Is depreciation an operating expense?
Quick insights
- Depreciation spreads the cost of a tangible asset over its useful life rather than recording it all at once.
- In many cases, depreciation is classified as an operating expense because it relates to assets used in daily business activities.
- Depreciation applies to tangible assets like machinery, while amortization applies to intangible assets like patents.
Depreciation is a common line item on financial statements, but its classification can raise questions for business owners. An understanding of how depreciation fits into expense categories can help clarify what it represents and where it belongs.
What is depreciation?
Depreciation is an accounting method that spreads the cost of a tangible asset over the period it is used. Some assets gradually lose value as they become worn out or outdated, so depreciation lets a business account for that decline over time.
For example, if a company buys a delivery truck for $50,000 and expects to use it for five years, the cost can be spread across that period rather than recorded entirely in the year of purchase. This approach helps match the expense of the asset to the revenue it helps generate.
Understanding operating expenses
Operating expenses are the costs a business incurs as part of its core day-to-day activities. These are the expenditures tied to the regular functions that support revenue generation.
- Common types: Operating expenses typically include rent, utilities, salaries, office supplies and insurance. For example, the monthly rent a retailer pays for its storefront would be classified as an operating expense.
- Where they appear: These costs show up on the income statement as part of operating activities. A service company might list employee wages and software subscriptions as operating expenses on its financial statements.
- What they exclude: Costs not tied to daily operations, such as interest payments or lawsuit settlements, are classified separately. For instance, a one-time legal settlement would not appear as an operating expense.
Is depreciation considered an operating expense?
In most cases, depreciation is considered an operating expense because it relates to assets used in a company's core operations. Depreciation is also a non-cash expense, meaning it reduces reported profit on the income statement without an actual outflow of cash. On the cash flow statement, the depreciation amount is typically added back to net income, which can help reflect the business’s actual cash position. Depreciation may also appear on the balance sheet as accumulated depreciation, reducing the book value of the asset over time.
An exception can arise when depreciation relates to assets that are not part of the company's primary operations. If a business owns real estate it rents out but does not use in its operations, the depreciation on that property would not be included in operating expenses. Instead, it would be classified as a non-operating expense.
Depreciation vs. other business expenses
Depreciation shares similarities with other expense categories but has some characteristics that set it apart.
- Depreciation vs. amortization: Depreciation applies to tangible assets like machinery, vehicles and buildings, while amortization applies to intangible assets like patents and software. For example, the cost of a factory machine is depreciated, while the cost of a software license is amortized.
- Depreciation vs. cost of goods sold: Cost of goods sold (COGS) includes the direct costs of production and for manufacturers, depreciation may be part of COGS because production equipment contributes directly to goods for sale. A bakery might include depreciation of its ovens in COGS rather than as a separate operating expense.
- Depreciation vs. non-operating expenses: Non-operating expenses are not tied to daily operations and can include items like interest or lawsuit settlements. Depreciation on idle equipment may also fall into this category rather than operating expenses. A company that no longer uses a machine in production may classify its depreciation as non-operating.
Practical examples and scenarios
How depreciation is classified can depend on how the asset is used within the business.
- Production equipment: A factory that depreciates its production machinery may include that depreciation in cost of goods sold rather than as a separate operating expense. The equipment directly supports the company's core activity of manufacturing products for sale.
- Office furniture: A marketing firm that depreciates its desks and computers would record that depreciation as an operating expense. These assets support the firm's primary function of the delivery of services to clients.
- Investment property: A retailer that owns a warehouse it leases to another company would not classify the depreciation on that warehouse as an operating expense. The property generates passive income rather than a role in the retailer's core sales operations.
The bottom line
Depreciation is usually classified as an operating expense when it relates to assets used in a company's day-to-day operations. When an asset supports the core activities of the business, its periodic cost allocation is recorded as an operating expense on the income statement.
However, the classification can shift when depreciation involves assets outside of primary operations. An understanding of how depreciation compares to other expense categories can help business owners make sense of their financial statements and communicate more effectively with financial professionals.
