Key Takeaways

  • The cost of doing business includes all expenses needed to operate and maintain a company.
  • Expenses are categorized as direct/indirect, product/period, and capital/operational.
  • Calculating these costs helps determine pricing, profitability, and sustainability.
  • Tools like cost calculators and benchmarking studies can aid in estimating accurate expenses.
  • Industry studies and tax deduction rules can inform better financial planning.

The Cost of Doing Business

The cost of doing business definition is any expense a business incurs while in the process of conducting business. A cost of doing business could be a direct cost, like raw materials, or an indirect cost, like building security. Regardless of type, such costs must be considered carefully by managers, business owners, and anyone involved in running a company, since the amount of such costs will play a large role in determining if a company is profitable or not.

Calculating the Cost of Doing Business

Understanding the cost of doing business is essential to running a business properly. This cost depends on many factors, including the costs of services and goods, compliance with regulations, and interest rates for taxes and borrowed funds. The lower a business’s overall cost, the easier it will be for it to operate, pay taxes, and hire employees, if necessary.

Figuring operational cost can be done by using the following equation: non-reimbursable expenses + desired salary (yielding total annual costs) ÷ number of billable days = the cost of doing business. If you are starting a business, it is also important to remember to factor in:

  • Startup costs.
  • Registration and licensing costs.
  • Rent costs.
  • Employee salary costs.
  • Advertising costs.

Aside from startup and registration costs, such costs would most likely be incurred by a business in any event, but new business owners may be more likely to neglect factoring them in. New business owners may also be more concerned with reducing their costs. Some cost-cutting possibilities include leasing or hiring equipment rather than buying and avoiding unnecessary expenses by finding multiple uses for labor, computer systems, or production facilities.

Tools and Resources for Cost Estimation

Accurately estimating the cost of doing business is crucial for long-term sustainability. Several tools and studies are available to help entrepreneurs make informed financial decisions.

  • Cost Calculators: Online calculators, such as those created for freelancers or photojournalists, allow users to input annual expenses, desired salary, and estimated revenue to determine the minimum daily earnings needed to break even.
  • Benchmarking Studies: Industry associations often conduct cost of doing business studies that provide comparative data across businesses. For example, the North American Equipment Dealers Association (NAEDA) publishes annual reports that allow businesses to benchmark expenses, employee costs, and gross margins against industry peers.
  • Government Resources: The U.S. Small Business Administration offers detailed guidance for calculating startup costs. This includes templates and worksheets to help entrepreneurs estimate necessary capital for categories like legal fees, permits, inventory, and payroll.

These resources can help identify gaps in financial planning and support strategic budgeting.

Business Expenses

Business expenses are the economic costs a business must incur in order to operate and, hopefully, make revenue. Common business expenses include:

  • Payments to suppliers.
  • Factory leases.
  • Equipment depreciation.
  • Employee wages.

Some business expenses may be tax deductible, but the IRS has strict rules regarding which expenses a business can claim a deduction on. The IRS rules for deductibles state that a deductible business expense must be both necessary and ordinary. Necessary meaning that the expense helps the business earn income, while ordinary means that such an expense is accepted as common to the business’s particular industry. Thus, business owners cannot claim personal expenses as necessary expense deductibles, nor can outlandish purchases be justified as deductible in the name of business.

Larger, long term expenses are known as capital expenses, and they may include:

  • Business startup costs.
  • Real estate.
  • Vehicles.
  • Patents.
  • Equipment.
  • Construction and building improvements.

Such expenses may also qualify for tax deductions, but they must be written off over a period of years, and this is subject to a schedule the IRS has that dictates how much of the capital expense a business may write off annually. The number of years a capital expense may be written off and for how much varies from expense to expense.

Fixed vs. Variable Costs

A useful way to evaluate business expenses is to separate them into fixed and variable categories:

  • Fixed Costs: These are expenses that remain constant regardless of output or sales volume. Common examples include rent, salaries, insurance, and loan payments.
  • Variable Costs: These fluctuate based on production or service delivery. Examples include utilities, shipping fees, raw materials, and hourly labor.

Understanding this distinction can aid in forecasting, cost control, and break-even analysis.

Product Expenses

Business expenses may be divided into two broad categories, one of which is product expenses. Product expenses relate to the cost of production, which may either be the direct or indirect costs associated with manufacturing a product and getting it ready for sale. Such costs consist of labor, materials, and overhead, and these can further be divided into two groups: conversion costs and prime costs. Conversion costs relate to converting raw materials into a final product, while prime costs are the materials themselves plus labor. The sum of all such costs is the total cost of producing a product.

Period Expenses

Period expenses are the other category of business expenses, and they are any costs unrelated to production costs, which may include advertising, salaries, and office supplies, for example. These costs will appear as expenses in the income statement rather than inventory on the balance sheet. If one expects a period costs to create an economic benefit for more than one year, then such a cost can be capitalized and written off through depreciation across a number of years, instead of being expensed in one year.

Tax Planning and Deductibility

Effective tax planning plays a significant role in managing the cost of doing business. While not all expenses are deductible, understanding which ones qualify can reduce tax liability:

  • Ordinary and Necessary: As defined by the IRS, expenses must be both ordinary (common in your trade) and necessary (helpful and appropriate for your business) to be deductible.
  • Documentation: Keep detailed records and receipts for all expenses, especially travel, meals, entertainment, and home office costs.
  • Capital Expenses: These must be capitalized and depreciated over time rather than deducted all at once. For instance, a $50,000 piece of equipment may need to be written off over five years.

Consulting a tax advisor or CPA can ensure compliance and optimize deductions.

Frequently Asked Questions

  1. What is included in the cost of doing business?
    It includes all expenses a company incurs to operate—such as salaries, rent, supplies, taxes, and equipment.
  2. How can I calculate the cost of doing business?
    Use the formula: (Non-reimbursable expenses + desired salary) ÷ billable days. Cost calculators and financial templates can simplify this.
  3. Are all business expenses tax deductible?
    No. Only expenses deemed “ordinary and necessary” by the IRS are eligible for deductions. Capital expenses are subject to depreciation.
  4. What are examples of indirect costs?
    Examples include utilities, office supplies, administrative wages, and security—costs not directly tied to production but necessary for operations.
  5. Why are benchmarking studies important?
    They help compare your costs to industry standards, uncover inefficiencies, and make strategic business decisions based on peer performance.

Ultimately, when business decisions are being made, you will want to include the cost of doing business in your calculations. If you need help understanding the cost of doing business definition, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.