Financial statements allow a business to stop in time and take a snapshot of how well the company’s performing. The income statement reports the company’s net profit (or loss), usually at the end of each month. In simple terms, the net profit (before taxes) is formulated by deducting expenses from gross profit and other gross income. There are usually two separate expense categories that are reported on the income, fixed and operating expense.
Fixed Expenses – The Income Statement
Fixed expenses are business expenses that generally remain somewhat consistent from month to month. They are not normally affected by the daily business activities such as sales and production activities. Since fixed expenses remain consistent, they are normally separated from other types of expenditures on the income statement.
Examples of Fixed Expenses
- Rent
- Utilities
- Insurance
- Salaries
Operating Expenses – The Income Statement
Operating expenses, sometimes called variable expenses, are business expenditures that fluctuate over time. Variable expenses are generally related directly to business activities. As production or sales increase, variable expenditures generally increase. Operating costs are usually separated on the income statement from fixed costs.
Examples of Operating Expenses
- Equipment maintenance
- Vehicle maintenance
- Freight
- Supplies
- Hourly wages
- Commission
Recording Expenses on the General Ledger
Expenses are usually recorded in the purchase journal or check register. If expenses are purchased on open account, they are generally recorded in the purchase journal. If they are not purchased on open account, they are generally recorded in the check register, as the check is written.
A debit would increase the expense and the offsetting credit would be to either cash (check register) or accounts payable (purchase journal). The credit to cash would decrease the cash and the credit to accounts payable would increase accounts payable. When the account is paid, the debit would decrease accounts payable and the credit would decrease cash. The amounts are then transferred to the appropriate general ledger accounts.
Analyzing Operating Expense from the Income Statement
Since fixed expenses remain consistent, there’s not as much need to analyze them. Since operating expenses fluctuate along with business activities, they should be analyzed from the income statement to make sure they align with profits. One important ratio to analyze is the variable expense to gross profit ratio. Simply divide the total gross profit into each individual operating expense.
To ensure that variable expenditures aren’t increasing in relationship to gross profit, the current months percentage should be compared to a 12-month average percentage. If a trend is developing, where the percentage is increasing, further analysis should be undertaken to find the root cause. Once the root cause is determined, immediate action should be taken to correct the negative affect to net profits.
James Clausen - Clausen received a Bachelors Degree in Business Administration in Automotive Management and Marketing at Northwood University, graduating ...
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