Introduction to expense:
An expense is a cost a business incurs to generate revenue. An expense can also be defined as the cost of using an asset to generate revenue. Expenses in the income statement are deducted from the revenue.
According to the matching principle, they are to be recorded in the period they are incurred to match them against the revenue generated for the period.
An expense account is a debit in nature, which shows a decrease in equity as expenses increase. There are several types of expenses but can be categorized into two main types: operating and non-operating.
Operating expenses are those that are not directly involved with the production of goods and services. For example, selling general and administrative expenses. Purchase of an asset like land or building is not included in expense since these are capital expenditures.
However, when the asset is being used, it is depreciated, and that depreciation is counted as a revenue expenditure since this expense is incurred due to revenue generation.
Some other examples of expenses include costs of goods sold and non-operating expenses like interest expenses. Operating expenses examples are sales commissions, depreciation, advertising expenses, etc.
Introduction to the cost of goods sold:
Cost of goods sold is a type of expense the business incurs, which refers to the production costs attributed to the goods being sold. It does not include any indirect costs such as rent, selling costs, etc.
Unlike operating expenses, the cost of goods sold is recorded when the good has been sold. Direct labor and raw material are included in the cost of goods sold calculation. This is in the production industry.
In the retail industry, all the costs incurred to acquire the inventory and merchandise from the supplier will be the cost of goods sold.
When calculating the cost of goods sold, we do not include the cost of the goods that haven’t been sold yet. To find the cost of the goods sold, the following formula is used:
COGS = beginning inventory + purchases during the period – closing inventory
The cost of goods sold is deducted from the sales revenue in an income statement to calculate the gross profit. There are three ways businesses calculate costs of goods sold- first-in, first-out (FIFO), last in first out (LIFO), and average cost method.
In the first in and first out, the goods bought first are sold first. In last in first out, the latest purchase of goods are to be sold first.
The average cost method includes calculating the average price of the goods bought, and then they are recorded at that cost when being sold.
To understand the expenses and cost of goods sold better, let’s first establish that an expense is the cost of generating revenue but not all costs are expenses. However, the cost of goods sold is an expense, but we separate them on the income statement.
To understand this better, let’s take a look at an example. You’re running a business selling jewelry. For today’s sales, you buy $800 worth of jewelry.
However, you only sell $600 worth of jewelry. Your cost of goods sold which is your expense, will only be $600, not $800.
The treatment for the cost of goods sold is the same as an expense. That is, it will be matched to the revenue generated. But costs are mostly recorded when you have spent something to acquire a resource.
Whereas expense is incurred when we start consuming up that resource or utility. The cost and expense treatment is the same because costs are usually immediately converted into an expense as soon as the revenue or profit is realized; hence, people use these two terms interchangeably.