Defining Costs and Expenses in the Business World
In the world of business, costs aren’t the same as expenses. When a business incurs a cost, it exchanges a resource (usually cash or a promise to pay cash in the future) to purchase a good or service that enables the company to generate revenue. Later, when the asset is used to create a product or service, the cost of the asset is converted into an expense.
When the product or service is sold, the company generates revenue. The revenue is matched with the expenses incurred to generate the revenue. Businesses use this matching principle to calculate the profit or loss on the transaction.
Here’s an example of a common business transaction that demonstrates the process:
Suppose you’re the manager of the women’s apparel department of a major manufacturer. You’re expanding the department to add a new line of formal garments. You need to purchase five new sewing machines, which for this type of business are fixed assets.
When you buy the sewing machines, the price you pay (or promise to pay) is a cost. Then, as you use the sewing machines in the normal activity of your business, you depreciate them: You reclassify the cost of buying the asset to an expense. So the resources you use to purchase the sewing machines move from the balance sheet (cost) to the income statement (expense).
Your income statement shows revenue and expenses. The difference between those two numbers is the company’s net income (when revenue is more than expense) or net loss (when expenses are higher than revenue).
Still wondering what the big deal is with accountants having to depreciate fixed assets? Well, the process ties back to the matching principle.
In accounting, every transaction you work with has to satisfy the matching principle. You have to associate all revenue earned during the accounting period to all expenses you incur to produce that revenue. The idea is that the expenses are matched with the revenue — regardless of when the expense occurs.
Continuing with the sewing machine example, suppose the life of the sewing machine — the average amount of time the company knows it can use the sewing machine before having to replace it — is five years.
The average cost of a commercial sewing machine is $1,500. If the company expenses the entire purchase price (cost) of $1,500 in the year of purchase, the net income for year one is understated and the net income for the next four years is overstated.
Why? Because although the company laid out $1,500 in year one for a machine, the company anticipates using the machine for another four years. So to truly match the sales the company generates from garments made by using the sewing machine, the cost of the machine has to be allocated over each of the years it will be used to crank out those garments for sale.