Business expenses are costs related to the business's operations and management on a daily basis. Total business expenses include the cost of goods sold and the business's operating expenses.
Business expenses are deducted from revenue to calculate operating profit and are reflected in the business's income statement.
Use the following formula to calculate your business's expenses. You will find this information in your business's income statement within your financial reporting package for the specific accounting period.
Business Costs = Cost of Goods Sold + Operating Expenses
From a company's income statement, you can only see the total cost; however, you need to understand the details of what it includes and where it comes from to see where your money has gone, and whether it has been effective and reasonable.
1. Business costs
Businesses must track costs incurred while the business is operating and costs incurred when the business is not operating.
- Because profit is defined as revenue earned by a business minus expenses incurred in its operations, profit can be increased by increasing revenue and decreasing operating expenses. Since cost reduction often seems like an easier and more accessible way to increase profits, managers are often quick to choose this approach.
- However, cutting operating costs too much can reduce a business's productivity and, consequently, its profits. While reducing any specific operating expense will generally increase short-term profits, it can also impact a business's long-term profitability. For example, if a business cuts advertising costs, its short-term profits are likely to improve, as it is spending less on operating expenses. However, by reducing advertising, the business may also reduce its ability to generate new revenue, and future profits could be affected.
- Ideally, businesses should aim to keep operating costs as low as possible while maintaining the ability to increase sales. To achieve this, managers need a thorough understanding of operating costs and how to manage them effectively.
1.1. Cost of goods sold
These are direct costs associated with the production of finished goods, the purchase of goods for resale, or the direct costs of providing services, including the following cost items:
- Direct material costs
- Costs of renting a factory or production facility.
- Wages for production workers and production managers.
- Depreciation costs of machinery and equipment
- Costs of repairing machinery and equipment
- Costs of electricity and water used in the production facility.
- Costs incurred in using the production facility.
1.2. Types of business operating expenses
The operating costs of a business include the following types of expenses:
- Salaries for management staff
- Salaries for the accounting and tax preparation department.
- Salaries for the human resources management department, labor wages, and insurance.
- Salaries for the legal department
- Sales and marketing expenses
- Bank fees
- Travel expenses
- Entertainment and social expenses
- Research and development costs
- Office rental costs
- Office expenses
- The cost of repairing and maintaining office equipment.
- Office electricity and water costs
2. Fixed costs and variable costs
2.1. Fixed Costs
Fixed costs are expenses that do not change with increases or decreases in sales or productivity and must be paid regardless of the business's activity or performance. For example, a manufacturing business must pay rent for its factory premises, regardless of how much it produces or earns. While it may be possible to reduce and minimize rent payments, these costs cannot be eliminated and are therefore considered fixed costs. Fixed costs typically include initial investment costs, property insurance, security guarantees, and equipment installation.
Fixed costs can help achieve economies of scale, because when many of a business's costs are fixed, the business can earn more profit per unit as it produces more units. In this system, fixed costs are spread across the number of units produced, making production more efficient as production increases by reducing the average variable cost per unit. Economies of scale can allow large businesses to sell the same goods as smaller businesses at lower prices.
Economies of scale can be limited in that fixed costs often need to increase with certain standards of production growth. For example, a manufacturing business that increases its production rate over a defined period will eventually reach a point where it needs to increase its factory space to match the increase in product output.
2.2. Variable Costs
Variable costs, also known as variable expenses, include costs that change with production. Unlike fixed costs, variable costs increase when production increases and decrease when production decreases. Examples of variable costs include the cost of raw materials, wages, and electricity. For instance, to increase sales of french fries, a fast-food chain would need to increase the cost of purchasing potatoes from its supplier.
Sometimes, a business may obtain discounts or price reductions when purchasing supplies in bulk, where the seller agrees to slightly lower the cost per unit in exchange for the buyer's frequent bulk purchases. Therefore, this can somewhat mitigate the correlation between increased or decreased output and increased or decreased variable costs for the business.
Volume discounts typically have a relatively small impact on the relationship between production costs and variable costs, and the nature of variable costs as they change with production levels remains unchanged.
Generally, businesses with a high ratio of variable costs to fixed costs are considered less volatile, as their profits depend more on sales. Except for manufacturing and transportation businesses with large fixed-cost investments, most commercial, construction, and service businesses have high variable cost ratios. However, this trend is changing in a competitive environment and with the application of information technology, leading these businesses to invest more in fixed costs to facilitate expansion and control the quality of their services.
2.3. Selling variable costs
In addition to fixed and variable costs, a business's operating costs can also be considered as semi-variable costs (or semi-fixed costs).
These costs represent a mixture of fixed and variable components, and can therefore be thought of as existing somewhere between fixed and variable costs. Partial variable selling costs change with increases or decreases in production, like variable costs, but remain present even when production is zero, like fixed costs. This is the key factor distinguishing partial variable selling costs from fixed costs and variable costs.
An example of a semi-variable cost is overtime pay. Regular wages for workers are generally considered fixed costs, because while a business can reduce the number of workers and paid hours, it will always need a minimum workforce to operate. Overtime payments are generally considered variable costs, because the number of overtime hours a business pays its workers will typically increase when production increases and decrease when production decreases. When wages are paid that include overtime pay, the worker's wages have both fixed and variable components and are therefore considered a semi-variable cost.
3. Cost management and cost reduction solutions
3.1. Using automation systems
There are many online systems and software programs that can automate and streamline your business operations. These systems can cover a range of departments, including accounting, payroll, marketing communications, customer interaction and relationship management, service quality control and customer care, sales forecasting and operating budgeting, etc.
Technology is very useful because it promotes efficiency. The result of this efficiency is reduced operating costs in areas where traditional managers habitually rely on direct labor. Technology operates faster than humans with fewer errors. Technology can also improve the efficiency of supply chain processes, seeking to reduce things like the cost of transporting raw materials.
To choose the right technology or software service for you, ask yourself the following questions:
- What am I good at? And what am I not good at? For example, if you have accounting knowledge and background, you might not need accounting and financial technology right away; you might need marketing technology instead. There's a crucial point here: you tend to invest in technology that you already possess. For instance, if you have a strong accounting and financial background, you might invest heavily in accounting and financial management technology because it feels easy, whereas you should prioritize investing in your weakest area to balance your business's strengths, such as automated marketing communication technology.
- What makes me feel like I spend too much time on something each week?
- If I could eliminate one of my most time-consuming tasks, what would it be?
Your answers to these questions will give you a clear indication of the task or subject area where you should utilize the technology.
3.2. Outsourcing
Another option to improve efficiency is to outsource certain business activities to a third-party professional. For example, if you lack a background in accounting or tax law, you might find it difficult to determine how to manage your finances, or how to reduce your tax liabilities. A professional clearly trained in this area can assist you.
Although it might seem like outsourcing a service would lead to higher costs, in the long run, delegating specific tasks to experts in that field will save you money and produce better results. This is because you can't train experts yourself, nor can you afford to hire a true expert, and only experts can advise you on the best practices in each area.
Outsourcing certain activities is an investment that will gradually pay you dividends over time.
3.3. System Setup
If you work with suppliers regularly, you might want to set up a bid evaluation system for your purchases. If you ask different suppliers to provide you with price quotes, you'll be able to choose the best price.
Make sure you define the full product/service specifications and the precise scope of work when requesting quotes from suppliers for bidding, as missing information about your requirements or adding or removing complexity will significantly alter the price.
Having an accurate quote can allow you to better plan for your projected operating costs.
3.4. Managing remote work for employees
Renting office space, paying for office utilities, and managing a physical office can be a significant drain on your finances. Consider allowing your team to work remotely as a way to reduce overall costs.
With the number of connections available today, the difference between an employee sitting in an office and one sitting at home is almost imperceptible. Employees will often find this advantageous, as they can cut down on their commuting time and expenses.
To determine the cost and time involved in face-to-face physical interaction, do the following two things:
- Calculate the time your staff spends preparing and traveling for a face-to-face meeting; sometimes you'll find that a meeting will take you and your team at least 1 to 2 hours for preparation and travel, and also incur a significant cost.
- Create a list of activities that can be communicated via video call without needing to "see the physical partner," then increase online communication from 10% > 20% > 30% ... 50% while maintaining or even improving your work performance. The success of this approach will surprise you with its effectiveness.
3.5. Tighten processes and procedures.
You should always be looking for ways to make your business more efficient. By streamlining your processes and procedures, you can reduce waste in both money and time.
Encourage your employees to identify inefficiencies and suggest solutions to problems. Consider providing an incentive for employees to do so. Again, you can think of this as an investment in your company. A small reward for an employee could ultimately save you hundreds of millions of dollars.
3.6. Review variable costs.
3.7. Reviewing potential costs
The hidden costs of a business are enormous; you often incorporate them into a fixed operational schedule and take them for granted as expenses you have to pay.
Use the corresponding Cost-Income Statement template (not the cost-income statement from the company's overall financial report) for each individual or department within the business; this will help each department save on unnecessary expenses.
For example: When reviewing a salesperson's Cost-to-Earnings report, you see travel, phone, and entertainment expenses incurred for 10 potential customers, but those 10 potential customers did not make any purchases, or had a low purchase rate, or the purchase value was small. This is the area where you need to immediately address the effectiveness of spending compared to the results generated, also known as the Cost-to-Earnings report.
4. Summary
Are you currently using a management style that only tracks business expenses and revenue without considering the finer details? If so, now is the time to change that. As your business grows, understanding things like operating expenses will become increasingly important.
Operating expenses allow you to gain insight into how your costs impact your profits, helping you improve your financial health. Once you understand your costs, you can use the methods we've provided to begin cutting expenses and increasing profits.
