How to Categorize Expenses for Small Business

Properly categorizing expenses is a critical accounting task for small businesses. Assigning transactions to the correct expense categories provides valuable insights into where your money is going. With well-organized expense data, you can analyze spending patterns, make budgets more accurate, and maximize tax deductions. This guide will explain the benefits of expense categorization and how to develop an effective system.

Why Categorize Expenses?

Categorizing every business expense serves multiple purposes

• Taxes At tax time, your income and expenses must be assigned to the proper IRS categories like advertising, wages, utilities, etc Proper categorization ensures maximum write-offs

• Reporting: Financial reports break out spending by type. Accurate categories give you true departmental or functional area spending.

• Analysis: You can dig into expenses by category to identify waste, compare period-over-period, find opportunities to cut costs, etc.

• Budgeting: Building a realistic budget relies on historical spending data classified into logical groups.

• Auditing: Cleanly categorized transactions simplify the organization and adjustments needed when your books are audited.

• Benchmarking: Compare your expense categories to competitors or industry averages to assess performance.

Without the order of a well-planned categorization scheme, your financial data is far less useful for critical business decisions.

Common Expense Categories

While you can create customized categories for your business, most fit into the following standard types:

• Cost of Goods Sold: Expenses directly tied to producing your products or delivering your services. For example, material, labor, and manufacturing overhead for a manufacturer.

• Operating Expenses: Ongoing overhead costs like salaries, rent, utilities, insurance, equipment leases, etc.

• Selling, General & Administrative: Day-to-day costs of running operations, business development, and sales. For example, advertising, office supplies, software, travel, meals & entertainment, vehicle expenses, etc.

• Other Income/Expenses: One-time or unusual profit or loss transactions like the sale of assets, interest/dividends, lawsuits, etc.

• Non-Operating: Expenditures unrelated to core operations, like interest on debt or investments in other companies.

• Taxes: All tax obligations incurred, including payroll, sales, property, and income taxes.

Within these broad categories, develop subcategories relevant to your business model and reporting needs.

Developing Your Expense Category Scheme

Follow these steps to build a logical and consistent system:

1. Review past expenses. Examine several months of your income statement and chart of accounts. Identify gaps and areas needing better organization.

2. Benchmark competitors. Research how similar businesses categorize expenses for ideas. Industry associations sometimes publish expense category benchmarks as well.

3. Align with financial statements. Your categories should map to line items on your income statement, balance sheet, and cash flow statement.

4. Consider taxes. Organize categories based on IRS deductions like advertising, repairs, wages, utilities, etc.

5. Start broad. Begin with the five to ten high-level categories that represent the largest shares of spending.

6. Add subcategories. Within each high-level category, break expenses down into logical groupings and sensible levels of detail. Avoid going overboard.

7. Make a list. Compile a master list of expense categories and subcategories for reference. Keep list handy for data entry.

8. Assign account codes. Match your list to account codes in your chart of accounts. Use numerical or alphabetical coding that indicates category hierarchy.

9. Test and adjust. Try using the new categories for a month. Review results and refine categories as needed.

10. Document rules. Detail the types of expenses and specific accounts that belong under each category for reference. Update documentation as needed.

Best Practices for Expense Categorization

Follow these tips and tricks for an effective system:

• Use consistent wording like “Overhead” instead of mixing “Overhead,” “Overheads,” and “Over head.”

• Classify consistently. Don’t flip-flop a particular expense between different categories.

• Review periodically. As your business evolves, expense patterns change. Tweak categories accordingly.

• Enforce discipline. Train employees on proper categorization, and review their work to ensure compliance.

• Use enough detail. Overly broad categories limit insights, but too much detail gets cumbersome. Find the right balance.

• Watch outsourcing. If bookkeeping is outsourced, take extra care to align on expense classification.

• Automate rules. In accounting software, build automated rules to code expenses the same way each time.

• Follow the money. Assign expenses to where the money actually goes, not vague allocations.

• No miscellaneous. Don’t use this as a catch-all for expenses you can’t classify. It renders data worthless.

Getting expense categorization right takes work but pays major dividends. The business insights uncovered help you control costs, plan accurately, and maximize tax deductions.

Examples of Common Small Business Expense Categories

To give you a head start, here are some examples of expense categories and subcategories that most small businesses use:

Cost of Goods Sold

• Direct material
• Direct labor
• Manufacturing overhead

Operating Expenses

• Occupancy
  • Rent
  • Utilities
  • Repairs & maintenance
  • Property insurance
  • Property taxes
• Depreciation
• Salaries & wages
• Payroll taxes
• Employee benefits
• Office expenses
  • Office supplies
  • Postage
  • Printing
  • Equipment leases
• Equipment repair & maintenance
• Dues & subscriptions
• Telephone & internet
• Business insurance
• Permit & license fees
• Bank fees
• Interest expense
• Professional services
  • Legal
  • Accounting
  • Consultants

Selling, General & Administrative

• Advertising
• Marketing programs
• Commissions
• Travel
  • Air & rail fare
  • Lodging
  • Meals & entertainment
• Auto mileage reimbursement
• Customer gifts
• Website hosting
• Trade shows
• Sales training
• Entertainment
• Credit card fees

Other Income/Expenses

• Gain/loss on asset sale
• Currency exchange gain/loss
• Interest income
• Other miscellaneous income

Non-Operating Expenses

• Charitable contributions
• Political donations

Taxes

• Income taxes
• Payroll taxes
• Property taxes
• Sales taxes
• Excise taxes

Categorizing Expenses in Practice

With the basics covered, let’s look at some examples to get a feel for categorizing real-world expenses:

• A vegetable oil manufacturer buys soybeans for production. Cost of Goods Sold → Direct Materials

• A law firm pays attorneys their salaries. Operating Expenses → Salaries & Wages

• A retailer pays the electric bill for their store. Operating Expenses → Occupancy → Utilities

• A consultant buys a plane ticket for a client project. Selling, General & Admin → Travel → Air & Rail Fare

• A wholesaler sends flowers to a customer. Selling, General & Admin → Customer Gifts

• A manufacturer pays state income tax. Taxes → Income Taxes

Get in the habit of thinking through the proper category for each transaction. Over time, you will develop an intuitive sense for expense classification.

Automating Expense Categorization

For most small businesses, accounting software is essential to eliminating tedium while enforcing consistency. In particular, rules-based auto-categorization streamlines the process.

When setting up rules, first bulk re-categorize historical transactions to align with your new scheme. Then build rules based on:

• Vendor or customer name: Code all transactions from utility companies under utilities.

• Account code: Expenses from certain accounts like travel automatically go to certain categories.

• Transaction description: Contains keywords to trigger categorization (i.e. “marketing” goes to advertising).

• Amount: Transactions amounts within specified ranges land in set categories.

• Date: Transactions on certain dates fall under given categories (i.e. dues paid the first of each month).

The rules will automatically populate the appropriate expense category for each new transaction. You can still manually override any improperly coded transactions.

Well-organized expense data is a must for small business success. Following the steps in this guide will help you implement a logical, robust system for expense categorization. The insights gained into cost drivers and spending patterns are well worth the effort.