What is Cost?

Cost most closely equates to the term expenditure, so it means that you have expended resources in order to acquire something, transport it to a location, and set it up. However, it does not mean that the acquired item has yet been consumed. Thus, an item for which you have expended resources should be classified as an asset until it has been consumed. Examples of asset classifications into which purchased items are recorded are prepaid expenses, inventory, and fixed assets.

Example of Cost

The cost of an automobile may be $40,000 (since that is what you paid for it) and the cost of a product you built is $25 (because that is the sum total of the expenditures you made to build it). The cost of the automobile likely includes sales taxes and a delivery charge, while the cost of the product probably includes the cost of materials, labor, and manufacturing overhead. In both cases, you have expended funds to acquire the automobile and the product, but have not yet consumed either one. Accordingly, the first expenditure is classified as a fixed asset, while the second one is classified as inventory. Similarly, an advance paid to an employee is classified as a prepaid expense.

What is Expense?

Expense is a cost whose utility has been used up; it has been consumed. For example, the $40,000 automobile you purchased will eventually be charged to expense through depreciation over a period of several years, and the $25 product will be charged to the cost of goods sold when it is eventually sold. In the first case, converting from an asset to an expense is achieved with a debit to the depreciation expense account and a credit to the accumulated depreciation account (which is a contra account that reduces the fixed asset). In the second case, converting from an asset to an expense is achieved with a debit to the cost of goods sold and a credit to the inventory account. Thus, in both cases, we have converted a cost that was treated as an asset into an expense as the underlying asset was consumed. The automobile asset is being consumed gradually, so we are using depreciation to eventually convert it to expense. The inventory item is consumed during a single sale transaction, so we convert it to expense as soon as the sale occurs.

Another way of thinking of an expense is any expenditure made to generate revenue under the matching principle, which was particularly apparent in the last case, where inventory was converted into an expense as soon as a sale occurred. Under the matching principle, you recognize both the revenue and expense aspects of a transaction at the same time, so that the net profit or loss associated with the transaction is immediately apparent. Thus, a cost converts to an expense as soon as any related revenue is recognized.

Comparing Cost and Expense

The key differences between the cost and expense concepts are as follows:

Scope. Cost is a broader term that encompasses all outflows of resources, while expense is a subset of cost that focuses on income statement recognition.
Accounting treatment. A cost may be categorized as an asset, expense, or liability depending on its nature, while an expense is always recorded on the income statement as a deduction from expense.
Timing. Cost refers to the total investment made (past or future), while expense relates to the amount incurred in a specific period for operations.
Purpose. The cost concept is used for the acquisition, production, or setup of goods and services, while the expense concept reflects the consumption or use of goods or services to generate revenue.
Relationship to profit. A cost may or may not directly affect profit, depending on whether it is treated as an asset or an expense, while an expense directly impact profit, since it reduces net income.
Nature. A cost can be either capital or revenue in nature, while an expense is always related to the revenue incurred.

In summary, cost is a more comprehensive term related to acquiring or producing something, while expense refers to the specific portion of that cost that is consumed or allocated to an accounting period.