Many merchants struggle with cash flow, and operating expenses have a big impact on this key metric. More than 50% of small business owners report challenges in paying operating expenses and managing cash flow. Understanding how to classify operating expenses (OpEx) compared to cost of goods sold (COGS) and capital expenditures (CapEx) is foundational to maintaining a healthy budget.
Learn the differences between these cost categories to get a better understanding of how much cash on hand you need and to better manage your cash flow.
What are operating expenses?
Operating expenses are expenses that your company incurs in the course of doing business. Without these costs, your business cannot function. Operating expenses include things like rent, equipment, inventory costs, marketing, payroll, and insurance. Typically, operating expenses are not directly tied to the production of goods or services.
Operating costs are classified as either fixed or variable. Fixed operating costs are predictable and prescribed for a certain duration: things like rent, interest payments, or insurance payments. Variable costs are impacted by the production and sales of your product or service. Advertising is considered a variable cost.
For tax purposes, the IRS allows businesses that earn a profit to deduct operating expenses. Work with a CPA or read the IRS guidelines to learn what the agency specifically classifies as deductible operating expenses. These details are important but often complex; for instance, inventory is not considered an operating cost, but inventory management expenses are.
What is cost of goods sold?
Inventory falls under cost of goods sold (COGS). COGS is the sum of all direct costs associated with selling a product or service. Direct costs include things like materials and labor used to create the product, but not indirect expenses such as overhead.
“When the coffee shop sells a double espresso, COGS accounts for the price of the to-go cup, the protective sleeve, the coffee filter, the water, the processed beans, and so forth,” explained Investopedia.
Like operating expenses, businesses are eligible to take a deduction for COGS according to IRS guidelines. Your company can deduct COGS for any products you manufacture yourself or purchase with the intent to resell.
If an expense would have occurred regardless of whether a sale took place, it doesn’t fall under COGS. It could be an operating expense or a capital expenditure.
What are capital expenditures?
Capital expenditure (CapEx) refers to money spent on major, long-term business assets: property, equipment, or technology, for instance. Capital expenditures are defined by their longevity, specifically that the purchase must benefit the company for more than one tax year. CapEx are typically fixed assets — tangible pieces of property or equipment.
CapEx and OpEx are recorded differently, with CapEx appearing on a balance sheet while OpEx resides on the income statement. That means CapEx is considered an asset for accounting purposes, while OpEx is an expense. CapEx depreciates over time, so the IRS generally expects capital expenditures to be deducted over a number of years.
[Read more: 5 Tips for Ensuring Your Business Has Enough Cash on Hand]
CapEx and OpEx both play a key role in growing your business. "Knowing the difference between CapEx and OpEx enables businesses to evaluate the long-term impact of investments versus operational costs on overall financial health and strategic growth," Dominic Monkhouse, Business Coach at Monkhouse & Company, told American Express.
When you’re trying to cut costs, balancing your capital and operational expenses is a better plan than cutting either or both budgets without considering how they relate to each other.NextProcess
GAAP rules for classifying expenses
Under the Generally Accepted Accounting Principles (GAAP), the accounting treatment for CapEx, OpEx, and COGS is distinct based on their nature and impact on financial statements.
Under GAAP, CapEx is recorded as an asset on the balance sheet. This asset is then depreciated (for tangible assets) or amortized (for intangible assets) over its useful life, spreading the expense over multiple periods.
OpEx is expensed immediately in the income statement in the period incurred. OpEx does not get capitalized or depreciated.
COGS is distinct from both CapEx and OpEx, since it impacts your gross profit calculation. Therefore, COGS is expensed on the income statement.
“In addition, COGS is used to calculate several other important business management metrics,” wrote Oracle NetSuite. “For example, inventory turnover—a sales productivity metric indicating how frequently a company replaces its inventory—relies on COGS. This metric is useful to managers looking to optimize inventory levels and/or increase salesforce sell-through of their products.”
How to budget for CapEx vs. OpEx
Many financial planners are careful about budgeting for CapEx, since these are large expenditures that will have a direct role in the company’s success. CapEx also depreciates over several years in accordance with tax rules, making it essential to plan ahead.
Comparatively, individual OpEx purchases are small; they don’t require as many resources and can be accounted for within one accounting period. As a result, when writing a budget, financial planners tend to be less proactive about managing these costs.
A more strategic approach to budgeting CapEx and OpEx can help you improve your cash flow and lower your taxes. “When you’re trying to cut costs, balancing your capital and operational expenses is a better plan than cutting either or both budgets without considering how they relate to each other,” wrote NextProcess, a procurement software company.
“Because operational expenses count 100% as a tax deduction for the current year, many companies are looking for ways to turn elements of their CapEx into OpEx. There are a few ways to do this. One example is leasing equipment instead of purchasing it. When leasing, your business can deduct the full cash expense when computing its taxes for that accounting year.”
Technology is another budget category where CapEx can be limited in favor of OpEx. Rather than purchasing a physical phone system for the office, for example, your business can use VoIP, which can be classified as OpEx.
Managing CapEx, OpEx, and COGS
Accounting professionals and investors can help you stay compliant with IRS rules while strategically classifying your expenses as CapEx, OpEx, or COGS.
“You can’t record something as OpEx and under COGS, but something that would be COGS could be reclassified as CapEx or OpEx if it’s an expense for an asset that adds value to your company, or it’s required for the production or delivery of your product or service,” wrote Aimably.
These cost categories not only impact your taxes but could also affect your ability to attract investors. Aimably goes on to say that investors prefer to see CapEx or OpEx instead of COGS; you can’t reduce or eliminate COGS from your income statement (such as OpEx) or sell them (such as CapEx). Comparatively, COGS has lower utility to investors than CapEx or OpEx.
As you consider your accounting strategy, make sure you’re clear on the rules around recording expenses under these three categories. Utilize them strategically to ensure you have a clear understanding of your cash flow and tax obligations.
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