But when you take steps to categorize your business expenses properly, you start to tell a story about your spending. This can help you make more-informed decisions and projections.
Here's what to know about identifying and categorizing business expenses to streamline your financial operations.
What Qualifies as a Business Expense?
Business expenses are any costs associated with operating your business, creating your product, and paying your employees.
The IRS defines business expenses as "ordinary and necessary" costs to your work.
Every expense that you have falls into a different category or “label.” Expense categories include the cost of revenue, research and development (R&D), sales and marketing, or general and administration costs.
Four Tips on How to Categorize Expenses
Categorizing helps you break all of your expense information down into digestible bites and helps you see the connections between money spent and money earned.
For example, sorting your marketing expenses can show you how spending money on YouTube advertisement videos correlates to improving profits. This can help you predict things like cash flow.
If you are just getting started categorizing expenses or building what we can your chart of accounts, it may feel difficult to know where to start. So, check out these four tips to get started.
NOTE: We’ve laid out these steps to help you if you are categorizing your expenses manually or using a spreadsheet. However, we recommend using automated accounting software to do the real heavy lifting!
1. Make a List of Your Business Expenses
A good place to start is to make a list of business expenses. You may find documentation of recent costs by looking at your:
- Business bank account
- Business credit card
- Vendor invoices
- Utility bills for physical locations
Once you’ve tracked everything down, add each one to a list. You can categorize the expenses from here to better understand your spending.
2. Organize the List by Common Business Expense Categories
A list of business expenses can only tell you so much, but a list organized into categories may paint a picture of your business's costs, needs, and financial movements.
Categorizing expenses relies on a certain underlying organization. You can achieve this by sorting your common business expenses into some of the following categories.
Cost of Revenue
COGS plus any costs associated with the production and delivery of your product fall under the cost of revenue. For a SaaS company, this might look like the following:
- Marketing costs
- Web hosting or server fees
- Web development costs
- Software licenses
- Salaries for customer support team or sales
Categorizing items under revenue can help you compare the costs of doing business to the amount of profits. You should know the profit margin you need to make your business successful. Understanding the cost of revenue is one of the first steps toward doing so.
Research & Development
As a SaaS startup, many expenses may look toward the future with research and development. The money you invest in staff members strictly doing research may be one such cost.
Similarly, costs associated with equipment needed for developing new products may also fall under this category. If you run an app company and upgrade all of your programmers' hardware so they can begin working on the next version of your app, this could fall under development.
Sales & Marketing
Startups must invest in sales and marketing. Getting your name and product out there comes with big expenses. Tracking your sales and marketing costs will help identify these business expenses.
If you run a new ad campaign online, tracking your click-to-conversion ratio is given. But what about tracking your money invested in the campaign versus the profits made during the same timeframe?
This can help you estimate the return on investment for your sales and marketing expenses. When you have these categorized separately from other operating expenses, you'll know how your profit compares to the money you put into promoting your product.
General & Admin
Running your business comes with a cost in addition to other categories. Identifying the general and administrative costs can help round out your categorization project.
Some of the general and administrative costs associated with your business may include things like:
- Payroll software
- Phone service for employees
- Travel costs
3. Identify Deductible Expense Categories for Taxes Based on Your Industry
Consult with a tax advisor to determine which categories are deductible or where you can find tax credits. Some overhead costs may help reduce your taxable income depending on your industry. Identifying tax expense categories can help you pay less at tax time.
Some examples of potentially deductible expenses include:
- Office supplies
- Employee benefits and health insurance
- Interest paid on business loans
- Business insurance
4. Reconcile Your Bank Account Using Accounting Software
Reconciling your accounts at the end of the month is critical to understanding the big picture of your cash flow. You can automate this process by connecting all of your financial operations (including expense categorizing) to AI-powered accounting software.
You can also fully automate categorization. Good AI software will learn about your vendors and spending patterns over time and automatically place your expenses into categories for you.
For example, you might upload an invoice to your finance or bill pay platform. Its AI reads the invoice for you, pulls out vendor information, saves that information, and then categorizes the expense back on your chart of accounts in one single action.
Categorize Your Business Expenses With Confidence
You can confidently categorize your expenses by making a list of common business expenses, identifying deductible expenses, and reconciling your accounts with automated software.
Doing so is crucial for SaaS startups who want to get a better picture of their finances and make decisions faster. You can also identify and correlate costs with profits to understand your investment return.
Be systematic in categorizing expenses and utilizing financial AI tools to understand your expenses and how to use this information to encourage data-driven growth. With proper categorizing approaches, you can see improvements and positive effects on your business.