Business Expenses & How They Affect Profit
Profit is the bottom line on an income statement and is the motive for running a business. Cost of goods sold and expenses are the deductions that determine the amount of profit generated by your business, but expenses is the one deduction that requires constant attention and monitoring. Ignorance about the effects of expenses on your profits can make it difficult for you to maximize operational efficiency.
Expenses can vary according to type or classification, but with all factors being equal, any increase in expenses results in a decrease in profits. There are three levels of profitability in an income statement. Profit generated after deducting cost of goods sold is known as gross profit. Profit generated after deducting operating expenses is referred to as operating profit or profit before interest and taxes. Profit earned after deducting taxes and interest is called net profit.
Profit at the revenue level, or gross profit, is the result of subtracting cost of goods sold from total net sales. Although cost of goods sold is a revenue deduction and is not directly classified as an expense account, it includes production expenses that are incorporated into the cost of goods manufactured. Both fixed and variable production costs reduce gross profit at different ratios. Fixed production expenses, such as buildings and equipment, are production expenses that decrease as the production volume increases. Variable production costs do not change according to production quantity, but such costs are part of cost of goods.
Subtracting operating expenses from gross profit results in operating profit, or profit before interests and taxes. Operating expenses are those incurred by a business as a result of performing its normal core business operations. The amount of increase or decrease in total operating expenses will result in a similar change in the amount of profits. Rent, utilities and payroll are some of the most common types of operating expenses.
Non-operating expenses are those incurred as a result of activities not related to the core operations of a business. Taxes and interest are the most common types of such expenses. These expenses are deducted from operating profit to yield net profit or net income. Non-operating expenses directly reduce whatever profit is left after deducting operating expenses.