Is depreciation an operating expense?

In most cases, depreciation is an operating expense. When an asset supports your day-to-day operations, its periodic cost allocation is recorded as an operating expense on the income statement. The exception is when depreciation relates to non-operating assets, such as idle equipment or investment property, where it's classified separately.

Understanding when depreciation belongs in operating expenses versus elsewhere helps you read financial statements more accurately and spot how these costs affect profit metrics like operating income and EBITDA.

What is depreciation?

Depreciation is the process of spreading the cost of an asset over the time that it's used. Some assets gradually lose value as they become worn out or outdated, and depreciation lets you account for that decline.

When a business acquires a long-term asset, it doesn't expense the entire cost immediately. Instead, it spreads the cost across several years to reflect the asset's usage over time. This approach follows the matching principle, which aims to align expenses with the revenues they help generate.

Depreciation appears on the income statement as a non-cash expense that reduces taxable income, a useful tool for tax planning. However, it doesn't involve any actual cash outflow during the period it's recorded. This matters because it affects cash flow analysis and financial planning.

Examples of depreciation expense

• Company vehicles: Over time, vehicles used for deliveries, transportation, or other operational needs depreciate as they wear out and require replacement
• Equipment: Machinery and equipment used in production or service delivery have useful lives that vary by type and use. Depreciation allocates their cost over the period they generate revenue.
• Buildings: Office buildings, warehouses, and other facilities have longer useful lives than vehicles or equipment but still experience wear and tear. Depreciation on buildings captures this gradual decline in value, helping financial statements reflect a more accurate picture of the asset's worth.

Depreciation vs. amortization

Depreciation and amortization are similar concepts, but have key differences. Depreciation expenses are for tangible assets, like machinery, vehicles, and buildings, while amortization is reserved for intangible assets like patents, trademarks, and software.

There is no wear-and-tear for amortization of assets. Instead, it records the decline in the value of these assets over time.

How depreciation works

Depreciation lets you spread the cost of an asset over its useful life. For example, if you purchase an asset for $20,000 and expect it to last 10 years, you'd record an annual expense of $2,000.

Common depreciation methods include:

• Straight-line method: The most common approach is to divide the asset's cost by its useful life, recording the same expense each year
• Declining balance method: If an asset loses value more quickly in the early years, you can record a larger depreciation amount at the start and smaller amounts later

For instance, if you buy office equipment for $15,000 with a useful life of 5 years, the straight-line method records $3,000 in depreciation expense each year. Using the declining balance method, if you expect it to lose half its value in the first year, you'd record $7,500 in depreciation the first year and $1,875 in each of the next 4 years.

Understanding operating expenses

Operating expenses are the everyday costs of running a business. They directly relate to producing and delivering your company's products or services. Common categories include:

• Rent or mortgage payments
• Utilities
• Payroll
• Office supplies and equipment
• Marketing and advertising

Operating expenses keep your business running by maintaining your base of operations, supporting your employees, and helping you deliver your offerings.

Characteristics of operating expenses

Operating expenses share a few key traits. They:

• Recur: Operating expenses are predictable, ongoing, and planned to support your business over time
• Directly connect to generating revenue: Each operating expense should clearly support the products or services you provide and help drive revenue
• Impact operating income: Operating expenses are subtracted from gross revenue to calculate operating income, so managing them efficiently can improve profitability

Is depreciation an operating expense?

In most cases, yes, depreciation is considered an operating expense because it relates to assets used in a company's core operations. For example, depreciation on manufacturing equipment or office furniture is classified as an operating expense since it's tied directly to the day-to-day functioning of the business.

If an asset isn't part of the company's primary operations, like investment properties or unused equipment, its depreciation may instead be categorized as a non-operating expense. For instance, if a business owns real estate it rents out but doesn't use in operations, the depreciation on that property wouldn't be included in operating expenses.

While depreciation is an operating expense, it's also a non-cash expense that reduces reported profit without affecting cash flow. It's important for financial reporting and analysis because it influences key performance metrics such as operating income and EBITDA.

Don't confuse depreciation expense with accumulated depreciation. Accumulated depreciation is a running total on the balance sheet, recorded as a contra-asset account that reduces the carrying value of a fixed asset over time. It is not an expense.

Only the periodic depreciation charge (the amount recorded each year) appears on the income statement as an operating expense.

Depreciation on the income statement

When you review your income statement, depreciation may appear in different sections depending on how the asset supports your business. If the asset is part of your core operations, its depreciation is included in operating expenses.

This placement reflects the ongoing costs of maintaining your primary activities. It appears above the operating income line because it reduces operating income.

If an asset isn't directly tied to your main business operations, its depreciation appears below operating income as a non-operating expense. Placing depreciation here separates costs related to secondary activities from those essential to your core operations, maintaining clarity in financial reporting.

EBITDA vs. operating income

Operating income includes depreciation, which reduces your reported profitability. EBITDA, short for earnings before interest, taxes, depreciation, and amortization, is another accounting metric often used to evaluate operational performance. It provides a clearer view of financial results by excluding non-cash expenses like depreciation and amortization.

Here's how the two metrics differ in practice. Say your company has $500,000 in revenue, $300,000 in operating expenses (excluding depreciation), and $50,000 in depreciation:

Operating income = $500,000 – $300,000 – $50,000 = $150,000

EBITDA = $500,000 – $300,000 = $200,000

The $50,000 gap is the depreciation add-back, which is why EBITDA is often used to compare companies with different capital structures or asset bases.

How depreciation works in different industries

Accounting for depreciation varies across industries based on how assets support day-to-day operations:

Manufacturing

Depreciation is often included in the cost of goods sold (COGS) because manufacturing equipment directly contributes to production. This approach provides a clearer view of total production costs and helps ensure your income statement accurately reflects the profitability of your core manufacturing activities. Managing these allocations carefully also improves visibility into unit-level margins.

Service businesses

Service-oriented companies typically classify depreciation under selling, general, and administrative (SG&A) expenses. Equipment like laptops, servers, and office furniture supports operations but doesn't directly tie to production. Properly categorizing these costs helps service firms track overhead more accurately and understand their true operating efficiency.

Real estate

Buildings used in operations depreciate as operating expenses, though over much longer periods than other assets. While the structures lose value, the land itself does not. Real estate companies often use component depreciation to separately track structures and improvements, ensuring more precise reporting over time.

Transportation and logistics

Fleet depreciation on trucks, trailers, and delivery vehicles is a major operating expense in logistics. Truck and trailer payments reached a record $0.39 per mile in 2024, rising 8.3% year over year according to ATRI's operational costs report. These assets depreciate quickly due to daily use, high mileage, and wear from loading and unloading. Tracking fleet depreciation accurately is critical for logistics companies because it directly affects route profitability and replacement planning.

Depreciation vs. other business expenses

Depreciation is a type of non-cash operating expense. Here's how it compares with other common business expenses:

Depreciation expense vs. cost of goods sold

Cost of goods sold (COGS) includes the direct costs of producing goods. For manufacturers, depreciation is often part of COGS because production equipment directly contributes to goods for sale. Including depreciation in COGS helps capture the total cost of production accurately.

For example, if a pencil factory purchases a $200,000 machine for production, the annual depreciation cost is recorded as part of COGS since the equipment is directly tied to creating inventory.

In service-based businesses such as marketing agencies, software providers, and law firms, there's no physical inventory to produce. However, assets like computers, printers, and office furniture still depreciate as operating expenses. These are typically recorded within SG&A (selling, general, and administrative) expenses.

Operating vs. non-operating expenses

Depreciation is usually an operating expense, but there are exceptions. Non-operating expenses aren't tied to daily operations and can include items like interest expenses, lawsuit settlements, and inventory write-offs.

Occasionally, depreciation is treated as non-operating, for example, depreciation on an investment property not used in operations or on idle equipment that's no longer in production.

Tax implications of depreciation

Although no cash is actually spent during the period when you record depreciation, it's treated as a business expense on your profit and loss statement. That means it reduces your taxable income and the amount you'll owe in taxes.

However, how you account for depreciation differs depending on whether you're using book or tax depreciation:

• Book depreciation: Used in financial statements; based on accounting standards; can use straight-line or declining balance methods; reflects an asset's expected life
• Tax depreciation: Used in tax filings; based on tax code rules; can use accelerated methods for faster write-offs; follows asset class definitions in tax law

Impact on cash flow

Depreciation is recorded as an expense, but no money changes hands when it's recognized, so it's considered a non-cash expense on your financial statements.

On the income statement, depreciation reduces net income. Because it doesn't involve any cash outflow, it's added back under operating activities on the cash flow statement.

Depreciation also provides a tax shield benefit by lowering your total taxable income. As a tax deduction, it reduces your tax burden and helps improve cash flow.

Practical examples and scenarios

Depreciation can be tricky. These three scenarios show how it works in practice.

Example 1: Retail

A department store prepares new storefront windows and spends $10,000 on lighting and shelving. The store anticipates these items will last about 10 years. Using the straight-line method, the annual depreciation is $1,000.

Example 2: Manufacturing

A manufacturing plant buys a conveyor system for $45,000 to speed up production. The company expects to use the system for 5 years, with most wear occurring in the first 2 years. Using the declining balance method:

Example 3: Service

A growing law firm upgrades its team's laptops. The total cost is $30,000, and the firm expects the computers to last 4 years. Using the straight-line method, the annual depreciation is $7,500.

Common mistakes to avoid

Depreciation isn't always straightforward. These are common mistakes and how to address them:

• Misclassifying depreciation expenses: If you've put all expenses under COGS when they aren't all production-related, reallocate the depreciation to operating expenses or selling, general, and administrative (SG&A) expenses
• Forgetting to record depreciation: If you don't record depreciation, you may overstate the value of your assets and your business. Set reminders to post entries regularly.
• Using incorrect depreciation methods: Don't mix book and tax methods. Decide whether you're recording for financial or tax purposes before selecting a method.

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