When managing a business, it’s important to understand financial statements to make the right. A concept that often raises questions is depreciation. But is depreciation an operating expense, and why does its classification matter?

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Depreciation allows businesses to spread the cost of fixed assets like machinery, vehicles, and buildings over their useful life. This ensures accurate financial reporting, aligns expenses with revenue, and helps businesses claim tax deductions.

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However, whether depreciation is considered an operating expense or a non-operating expense depends on various factors.

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In this article, we’ll discuss what depreciation is and whether it’s an operating expense.

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What Is Depreciation?

Depreciation is the systematic allocation of an asset's cost over its useful life. It represents the gradual reduction in the value of tangible fixed assets due to wear and tear, obsolescence, or aging. Depreciation ensures that a business recognizes the expense of using an asset over time rather than all at once.

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For example, if a company purchases machinery for $50,000 with a useful life of 10 years, it cannot deduct the entire cost in the year of purchase. Instead, it spreads the expense over the asset's lifespan using an appropriate depreciation method.

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Purpose of Depreciation in Accounting

Depreciation serves several purposes in financial accounting and business operations:

• Matching Principle Compliance: In accrual accounting, expenses must be matched with the revenues they help generate. Depreciation ensures the cost of an asset is allocated over the periods it contributes to revenue.
• Accurate Financial Reporting: Depreciation provides a more realistic representation of an asset's value, thereby preventing overstatement of profits and assets.
• Tax Deduction Benefits: Businesses can deduct depreciation as an expense, reducing taxable income and lowering tax liabilities.
• Investment and Budgeting Decisions: Understanding depreciation helps businesses plan for asset replacements and make informed capital investment decisions.

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How Depreciation is Calculated

There are different methods for calculating depreciation. Each method is suitable for different asset types and business needs. The choice of method impacts financial statements and tax reporting.

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Straight-Line Depreciation

The straight-line method is the simplest and most commonly used approach. It spreads the asset's cost evenly over its useful life.

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Formula:

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For instance, if a company buys office furniture for $10,000 with a 10-year useful life and no salvage value, the annual depreciation expense would be:

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The company records $1,000 as an expense each year.

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Declining Balance Depreciation

The declining balance method applies a fixed depreciation rate to the asset's book value, resulting in higher depreciation expenses in the early years and lower expenses later.

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A common variation is the double-declining balance (DDB) method, which doubles the straight-line rate.

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Formula for DDB:

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For instance, consider a $20,000 asset with a 5-year useful life using DDB;

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First-year depreciation:

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Second-year depreciation:

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This method accelerates depreciation, making it ideal for technology and vehicles that lose value quickly.

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Units of Production Depreciation

The units of production method bases depreciation on asset usage instead of time. It is commonly used for machinery, vehicles, and equipment that wear out based on operational output.

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Formula:

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For instance, if a printing machine costs $50,000, has a salvage value of $5,000, and is expected to produce 1,000,000 pages, the depreciation per page is:

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If it prints 100,000 pages in a year, the depreciation expense is: 100,000 x 0.045 = 4,500

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Sum-of-the-Years’ Digits (SYD) Depreciation

The SYD method accelerates depreciation by assigning higher expenses to the earlier years of an asset’s life.

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Formula:

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The Nature of Depreciation in Financial Reporting

Depreciation is not an asset itself but rather an accounting method used to allocate the cost of a tangible asset over its useful life.

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When a business acquires a fixed asset—such as machinery, buildings, or vehicles—it does not immediately recognize the full cost as an expense. Instead, the expense is spread out over the asset’s estimated lifespan.

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This ensures financial statements accurately reflect the wear and tear of assets over time.

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Depreciation appears on financial statements in two ways:

• On the Income Statement: Depreciation is recorded as an expense, reducing taxable income and net profit.
• On the Balance Sheet: The asset’s book value decreases over time due to accumulated depreciation, reflecting the asset's declining worth.

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While depreciation itself is not an asset, it impacts the asset side and the expense side of a company's financial records.

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Accumulated Depreciation vs. Book Value of Assets

Two concepts in depreciation accounting are accumulated depreciation and book value:

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Accumulated depreciation is the total depreciation expense recorded against an asset since its acquisition. It appears on the balance sheet as a contra asset account, reducing the asset’s recorded value.

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Book value, on the other hand, is the asset’s original purchase price minus accumulated depreciation. It represents the asset's net value at a given point in time.

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For example, if a company purchases a delivery truck for $50,000 and records $5,000 in depreciation per year, after three years:

• Accumulated Depreciation = $15,000
• Book Value = $35,000 ($50,000 - $15,000)

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When an asset is fully depreciated, its book value may be zero or close to its estimated salvage value (the expected residual worth after full use).

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What is an Operating Expense (OPEX)?

An operating expense is the ongoing costs a business incurs to maintain its day-to-day operations. These expenses are necessary for running a company but do not directly contribute to the production of goods or services.

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The main features of operating expenses include:

• Recurring in nature: These costs are incurred regularly, such as monthly rent or employee salaries.
• Essential for business operations: Without these expenses, the company may struggle to function effectively.
• Reported on the income statement: Operating expenses are deducted from revenue to calculate a business’s operating profit.
• Not directly tied to production: Unlike the cost of goods sold (COGS), which includes materials and labor directly used in manufacturing, OPEX covers general and administrative expenses.

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Examples of Common Operating Expenses

Operating expenses vary by industry but generally include:

• Rent and Utilities: Payments for office or warehouse space, electricity, water, and internet services.
• Salaries and Wages: Compensation for employees who are not directly involved in manufacturing or production.
• Marketing and Advertising: Costs for promotions, social media ads, pay-per-click (PPC) campaigns, and branding efforts.
• Office Supplies and Equipment: Expenses for stationery, computers, printers, and office furniture.
• Insurance Premiums: Coverage for business liabilities, property, and employee benefits.
• Depreciation and Amortization: The gradual reduction in the value of tangible and intangible assets.
• Legal and Professional Fees: Payments for consultants, accountants, and legal advisors.
• Maintenance and Repairs: Costs of keeping business equipment and facilities in good condition.
• Travel and Transportation: Expenses for business trips, vehicle maintenance, and fuel.
• Software Subscriptions: Monthly or annual fees for business tools such as CRM software, accounting platforms, or cloud storage services.

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These expenses help businesses run efficiently, and effectively managing them can increase profitability.

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Impact of Operating Expenses on Financial Statements

Operating expenses appear in two financial statements:

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Income Statement

Operating expenses are deducted from gross profit (Revenue - Cost of Goods Sold) to calculate operating income (also called EBIT; Earnings Before Interest and Taxes). High OPEX can reduce profitability, while well-managed expenses can improve net income.

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Cash Flow Statement

OPEX affects the operating cash flow section, showing how much cash is spent on daily business activities. Companies must maintain a healthy operating expense ratio (OPEX ÷ Revenue) to ensure financial stability.

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Difference Between Operating and Non-Operating Expenses

While operating expenses are important for daily business activities, non-operating expenses refer to costs that are not directly related to the main business operations.

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Here’s a tabular illustration of their differences:

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Is Depreciation an Operating Expense?

Depreciation is classified as an expense in financial accounting because it represents the systematic allocation of an asset’s cost over its useful life.

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It reduces the book value of tangible assets, such as machinery, vehicles, and buildings, reflecting the wear and tear or obsolescence of these assets over time.

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From a financial reporting perspective, depreciation appears in the income statement and affects net income. However, since depreciation is a non-cash expense, it does not directly impact a company’s cash flow but is adjusted for in cash flow statements under operating activities.

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In Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), depreciation is classified as either an operating expense or a non-operating expense, depending on how the asset contributes to the company's business operations.

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When Depreciation Is Considered an Operating Expense

In certain industries, depreciation is classified as an operating expense because it directly relates to core business operations. Here are industry-specific examples of when depreciation qualifies as an operating expense:

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Manufacturing Business

Manufacturing businesses rely on machinery and equipment to produce goods. Since these assets gradually wear out over time, depreciation is recognized as an operating expense to account for their declining value.

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For instance, a car manufacturing company purchases automated assembly line robots for $5 million with an estimated useful life of 10 years. Using the straight-line depreciation method, the company records an annual depreciation expense of $500,000 ($5M ÷ 10 years).

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This depreciation is considered an operating expense because the equipment is directly involved in the production process.

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It helps the business allocate production costs more accurately over the equipment’s lifespan. The expense is recorded on the income statement, thereby impacting the company’s gross profit margin.

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Retail Business

Retail businesses invest in various physical assets to maintain store operations, including display shelves, checkout counters, lighting systems, and refrigeration units (for grocery stores). Over time, these assets lose value, requiring depreciation accounting.

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For instance, a supermarket chain installs refrigeration units worth $1 million, with a useful life of 8 years. Using the declining balance method, the business recognizes higher depreciation expenses in the early years of use.

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Since refrigeration is important for preserving perishable goods, its depreciation is treated as an operating expense.

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The depreciation cost is included in operating expenses because it affects the store’s ability to function. Properly accounting for the depreciation allows the business to maintain profitability and plan for replacements.

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Transportation and Logistics

Companies in transportation and logistics rely on vehicles, aircraft, or ships to deliver goods and services. The depreciation of these assets is recorded as an operating expense since they are critical to business functions.

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For example, a delivery company purchases 100 trucks for $10 million, with an estimated useful life of 7 years. Using the units of production depreciation method, the company allocates depreciation based on mileage driven per truck.

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Since transportation services are the company’s main business activity, vehicle depreciation is classified as an operating expense.

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Real Estate

Real estate companies that lease or manage commercial properties must account for property depreciation as part of operating expenses. Buildings and improvements such as HVAC systems, elevators, and structural components lose value over time.

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For example, a commercial property owner constructs an office building for $50 million with a 30-year useful life. Using the straight-line depreciation method, the company records an annual depreciation expense of $1.67 million ($50M ÷ 30 years).

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Since leasing office spaces is the company’s primary revenue-generating activity, property depreciation is categorized as an operating expense.

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It’s a standard accounting practice in real estate firms to track property value reductions for tax and financial reporting purposes. The expense is included in the operating costs of managing and maintaining commercial buildings.

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Situations Where Depreciation Is Classified as a Non-Operating Expense

In some cases, depreciation is categorized as a non-operating expense, meaning it does not directly relate to the company’s core business functions. This classification usually applies when the depreciated asset is not involved in revenue generation or when it belongs to a separate business division.

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Examples of non-operating depreciation include:

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• Investment Properties: If a company owns office buildings or rental properties that generate passive income but are not part of its main business, the depreciation on these assets is considered a non-operating expense.
• Idle or Non-Operational Assets: If a company has machinery or equipment that is not currently in use or has been mothballed, its depreciation expense may be categorized as non-operating.
• Corporate Office Buildings: Depreciation of headquarters or administrative buildings may be classified as non-operating if the company does not rely on them for revenue generation.
• Depreciation from Discontinued Operations: If a company shuts down a division or sells off part of its business, the depreciation on those assets before the sale may be recorded as a non-operating expense.

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Non-operating depreciation is recorded under other expenses in the income statement, separate from operating costs.

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Wrapping Up

As discussed in this guide, it is important to understand whether depreciation is an operating expense for accurate financial reporting, tax planning, and strategic decision-making.

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While depreciation is often categorized as an operating expense in industries where fixed assets are integral to operations, its classification depends on the business model and accounting approach.

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FAQs

What is included in operating expenses?

Operating expenses are the costs a business incurs to maintain daily operations. These include salaries, rent, utilities, marketing, office supplies, insurance, maintenance, and administrative expenses. Unlike capital expenditures, which involve long-term asset investments, operating expenses cover routine business functions.

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What is not an operating expense?

Non-operating expenses are costs that fall outside a company's core business activities. Examples include interest expenses (costs of borrowing), investment losses, losses from asset sales, inventory write-offs, restructuring costs, and lawsuit settlements. Any expense not directly tied to daily operations is considered non-operating.

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Is depreciation an administrative expense?

Depreciation can be classified as an administrative expense, but it depends on the type of asset being depreciated and how it is used in the business.

• When depreciation is an administrative expense: If the depreciated asset is used for general business operations (e.g., office buildings, furniture, computers in the corporate office), its depreciation is categorized as an administrative expense.
• When depreciation is not an administrative expense: If the asset is directly involved in production (e.g., factory equipment), its depreciation is classified as a cost of goods sold (COGS) or manufacturing overhead. If it's unrelated to core operations (e.g., depreciation of investment properties), it may be a non-operating expense.

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Is depreciation an expense or revenue?

Depreciation is an expense, not revenue. It represents the allocation of an asset's cost over its useful life, reducing a company's taxable income. Also, it does not directly impact cash flow but affects net income. It is not a source of revenue because it does not generate income for the business; instead, it accounts for the gradual reduction in asset value over time.

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