Cost vs. Expense - What is the Difference?
Business people like to throw jargon around, and the two terms - "cost" and "expense" - are used a lot every day. But what do these two terms mean? Are they just different words for the same concept?
We use the two terms interchangeably in our business conversations, but they have different meanings and applications in business. We'll look at these two terms - cost and expense - in general, and then as they apply to business accounting and taxes.
Cost and Expense Defined and Compared
First, a general definition of both terms:
Cost is "an amount that has to be paid or spent to buy or obtain something." Cost can be specific, like, "What's the cost of that car?" or it can be a penalty, like "Consider the cost of missing that event."
Notice also that cost implies a one-time event, like a purchase. The term "cost" is often used in business in the context of marketing and pricing strategies, while the term "expense" implies something more formal and something related to the business balance sheet and taxes.
The definition of expense sounds similar to that of cost: "an amount of money that must be spent especially regularly to pay for something." But notice the extra words "especially regularly."
- Price is often linked to the cost of a product to the producer or seller.
- Expenses show up on your business profit and loss statement.
An expense is an ongoing payment, like utilities, rent, payroll, and marketing. For example, the expense of rent is needed to have a location to sell from, to produce revenue.
You can also consider an expense as money you spend to generate revenue.
- You need to spend money on advertising to get customers, and on a phone number to get them to call you;
- You need to spend money on rent and utilities if you want to have a retail store, or
- You need to spend money on a web page to get customers over the internet.
There is usually no asset associated with an expense. You don't own a building; you pay rent, and your internet gets shut off if you don't pay the monthly expense. Although we use the term "cost" with expenses, they are really just payments.
Costs in Accounting
Accounting types use the term "cost" to describe several different instances in business situations:
Cost of goods sold. The term cost of goods sold refers to the calculation done at the end of an accounting year for businesses that sell products. The cost of goods sold includes several different types of costs:
Direct costs to make and ship products:
- Products bought for resale
- Raw materials to make products
- Packaging and shipping products to customers
- Inventory of finished products
- Direct overhead costs for utilities and rent for a warehouse or factory
Indirect costs like labor, storage costs, and pay of supervisors for the factory or warehouse.
Cost of an asset in accounting. Accountants use the term cost to refer specifically to business assets, and even more specifically to assets that are depreciated (called depreciable assets). The cost (sometimes called cost basis) of an asset includes every cost to purchase, acquire, and set up the asset, and to train employees in its use.
For example, if a manufacturing business buys a machine, the cost includes shipping, set-up, and training. Cost basis is used to establish the basis for depreciation and other tax factors.
The cost of assets shows up on the business accounting on the balance sheet. The original cost will always be shown, then accumulated depreciation will be subtracted, with the result as book value of that asset. All the business assets are combined for the purpose of the balance sheet.
Expenses in Accounting
In a business sense, an expense is a cost that is used up and has to be repaid periodically. These expenses reduce the revenue of the business. Think of the monthly activity of a business: The business starts with gross income for the month. Then all the expenses are subtracted from the business gross income to get a net income or profit on the net income (profit and loss) statement.
The cost of an asset isn't considered an expense because it's a one-time charge and it goes on the business balance sheet, not on the profit and loss statement.
Cost vs. Expenses and Taxes
Expenses are used to produce revenue and they are deductible on your business tax return, reducing the business's income tax bill.
Costs don't directly affect taxes, but the cost of an asset is used to determine the depreciation expense for each year, which is a deductible business expense. Depreciation is considered a "non-cash expense" because no one writes a check for depreciation, but the business can use it to reduce income for tax purposes.
The Bottom Line on Costs and Expenses
While there are exceptions to this statement, it's generally true that:
For accounting and tax purposes, COSTS are related to business assets and they are shown on the balance sheet. EXPENSES are related to business expenditures over time, and they are shown on the business net income (profit and loss) statement.