Typically used as synonyms, the words costs and expenses have different meanings when we need to talk about the financial management of a company. Knowing how to identify the two concepts, both in theory and in practice, is a challenge for the administrator.
This problem is understandable: the amount allocated to a certain activity may be classified in one company as a cost, while in another it will be designated as an expense. This distinction will depend exclusively on the core business activity.
After reading this text, you will understand the practical difference between costs and expenses, what the subdivisions of each of these categories are and why organizing the allocation of resources is fundamental for the company’s financial health .
What are costs?
Any amount applied to the production of goods or the provision of services by a company should be classified as a cost. Therefore, amounts used to pay for labor, raw materials, electricity and the depreciation of equipment, for example, are included in this account.
It is important to note that, in order to be considered costs, these amounts must be directly linked to the company’s production. This is the money allocated to what the business will offer to its consumers.
Therefore, for the organization to increase its production capacity, it will necessarily need to add costs to its operation .
Direct costs vs. Indirect costs
Depending on their use, costs must be classified as direct or indirect. Understand:
Direct costs
Direct costs are linked to the creation of the product or service offered. This calculation includes raw materials, packaging, and labor used to create the product or perform the service.
Indirect costs
Indirect costs include investments related to support for the development of products or services offered by the company. This includes electricity, maintenance, cleaning and other items that are linked to the productivity of the business.
What are expenses?
In turn, expenses include the resources used to support the activities that keep the company running, but which are not directly linked to the production of the merchandise sold or the provision of the service offered.
Typically, resources applied in the administration, human resources and marketing sectors, for example, are considered expenses.
Let’s take a shoe factory as an example. The areas mentioned do not have a direct correspondence with the core business activity (shoe production), although they are also important for managing and generating revenue for the company.
Therefore, the money used to support them must be classified as an expense, while the resources used to acquire raw materials and pay the labor employed to make the shoes will be considered costs.
Fixed expenses vs. Variable expenses
Just like costs, expenses can be classified into two subcategories: fixed or variable. Understand:
Fixed expenses
These are the values that do not vary according to what was produced by the company. This calculation includes expenses with rent and office supplies, for example.
Variable expenses
Values that vary proportionally with what is produced by the company are considered. For example: sales commission — the more goods that are sold, the greater the expense related to paying these employees.
The classification of costs and expenses will vary depending on the characteristics of the business. There are cases in which the value of an input needs to be divided according to the activity carried out.
For example: payment for electricity. The amount consumed by sectors that are not connected to the core activity will be considered an expense. That which is used in production will be classified as a cost.
Costs VS Expenses
In short, it is possible to classify costs as the amounts spent to build the final product, while expenses cover other areas of the business.
This differentiation will allow a manager to realize the correct financial composition of his company. Thereafter, he will be able to:
- calculate the Contribution Margin;
- establish the sales value;
- check production expenses.
Contribution Margin
Among the advantages that this knowledge provides is the construction of the Contribution Margin of each of the products offered to the market. Also known as Gross Profit, it is one of the most relevant metrics for the company.
It indicates how much of the sales value of each product contributes to paying structural expenses and also forming profit. To calculate it, it is necessary to subtract the costs and variable expenses from the sales value.
Sale price
By calculating the Contribution Margin, it is possible to indicate the price range at which the product or service must reach the market in order to make a profit. If this calculation is not made, the company may suffer losses even if it records good revenue .
Production expenses
Finally, the separation between costs and expenses allows the manager to identify where the amounts used to sustain the business are too high. This information allows him to act in financial management with greater security, as he will understand the consequences that any cuts will have on production.
As you may have noticed by reading this post, good practices for managing a company’s finances recommend that costs and expenses be calculated separately. While costs are related to the production of goods or the provision of services, expenses arise from the company’s sustaining activities.
This division of resource allocation will allow the manager to calculate and understand the Contribution Margin of each product, establish the best value for the sale and analyze all the business expenses. This will provide a solid basis for decisions about cuts and investments.