Demystifying Above the Line vs. Below the Line Expenses

As a business owner, you likely come across many unfamiliar finance and accounting terms Two such terms that often cause confusion are “above the line” and “below the line” expenses Though they may sound vague, these terms have distinct meanings in the world of accounting.

In this comprehensive guide, we’ll demystify these expense categories to help you better understand your company’s finances.

What Does Above the Line Mean?

Above the line refers to a company’s core expenses that are directly related to producing and selling its products or services These costs are deducted from total revenues to calculate a company’s gross margin or profit

Specifically, above the line expenses include:

• Cost of goods sold (COGS) – Direct costs of materials and labor to manufacture products
• Operating expenses – Rent, utilities, payroll, marketing, etc.
• Depreciation – Decline in value of fixed assets like equipment
• Amortization – Decline in value of intangible assets like patents

Above the line expenses are considered part of a company’s central operations. They can’t be easily eliminated without fundamentally changing the business model.

Key Attributes

• Vital to central operations
• Directly tied to revenue generation
• Generally recurring and predictable
• Deducted before gross margin on income statement

What is Below the Line?

In contrast, below the line refers to peripheral expenses that aren’t directly related to a company’s main operations. These expenses are listed after gross margin on the income statement.

Common below the line expenses include:

• Interest expense – Interest paid on business loans and debt
• Income taxes – Federal, state, and local tax payments
• Foreign currency exchange gains/losses
• Early repayment fees – Penalties for repaying loans ahead of schedule
• Discontinued operations – Costs to wind down discontinued products or business units

Below the line expenses are generally one-off or unpredictable costs. They are also called “non-operating expenses” since they stem from secondary activities outside a company’s core operations.

Key Attributes

• Incurred from secondary activities
• One-time or unpredictable
• Listed after gross margin on income statements
• Non-essential expenses

In essence, below the line refers to discretionary expenses that aren’t directly tied to generating revenue. These peripheral costs only exist to support the central business.

Why Do These Categories Matter?

Separating above and below the line expenses serves an important analytical purpose. It provides a clearer picture of a company’s core profitability.

Above the line expenses reflect the baseline costs of running central business operations. If a company can’t profitably cover these expenses, its business model is fundamentally flawed.

Meanwhile, below the line expenses are incidental costs that merely provide support. These costs don’t shed much light on the viability of a company’s core business.

Categorizing expenses in this manner allows stakeholders to better evaluate the drivers of profitability and operating efficiency. For example:

• High above the line costs could signal operational inefficiencies.
• Spikes in below the line costs may not be concerning if core operations remain profitable.
• Comparing above the line costs year-over-year shows the cost trajectory of core business activities.

The bottom line? Separating above and below the line items allows for an “apples to apples” comparison of the key profit drivers from period to period.

Above the Line Expenses Examples

Let’s look at some common examples of above the line expenses:

1. Cost of Goods Sold (COGS)

COGS includes the direct costs of materials and labor to manufacture products. For example, a furniture company’s COGS would include:

• Wood, fabric, and cushioning materials
• Factory worker wages
• Equipment depreciation
• Rent and utilities for manufacturing facilities

Tracking COGS is critical for companies that produce tangible goods. It reveals the baseline production costs that must be covered to earn a gross profit.

2. Employee Salaries

For service companies, employee salaries are typically the largest above the line expense. Employee wages are seen as a direct cost of generating revenue.

Let’s say a marketing consulting firm pays $60,000 in salary to a sales employee who generates $100,000 in revenue. The salary would be considered an above the line cost deducted from total revenues.

However, executive salaries may be excluded from this category, as they aren’t direct costs of providing services.

3. Sales Commissions

Sales commissions are also commonly accounted for above the line. When commissions are paid as a percentage of revenue generated, they are considered a direct cost of earning that revenue.

For instance, if a sales rep earns a 5% commission on their $100,000 of revenue, the $5,000 commission is deducted as an above the line expense.

4. Marketing Costs

Marketing costs include expenses for advertising, promotions, trade shows, and other sales-related activities. Since marketing aims to directly generate revenue, associated costs are generally classified above the line.

However, discretionary marketing for brand-building may be considered below the line, since it only indirectly supports sales.

Below the Line Expenses Examples

Now let’s examine some representative below the line expenses:

1. Interest Expense

One of the most common below the line items is interest expense paid on business loans, lines of credit, and other debt.

Even though debt provides operating capital, the interest cost is considered separate from core business activities. This highlights the company’s base profitability excluding financing decisions.

2. Lawsuit Settlements

Settlement costs from lawsuits or regulatory fines are considered one-time below the line expenses. These extraordinary costs aren’t part of standard business operations.

However, routine legal/professional fees for lawyers or auditors would likely be above the line operating expenses.

3. Foreign Exchange Losses

Currency exchange rate fluctuations often create foreign exchange gains or losses for global companies. Since forex swings are external and unpredictable, they are tracked below the line.

These non-operating costs allow analysts to isolate the actual revenues and expenses from core operations.

4. Write-downs and Impairment Charges

Write-downs or impairment charges reduce the book value of overvalued assets. For instance, a write-down could lower the book value of obsolete inventory or equipment.

Since write-downs don’t impact core operating cash flow, companies classify them as non-recurring below the line expenses.

Key Differences Summarized

Here are the key differences between above and below the line expenses at a glance:

Impact on Financial Statements

Above and below the line expenses appear in different sections of a company’s financial statements:

Income Statement

On the income statement, above the line items are deducted before gross margin. Below the line comes after gross margin and before net profit.

This format separates core operating profitability from ancillary expenses.

Balance Sheet

The balance sheet isn’t separated into above and below the line sections.

However, current assets/liabilities arise from core operations, while non-current assets/liabilities stem from secondary activities. This indirectly mirrors the categorization.

Cash Flow Statement

The cash flow statement classifies above the line items as core operating expenses. Below the line items are detailed under “Investing” or “Financing” activities.

Should You Focus on Cutting Above or Below the Line Costs?

When looking to reduce expenses, companies naturally gravitate towards above the line costs. However, this isn’t always the best strategy.

Since above the line expenses are vital for central operations, reducing them requires finding true efficiencies. This often involves rethinking processes, technologies, and capabilities—no small feat.

Conversely, below the line costs are typically easier to cut since they aren’t critical for core functions. Yet the savings may be less impactful or sustainable.

There’s no universal rule on where to focus cost-cutting efforts. The best approach depends on your specific business model and category of expenses.

That said, companies should be cautious about arbitrarily slashing above the line expenses to boost profitability. This risks damaging capabilities that drive revenue—the goose that lays the golden eggs.

The Bottom Line

At first glance, the terms “above the line” and “below the line” may not seem hugely important. But these categories offer invaluable insights into the true drivers of profitability and cost efficiency for businesses.

By separating vital operating expenses from discretionary ancillary costs, companies can better understand their core business performance. This analysis informs smarter strategic decisions and resource allocation.

So while the terminology seems obscure, properly distinguishing above and below the line expenses leads to sharper financial clarity.