Module 2: UNDERSTANDING EXPENSES

CONTROLLING EXPENSES characteristics. Costs may mean

differently to different people. We
Management accounting is about
will deal here with costs in the
profit management that include
perspective of accountants,
expenses as its vital component.
managers, and economist.
Expenses affect operating results,
hence should be understood and
intelligently managed. The
ACCOUNTANT’S PERSPECTIVES
accounting for the accumulation
preparation, and presentation of CAPITAL EXPENDITURES V.
expenses to serve as basis for OPERATING EXPENDITURES
management decisions is the
pioneering area of management Capital expenditures are investing
accounting. outlays normally requiring large
amount of money and resources
The end-point of operating
having a long-term investment
performance is to generate
impact to business profitability.
maximum profit out of the resources
These expenditures would create
used.
probable future economic value
Traditional management and benefit and are capitalized as
accounting provides intelligent assets. These costs are converted to
information to managers in order to expense once their related income
reduce expenses and increase has been generated. Examples of
profit. Reducing expenses requires capital expenditures are those used
for its thorough understanding in line in long-term projects and classified
with the planning and controlling as long-term assets and become an
functions of the management. This expense once consumed in the
drives the development of standard production or sale of a product.
costing system leading the brilliant
Operating expenditures are outlays
formulation of principles, techniques
or consumption used to directly
and processes, governing the cost-
support the normal operating
volume-profit analysis and profit
activities of the business. They are
planning, responsibility accounting,
expensed in the period the
operational budgeting, segment
statement of profit or loss is
reporting and variance analysis.
presented because of the following
COSTS CONCEPTS reasons:

The use of the term “costs” here i. immediate recognition, such

includes cost and expenses. advertising, salaries and
research
Managing costs means knowing
ii. Associating cost and effect
their nature, behavior and other
such as cost of sales
 Module 2: UNDERSTANDING EXPENSES

iii. Rational and systematic Product cost are those incurred in

allocation, such as the process of producing the
depreciation product. They are inventoriable and
are deferred as assets while the units
COST V. EXPENSES V. LOSSES
are unsold. Once sold, the cost of
Cost is traditionally classified in inventory is transferred from the
relation to the functional activities of asset classification to cover cost of
the business, that is according to goods sold classification as
the place and purpose of their use. expense. Direct materials, direct
labor and factory overhead are
Costs of goods manufactured are product costs. Direct materials and
those incurred in producing goods direct labor are called prime costs.
and services. Examples are direct Direct labor and factory overhead
materials, direct labor and factory are called conversion costs. Direct
overhead. Cost of goods sold are materials, direct labor and variable
production cost relating to the unit factory overhead are called
are that already sold. variable production costs.
Expenses are those incurred in Period costs are those incurred
distributing goods and managing a outside of the production activities.
business. Marketing promotions and They are incurred to administer a
shipping expenditures are business, sell or distribute a product,
distribution expenses. Those relating conduct researches, or attend to
to systems and control, government customer’s needs which are not
compliance, and other corporate directly related to the production
costs incurred to manage the activities. They are instantly
business are referred to as expensed once incurred.
administration expenses.

Both cost and expenses give

benefits to the business. DIRECT PRODUCT COST V. INDIRECT
PRODUCT COST

Losses are reduction in the value of Cost is further classified as to their

assets without benefit to the degree of relation to the product.
business leading to the impairment
Direct product costs are those that
of equity. Examples of losses are loss
are directly identified with the
on sales of equipment, loss on
finished goods or services or those
inventory obsolescence, loss on
that are directly attributable in the
shortages, spoilage and loss on
process of making them (i.e.,
uncollectable.
converting materials into finished
PRODUCT COST VS. PERIOD COST goods). Direct materials and direct
labor are direct products costs,
 Module 2: UNDERSTANDING EXPENSES

Factory overhead is an indirect DIRECT SEGMENT OR INDIRECT

product cost. SEGMENT

MANAGER’S PERSPECTIVE Cost may be classified as to their

relation to the business segment or
RELEVANT COST V. IRRELEVANT COST
unit.
Cost may be classified according to
Direct departmental cost is cost that
their use in the decision-making
are directly identified with the
process.
department, process, segment, or
Cost that are useful in making activity. They may be variable or
decisions are relevant costs, fixed costs.
otherwise they are irrelevant.
Indirect departmental cost is those
Relevant cost has two
that are not directly identified with a
characteristics, differential and
department or a business unit. They
future. Differential costs vary from
are sometimes referred to as
one alternative to another while
“allocated costs”, “common costs”,
future costs relate to the estimated
or plainly “unavoidable costs”.
quantification of the amount of a
prospective expenditure. Direct department cost are avoided
upon cessation of business unit
Managers have at least two
operations while indirect
alternatives in making a decision,
department costs continuously
otherwise there is no decision to be
persist despite thereof.
hardly made at all. When a cost
differs from one alternative to Examples of direct department cost
another, that cost is a differential are salaries of a department
cost. When a cost remains the same manager, salaries of a personnel
regardless of a choice to be made, assigned to the department,
that cost is irrelevant. supplies purchased and used, rental
of equipment directly used in the
Relevant costs are not only
departmental activities, utilities
differential costs, they should be
(electricity and water) which are
future costs as well. Those costs that
directly identified with a
are not to be incurred in the future
department, telecommunications,
are irrelevant. Past cost, sunk cost,
indirect materials, indirect labor and
historical costs are Irrelevant cost in
depreciation of equipment used in
making decisions because they can
the department. Examples of
no longer be changed.
indirect departmental costs (or
Management deals about the
allocated cost) are salaries of
future and not on the past. The
executives in the central office,
future could be influence or
other central administrative costs
directed while the past cannot.
such as advertising, system review
 Module 2: UNDERSTANDING EXPENSES

and development, interest authority granted to him by the

expenses, training, research and organization. The concept of
development, real estate property controllability is related to the
taxes, and allocated depreciation organizational structure of an
of noncurrent assets. organization. The organizational
structure reflects the manner on
AVOIDABLE COST V, UNAVOIDABLE
how the business, strategy is to be
COST
undertaken. Structures varies from
Cost may be classified in relation to one organization to another.
the occurrence of an activity. Noncontrollable costs are those
outside of the decision power or
Avoidable costs are those not influence of a given manager in a
incurred once an activity is not specific situation.
performed. They normally become
savings on the part of the business. Planned cost v. Actual cost
These savings are considered an
Cost may be classified in relation to
inflow in the economic sense and
its incurrence in a future
referred to as imputed costs.
undertaking.
Unavoidable costs remain to be
Planned cost relate to future
incurred regardless of option a
occurrences and are referred to a
manager chooses. They remain
multifarious name such as projected
constant, they do not change, and
costs, estimated costs budgeted
are irrelevant in short-term decisions.
cost, applied costs and standard
Common examples of unavoidable
costs.
costs are rent, depreciation, interest
property taxes and all other Projected costs are future values
committed fixed costs. derived from using forecasting
models such as profitability,
CONTROLLABLE COST V.
regression and causal models.
UNCONTROLLABLE COST
Estimated costs are those future
Cost may be classified in relation to values derived out of normal
the authority of the manager. observations without the aid of
standards or any reliable bases.
Another way of classifying costs Applied costs are estimated values
relates to the degree of authority derived using the normal costing
given to a manager. Controllable system. Standard costs are reliable
costs are those which incurrence or values accepted by men in the
non-incurrence can be decided or organizations derived from
influenced upon by a manager. The empirical, scientific, and controlled
influence or decision-making power studies.
of a manager depends on the
scope, nature and extent of
 Module 2: UNDERSTANDING EXPENSES

Actual costs are expenditures and cannot be avoided in the

already incurred and recorded in future. They are constant and not
the accounting books. The differential. They are historical and
difference between the planned irrelevant in short-term decisions.
costs and actual cost is called
Future costs are to be incurred in
planning gap or planning variance.
the upcoming periods. They are
relevant and are of value in making
decisions. They affect the upcoming
BUDGETED COST V. STANDARD COST
activities where the manager should
Cost may be classified in relation to plan, organize, direct, and control.
the level of activity being They are sometimes called planned
considered for estimation. costs, budgeted costs or estimated
costs.
Budgeted costs are those expected
to be incurred at the level of activity
used in preparing the master
ECONOMIST’S PERSPECTIVE
budget. Standard costs are those
expected to be incurred at any EXPLICIT COST V. IMPLICIT COST
level of activity aside from that
Cost may be classified according to
being used in the master budget.
the manner on how they are
The level of activity used in
stipulated.
computing the standard cost may
be actual or estimated. Explicit costs are those already
incurred or intended to be incurred.
Budgeted cost and standard costs
They are already recorded or to be
use the same predetermined
recorded in the accounting books.
standard rates. The difference
Implicit costs are theoretical costs.
between the budgeted cost and
They are assumed and are not
standard costs is called a capacity
recognized in the accounting
variance. Budgeted costs refer to
books. Two good examples of
the master budget while standard
implicit costs are opportunity costs
cost is called flexible budgets.
and imputed costs.
SUNK COST V. FUTURE COST
OPPORTUNITY COST V. IMPUTED
Cost may be classified according to COST
their period of incurrence.
Costs may be classified in relation to
Sunk costs are those that have the theoretical condition upon
been incurred in the past and can which they are created.
no longer be changed. They Opportunity costs are benefits given
represent commitments made by up in favor of another choice. In
the business in its previous decisions each decision, there is always a
 Module 2: UNDERSTANDING EXPENSES

beneficial alternative (or choice) Costs are classified as fixed or

not followed but could had been variable with regard to their
followed. behavior in relation to and the
changes in the activity level or
Imputed costs are those not
production sales.
incurred but are implied in a given
decision. Say, a business uses its own Fixed costs are those that remain
cash in buying an equipment. If the constant regardless of the change
borrows from a bank to buy the in the level of production and sales,
equipment, it should pay an interest but inversely changes from unit basis
rate of 15% per annum. The imputed Fixed costs could be either
rate of using its own money instead committed or discretionary.
of borrowing is, clearly, equivalent Committed fixed costs are those
to the amount of the 15% interest which incurrence have been
rate that should have been paid committed by the business in the
had the money been borrowed. past by reason of contract,
acquisition or agreement. Examples
Opportunity costs and imputed
are rental expenses, interest
costs are not recorded in the
expense, insurance expense,
financial accounting system
executive salaries, depreciation
because they are not actually
expense, patent amortization, real
incurred, they are only theoretical.
estate, property taxes, and salaries
But they are relevant in making
of production executives.
decision.
Discretionary fixed costs are costs
INCREMENTAL COST V. MARGINAL
which incurrence is assured but the
COST
amount may change depending on
Cost may be classified in relation to the discretion of value judgment of
particular product or activity. the manager. Examples are
advertising expense, research and
Incremental costs represent a total development costs, executive
increase in costs. Marginal cost is an training costs, salaries of the security
increase in cost per unit. guard and janitors, and repairs and
Decremental costs are decreases in maintenance of buildings and
costs. grounds. For academic purposes, all
VARIABLE COST V. FIXED COST fixed costs, whether committed or
discretionary should be treated as
Cost may be classified in relation to constant in total.
quantity or level of activity. In the
following discussions, we assume the Variable costs vary directly in
level of production and sales to be proportion to the change in the
equal. level of production and sales.
Hence, total variable costs change.
 Module 2: UNDERSTANDING EXPENSES

That is if sales increase by 10% total

variable costs also changes by 10%.
If sales decreased by 12%, total
variable costs also decreased by
12%. Notice that there is a direct or
complete proportion in the change
of variable costs and sales. Variable
costs change in total direct
proportion to changes in the level of
production and sales but are
constant per unit basis. Examples of
variable costs are direct materials,
direct labor, variable overhead,
and variable expenses. Examples of
variable overhead are factory
supplies, indirect materials, indirect
labor and repairs. Example of
variable expenses are delivery
expenses, salesmen’s commission,
packaging costs and supplies.