What is Natural Expense Classification?

Natural Expense Classification

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Natural Expense Classification

Natural expense classification is an accounting method that sorts expenses based on their nature rather than their function. This means that expenses are categorized based on what they are spent on, such as salaries, rent, utilities, depreciation, advertising, etc.

This is in contrast to a functional expense classification, where expenses are grouped according to the function or department they serve within the business, such as manufacturing, sales, administration, and research and development.

Here’s a simple example of natural expense classification:

  • Salaries and Wages
  • Rent and Utilities
  • Office Supplies
  • Depreciation
  • Advertising and Promotion
  • Interest Expense

Each of these categories represents the “nature” of the expense — what the money was actually spent on. The advantage of using this method is that it provides a straightforward view of the types of costs a company incurs. It’s useful for internal analysis as well as for external stakeholders like investors and creditors who want to understand the nature of a company’s expenses.

However, the functional classification can sometimes provide more useful information for decision-making, as it helps the management to understand which areas or functions of the business are incurring more costs.

In practice, many companies use a combination of both natural and functional classifications to get a comprehensive understanding of their expenses.

Example of Natural Expense Classification

let’s assume we have a hypothetical tech company, TechPioneers Inc., and it has incurred various expenses during a fiscal year. Here’s how these expenses might be classified using a natural expense classification:

  • Salaries and Benefits:
    • Software Engineer Salaries: $2,000,000
    • HR Department Salaries: $300,000
    • Executive Salaries: $500,000
    • Employee Health Benefits: $400,000
  • Rent and Utilities:
    • Office Rent: $800,000
    • Electricity: $200,000
    • Internet: $100,000
  • Supplies and Equipment:
    • Office Supplies: $50,000
    • Computer Equipment: $1,000,000
  • Depreciation and Amortization:
    • Depreciation of Office Equipment: $200,000
    • Amortization of Software Licenses: $100,000
  • Marketing and Advertising:
    • Digital Advertising: $500,000
    • PR Agency Fees: $200,000
  • Interest Expense:
    • Interest on Business Loan: $100,000

In the above example, each expense is classified based on what it was spent on, i.e., its nature. This gives a straightforward understanding of the types of expenses TechPioneers Inc. has incurred over the fiscal year.

Remember, this classification system is just one way to organize the company’s expenses. A different classification method, like functional expense classification, might group these costs by the business function they serve, such as research & development, administration, sales and marketing, etc.

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