Is depreciation an operating expense?

When your business invests in something significant, like a building or machinery, it's not just a one-time hit to your books. Instead, you spread out the cost over time. This is where depreciation comes in, allowing you to allocate the cost of an asset over its useful life.

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Understanding depreciation can impact how you report your financial health and plan for taxes. So, let's break it down.

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What are depreciation expenses?

Depreciation expense represents the allocation of the cost of a tangible asset over its useful life. When a business acquires a long-term asset, it doesn’t expense the entire cost immediately. Instead, it spreads the cost across several years, reflecting the asset’s consumption or usage over time. This approach aligns with the matching principle in accounting, which aims to match expenses with the revenues they help generate.

It shows up on the income statement as a non-cash expense, reducing taxable income—a handy tool for tax planning. However, it doesn't involve any actual cash outflow during the period it's recorded. This distinction matters because it affects cash flow analysis and financial planning. For a deeper dive into how depreciation impacts your financial statements, check out our guide on depreciation expenses.

Examples of depreciation expense

1. Vehicles: Businesses often use vehicles for deliveries, transportation, or other operational needs. Over time, these assets depreciate, reflecting their wear and tear and eventual replacement. Depreciation expense for vehicles accounts for their declining value as they age and rack up mileage.
2. Equipment: Machinery and equipment used in production or service delivery are prime candidates for depreciation. Their useful life can range from a few to several years, depending on their nature and usage. Depreciation helps allocate their cost over the period they contribute to generating revenue.
3. Buildings: Real estate, such as office buildings or warehouses, also undergoes depreciation. While buildings generally have a longer useful life compared to vehicles or equipment, they still experience wear and tear over time. Depreciation on buildings accounts for this gradual decline in value, ensuring that the financial statements reflect a more accurate picture of the asset’s worth.

Is depreciation an operating expense?

Depreciation can be an operating expense when the depreciated asset is integral to your company's core business activities. This means if the asset directly supports primary operations, its depreciation falls under operating expenses. For instance, if your business relies on machinery for production, the depreciation of that equipment is considered an operating expense. This classification helps reflect ongoing costs associated with maintaining essential business functions. 

When using equipment in manufacturing, its depreciation often becomes part of the cost of goods sold (COGS). This inclusion aligns with how the equipment contributes directly to producing goods for sale. By incorporating depreciation into COGS, you accurately capture the total cost of production, which includes both direct and indirect expenses. This approach ensures that your financial statements provide a clear picture of the profitability of your core operations.

Assets used for selling and administrative purposes also contribute to operating expenses through depreciation. These assets, such as office equipment or sales team vehicles, support daily functions necessary to run your business. Depreciating these assets as operating expenses reflects their role in facilitating business operations beyond direct production.

Alternatively, when an asset is used for peripheral activities, its depreciation is classified as a non-operating expense. Peripheral activities are those not directly tied to core business operations. For instance, if you own a piece of real estate that serves as an investment property rather than a primary business location, its depreciation would be non-operating. This distinction separates costs related to secondary activities from those essential to the core business, providing a more accurate financial overview.

Understanding whether depreciation is an operating or non-operating expense depends on the asset's role within your business. This classification impacts how you report expenses and assess the financial health of your operations. By accurately categorizing depreciation, you ensure that your financial statements reflect the true cost of running your business, aiding in resource allocation and financial planning.

Depreciation on the income statement

When you check your income statement, depreciation can appear in different sections based on how the asset supports your business. If the asset is part of your core operations, its depreciation is listed under operating expenses. This placement reflects ongoing costs associated with maintaining your business's primary activities. For example, office equipment used in daily operations will have its depreciation recorded here, showing its role in supporting essential functions. 

In manufacturing, depreciation often integrates into the cost of goods sold (COGS). This approach aligns with how manufacturing equipment directly contributes to producing goods. By including depreciation in COGS, you capture the full cost of production, encompassing both direct and indirect expenses. This method provides a comprehensive view of production costs, ensuring your financial statements accurately reflect the profitability of your core manufacturing activities.

If an asset isn’t directly tied to main business operations, its depreciation appears below operating income as a non-operating expense. This classification applies to assets used for peripheral activities, such as investment properties or equipment not central to your primary business. By placing depreciation in this section, you separate costs related to secondary activities from those essential to your core operations, maintaining clarity in financial reporting.

Streamline your financial operations with Ramp

Understanding depreciation and its impact on your financial statements is crucial for effective business management. At Ramp, we help you take control of your finances with our comprehensive suite of tools designed to automate and streamline your financial operations. Whether it's managing expenses, automating bill payments, or optimizing procurement processes, our platform ensures you save time and money. 

Join the thousands of businesses already benefiting from Ramp's innovative solutions. Let us help you focus on what truly matters—growing your business. Visit Ramp to learn more about how we can support your financial goals.

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