Expenses

Finance · 3 min read

Expenses are everything a business spends to keep operating. They sound simple. They are not. The category you put a cost in determines what kind of business you appear to be running.

Not all expenses are the same. The category matters as much as the number.

A business owner looks at her monthly profit and loss statement and sees a single line: Total Expenses, $87,400. She nods. It is roughly what she expected. She moves on to the next page.

She has just missed the most important piece of information about her business. Not the total. The composition.

Expenses are the costs a business incurs to generate revenue. They are everything the company has to spend in order to operate — salaries, rent, materials, software, advertising, utilities, professional services, interest on debt, taxes. Subtract expenses from revenue and you arrive at profit. That is the basic equation of every business that has ever existed.

But the total dollar figure is only the start of the story. Where the value actually lives — for managers, for investors, for the business owner trying to make smart decisions — is in the categories the expenses are sorted into. The three most useful categorizations are the ones every business owner should be able to read fluently.

Cost of Goods Sold, often abbreviated COGS, is the direct cost of producing whatever the business sells. For a coffee shop, COGS is the beans, the cups, the milk, the syrup, the labor of the barista who pulls each shot. For a software company, COGS is the hosting cost per customer, the payment processing fees, the support staff time. COGS scales with revenue — make more, sell more, spend more on COGS. Revenue minus COGS produces gross profit, and the percentage of revenue left after COGS is the gross margin. A coffee shop might have a 70% gross margin. A software company might have a 90% gross margin. A car manufacturer might have a 15% gross margin. The number tells you what kind of business you are looking at, before any other expense even enters the picture.

Operating expenses, sometimes called OpEx, are the costs of running the business that do not directly scale with how much you sell. The office rent. The salaries of people who are not directly producing or selling. The marketing budget. The accounting software. Operating expenses are what it costs to be in business at all, regardless of whether you sold one unit or a thousand. They are the floor underneath the business — the costs that exist even when the doors are quiet.

Capital expenditures, or CapEx, are the large one-time investments in things that will benefit the business for many years — buildings, equipment, vehicles, major software systems. Unlike operating expenses, capital expenditures are not fully counted against profit in the year they are spent. They are spread out over the useful life of the asset through depreciation. This is why a company can spend $5 million on a new factory and not have its profit drop by $5 million that year. The accounting math is doing real work behind the scenes.

There is a fourth, cross-cutting distinction that matters even more for day-to-day decisions: fixed versus variable expenses. Fixed expenses do not change in the short term regardless of how much business you do — your rent is your rent whether you sell ten units or a thousand. Variable expenses move with the volume of business — more orders means more shipping costs, more raw materials, more payment processing fees. The ratio of fixed to variable in a business determines a great deal about how risky it is. A business with mostly fixed expenses (a hotel, an airline, a manufacturing plant) has very high operating leverage: small changes in revenue produce large changes in profit, in either direction. A business with mostly variable expenses (a freelance consultant, a service business) is more resilient to revenue changes — when sales drop, the costs drop with them.

Understanding the expense composition of a business is what separates the operator from the bookkeeper. The bookkeeper records the costs. The operator looks at the costs and sees the structure of the business — where the leverage is, where the risk is, what would happen to profit if revenue doubled or halved. Two businesses with identical total expenses can be radically different businesses depending on how those expenses are distributed.

The next question — once you have categorized the expenses honestly — is what they leave behind. That number, the one most often confused with revenue in casual business conversation, is profit. And profit is where everything actually gets decided.