite a lot of havoc in personal finance communities a few years ago which proposed a scenario where someone bought and sold goats a few times and the question was how much profit the person had made. There were many different answers due to different perspectives and assumptions. While business expenses on the surface simply seem like a matter of money has left the business it’s not that simple in reality. We look at the character of expenses to categorise. While there are in earnest four types of business expenses, we’ve added a fifth category in this article and it will make sense why this has been done. How well do you know your expenses and how to treat them?
Capital expenditure
Let’s start with one of the more complicated ones to set the tone for the rest of this article. Say you bought a machine for $10, spent $5 on producing whatever the machine produces and made total sales of $20. What is your profit? Any answer that is not $15 is incorrect and I will explain. The machine purchase is classified as capital expenditure because the money was not spent on production but rather invested in creating the capacity to produce the products. To look at it another way, the machine remains after production, so whilst we have used the machine to produce, we have not fully used it up to a point we can count all the investment into it as an expense. The machine still has value. The example is meant to explain that capital expenditure is money spent on the creation of capacity in the long term. The items this expenditure goes to tend to last extended periods. Such things as machinery, licencing, software, equipment and so on all fall under capital expenditure. The important thing to remember is that capital expenditure does not go into your profit and loss calculation.
Product or direct costs
In our example above, product costs amount to $5, the money spent directly on creating the product (whether good or service). As you’ve surmised, these go into the profit and loss calculation. They are pretty easy to understand, but there’s a little nuance here. Firstly, costs that are incidental to direct product costs also count as product costs. A simple and relatable example is the cost of transporting materials used to produce products. We can also draw a parallel with transportation costs of goods for resale. So product costs include all costs that can be directly linked to the activity of providing our products. You can usually tell these because they increase as production increases and reduce as production reduces.
Operating expenses
Now that we have the big two out of the way, we can look at the operating expenses. These are expenses that seem rather incidental to being in business but do not amount to investments in capacity, such as capital expenditure. Let’s look at something like an internet plan or data bundle. Say you pay for 20GB of data on your phone. Of course, you will use your phone for business, but you will also scroll through Instagram and spend some time on the Startupbiz website. So how do we account for such expenses? This is where the nuance comes in. The following two categories will break down what we normally refer to as operating expenses.
Overheads
Overheads are so called because they are always hanging over your head. Sometimes they take the form of fixed expenses but not always. It is, however, easier to identify overheads by looking at the ones that qualify as fixed expenses. For example, if your business rents premises, then something like rental expense is an overhead. Whether you produce and sell 2000 units, produce 2000 and sell zero or produce and sell none, the rental bill still comes due. That is a typical overhead; it’s always hanging over your head. They are operating expenses, but it’s useful to group our operating expenses into overheads and consumables.
Consumables
Consumables are operating expenses that vary with the level of activity but not always directly. Let us look at your business, and as a generous employer, you decide to provide employees with tea and coffee in the building. It is very difficult to link the tea and coffee consumption to any business activity. If nobody reports for work, this expense will be a noticeable reduction. If say, winter hits, there will likely be an increase in this expense. So it does vary but not entirely because of business activity. And for the more advanced reader, such expenses are tax deductible in Zimbabwe for the provision of basic meals such as tea and coffee. Drawing the distinction between overheads and consumables helps us understand the behaviour of our business expenses.
That is how we break down business expenses. This distinction can help us better understand our business performance and cost behaviour.
