Is Depreciation an Operating Expense?

Depreciation involves systematically reducing the recorded cost of a tangible asset over its useful life. This process allocates the asset’s cost as an expense across the periods it benefits. An operating expense represents a cost incurred through a business’s normal activities to generate revenue. The classification of depreciation depends on how the underlying asset supports the core operations of the business.

Depreciation as a Core Operating Expense

Depreciation is classified as an operating expense when the asset is directly used in the main activities that produce revenue for a business. Consider a manufacturing company’s production machinery; the wear and tear on this equipment directly contributes to the creation of goods for sale. This cost, recognized through depreciation, is a direct operating cost.

Office equipment, such as computers, printers, and furniture, used daily by administrative and sales staff also falls into this category. These assets facilitate general business operations, from processing orders to managing customer relations. Similarly, vehicles used for sales, delivery, or general business travel are considered integral to core operations.

The depreciation of a building that houses a company’s primary offices, manufacturing facilities, or retail stores is also an operating expense. This cost is directly tied to providing the physical space necessary for conducting normal business activities. These expenses are presented alongside other operating costs like salaries and rent.

Depreciation in Other Financial Contexts

Depreciation is not always categorized as an operating expense, especially when the asset is not central to the company’s primary revenue-generating activities. For instance, if a company owns an investment property that it leases out, the depreciation on that property would be a non-operating expense. This is because the investment property generates income from a peripheral activity, not the company’s primary business. These expenses are reported below the operating income line on the income statement.

For companies that manufacture goods, depreciation on factory equipment or the manufacturing plant itself can be included as part of the Cost of Goods Sold (COGS). This occurs because the equipment’s use is directly tied to the production of inventory. Including it in COGS means the depreciation expense is recognized when the manufactured goods are sold, ensuring the full cost of production is matched against the revenue they generate.

Depreciation is non-cash in nature. While a company records depreciation expense, no actual cash outflow occurs at that moment. The cash outflow for the asset happened when it was initially purchased. Depreciation simply allocates that initial cost over time, reducing net income on the income statement without affecting the cash balance.

On the income statement, depreciation appears in a few ways. For assets directly used in operations, it might be grouped with other operating expenses like selling, general, and administrative costs. If it relates to manufacturing, it could be embedded within the Cost of Goods Sold. When the depreciated asset is not part of core operations, such as an investment property, the depreciation expense will be listed separately below the operating income section.

Key Aspects of Depreciation

Businesses employ various methods to calculate depreciation, each distributing the asset’s cost differently over its useful life. The straight-line method, for example, allocates an equal amount of expense each year. The declining balance method front-loads more depreciation in the early years of an asset’s life, while the units of production method ties depreciation to the asset’s actual usage or output.

Depreciation holds tax implications for businesses. It is considered a tax-deductible expense, reducing a company’s taxable income and leading to lower income tax liabilities. For instance, under the Internal Revenue Code, Section 167 allows for a depreciation deduction, while Section 168 provides for the Modified Accelerated Cost Recovery System (MACRS), which specifies depreciation periods and methods for various types of property.