A young woman sits at a desk with an open laptop and a notebook in front of her. She uses her right hand to write something in the notebook and has her left hand on the keyboard of the laptop. The woman has long blonde hair pulled into a ponytail and she wears glasses and a pale pink blouse under an olive green apron. Also on the desk are baskets of hand soaps and lotions and a receipt printer.
Differentiating between categories of costs and expenses is crucial to keeping track of your cash flow and knowing how much money you need on hand. — Getty Images/xavierarnau

Many small businesses struggle with cash flow, and managing ongoing expenses plays a big role in this challenge. More than 40% of small business owners say their biggest challenge is paying operating expenses. Understanding how to classify operating expenses compared to cost of goods sold (COGS) and capital expenditures is foundational to managing your 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 a sum of all direct costs associated with selling a product or service. This includes 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.

Bottom line: If an expense would have occurred regardless if a sale took place, it doesn’t fall under COGS. It could be an operating expense or a capital expenditure.

Some business expenses can feasibly be recorded as one of two cost categories, depending on how you use the product or service.

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.

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. Some business expenses can feasibly be recorded as one of two cost categories, depending on how you use the product or service.

“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.

CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.

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