Module II

UNDERSTANDING THE EXPENSES

Learning Objectives:
1. Differentiate expenditures, costs and expenses
2. Understand the importance of controlling expenses.
3. Describe the different perspective of classifying expenditures.
4. Discuss the classification of expenditures on accountant s perspective.
5. Discuss the classification of expenses on manager's and economists’ perspective.
6. Explain the relationship of economic costs and profit to the level of production and
sales.
7. Illustrate costs sensitivity analysis.
8. Describe the importance of relevant range in the management of volume and
expenses. Relate learning curve theory with the behaviour of costs.

Controlling Expenses

Management accounting is about profit management. As it considers expenses as a vital

component, it should be understood and intelligently managed. The accounting for the
management accumulation, preparation, and presentation of expenses to serve as a basis for
management accounting decisions is the pioneering area of management accounting.

Costs Concepts: ACCOUNTANT’S PERSPECTIVE

Capital expenditures vs. Operating expenditures

Capital expenditures are investing outlays normally requiring large amount of Capex is
long-term funds and resources having a long-term impact to business profitabiity and growth.
These investment, éxpenditures would create probable future economic value and benefit
and, therefore, are capitalized as assets. Examples of capital expenditures are those used in
long-term projects, classified as long-term assets, and recognised as expense once consumed
in the production and sale of a product or used in the administration and distribution functions
of business.

Operating expenditures are outlays or consumption used to directly support the normal
operating activities of the business. They are expensed in the period the statement of profit or
loss is presented because of the following accounting reasons:
a. Immediate recognition, such advertising, salaries, and research
b. Associating cause and effect, such as cost of sales, and
c. Rational and systematic allocation, such as depreciation.

Costs v. Expenses v. Losses

Costs are traditionally classified in relation to the functional activities of the business, that is
according to the place and purpose of their use. Costs of goods manufactured, recorded as an
inventory, are those incurred in producing goods and services: Examples are direct materials,
direct labor, and factory overhead. Costs of goods sold are production costs relating to the
units sold, already expensed in the period their corresponding revenue is earned.

There are expenses incurred in distributing the goods and managing a business. Those paid
or incurred in the marketing, promotions, and shipping activities are "distribution expenses".
Those relating to systems and control, government compliance, and other corporate costs
incurred to manage the business are referred to as “administration expenses".

Both costs and expenses give benefits to the business. Taken the meaning of new accounting
and terminology, expenses comprise all those charged against income in a given business
period.

Losses have no benefits Losses are reduction in the value of assets without benefit to the
business leading to the - |Impairment of equity. Examples of losses are: loss on sale of
equipment, loss on inventory obsolescence, loss on shortages, spoilage, and loss on
uncollectible.

Product cost v. Period cost

Product costs are those incurred in the process of producing the product. They are
inventoriable and deferred as assets while the units are unsold. Once sold, the cost of
inventory is transferred to the cost of goods sold and classified as an expense. Direct
materials and direct labor are called "prime costs". Direct labor and factory overhead are
called "conversion costs". Direct materials, direct labor and variable factory overhead are
called "variable production costs".

Period costs are those incurred outside of the production activities. They are incurred to
administer a business, sell or distribute a product, conduct researches, or attend to
customer's needs which are not direclty related to the production activities. They are instantly
expensed once incurred or recognized as an expense when consumed.

Direct product cost v. Indirect product cost

Direct product costs are those that are directly identified with the finished goods or services
or those that are directly attributable in the process of making them (i.e.,converting materials
into finished goods). Direct materials and direct labor are direct product costs. Factory
overhead is an indirect product cost.

MANAGER'S PERSPECTIVE

Relevant Cost v. Irrelevant Cost

Costs that are useful in making decisions are relevant costs, otherwise, they are irrelevant.
Relevant costs have two characteristics, differential and future. Differential costs vary from
one alternative to another while future costs are estimated expenditures relating to a
prospective activity.

Managers have at least two alternatives in making a decision, otherwise there is no decision
to be hardly made at all. When a cost differs from one alternative to another, that cost is a
differential cost. When a cost remains the same regardless of a choice to be made, that _ cost
is not differential and irrelevant.

Direct segment cost v. Indirect segment cost

Direct departmental costs are those that are directly identified with the department,
process, Segment, or activity regardless of whether they are variable or fixed costs.
Indirect department costs are those that are not directly identified with a department or a
business unit. They are sometimes referred to as “allocated costs”, “common costs”, or
plainly “unavoidable costs”. The litmus test on whether a cost is direct or indirect to a
business unit is when the said business unit ceases its operations. Direct department costs
are avoided upon the cessation of business unit operations while indirect department cost
continuously persist despite cessation of business operations thereof.

Avoidable cost v. Unavoidable cost

Avoidable costs are those not incurred once an activity is not performed. They become
savings on the part of the business. These savings are considered an inflow in the economic
sense and are referred to as “imputed costs".

Unavoidable costs remain to be incurred regardless of the option a manager chooses. They
remain constant, they do not,change, and are irrelevant in short-term decisions. Common
examples of unavoidable costs are rent, depreciation, interest, property taxes, and all other
committed fixed costs.

Controllable cost v. Uncontrollable cost

Controllable costs are those which incurrence, or non-incurrence, can be influenced or
decided upon by a manager. The influence or decision-making power of a manager depends
on the scope, nature and extent of authority granted to him by the organization.

Noncontrollable costs are those outside of the decision power or influence of a given
manager in a specific situation.
Planned cost v. Actual cost
Planned costs relate to future occurrences and are referred to in multifarious names such as
projected costs, estimated costs, budgeted costs, applied costs, and standard costs.

Budgeted costs are future values derived using budgeted quantities and prices as bases.
Applied costs are estimated values derived using the normal costing system. It uses the
standard price and the standard quantities are applied to the actual base. Standard costs are
reliable values accepted by men in the organizations derived from empirical, scientific, and
controlled studies.
Actual costs are expenditures already incurred and recorded in the accounting books.. The
difference between the planned cost and actual cost is called a "planning gap" or a "planning
variance”.

Budgeted cost v. Standard cost

Budgeted costs are those expected to be incurred at the budgeted level of activity.
Standard costs are those expected to be incurred at,"any level of activity” aside from that
being used in the master budget. The level of activity used in computing the standard cost
may be actual or estimated units.

Budgeted costs and standard costs use the same predetermined standard rates. The
difference between the budgeted cost and standard cost is the level of the activity used in
their measurement, and is called as the "capacity variance".

Sample Problem
Solution:
Out-of-pocket cost v. Non-cash costs
Out-of-pocket costs (OPCs) are those that are incurrred and paid in cash. OPCs require
cash payments. Those that are not paid in cash are non-cash costs.

Sunk cost v. Future cost

Sunk costs are those that have been incurred in the past and can no longer be changed.
They represent commitments made by the business in its previous decisions and cannot be
avoided in the future.

Future costs are to be incurred in the upcoming periods. They are relevant and are of value
in making decisions. They affect the upcoming activities where the manager should plan,
organize, direct and control. They are sometimes called as “planned costs", "budgeted costs"
or "estimated costs’.

ECONOMIST'S PERSPECTIVE

Explicit cost v. Implicit cost

Explicit costs are those already incurred or intended to be incurred (e.g., budgeted). They
are already recorded or to be recorded in the accounting books.

Implicit costs are theoretical costs. They are assumed and are not recognized in the
accounting books. Two classical examples of implicit costs are the opportunity costs and
imputed costs.
Opportunity cost v. Imputed cost
Implicit costs may be classified in relation to the theoretical condition upon which they are
created, Opportunity costs are benefits given up in favor of another choice. In each
decision, there is always a beneficial alternative (or choice) not followed but could had been
followed. The benefit sacrificed in favor of the alternative chosen is an opportunity cost.

Imputed costs are those not incurred but are implied in a given decision. Say, a business uses
its own cash in buying an equipment.

Incremental cost v. Marginal cost

Incremental costs represent a total increase in costs.
Marginal cost is an increase in cost per unit. Decremental costs are decreases in costs.

Variable cost v. Fixed cost

Fixed costs are those that remain constant in total but inversely changes on a per unit basis
in relation to the changes ‘in the level of quantity, volume or activity.. Variable costs change in
total in direct proportion to changes in the level of production and sales but is constant on a
per-unit basis.
Fixed costs could either be :
a. Committed fixed costs are those which incurrence have been committed by the
business in the past by reason of contract, acquisition or agreement. Examples are
rental expense, interest expense, insurance expense, executive salaries, depreciation
expense, patent amortization, real estate, property taxes, and salaries of production
executives,
b. Discretionary (or engineered) fixed costs are those which incurrence is assured but the
amount may change depending on the discretion or value judgment of the manager.
Examples are advertising expense, research and development costs, executive training
costs, salaries of outsourced security guards and utility personnel, and repairs and
maintenance of buildings and grounds. For academic purposes, all fixed costs, whether
committed or discretionary, should be treated as constant in total.

Variable costs vary directly in proportion to the change in the volume of activity Hence, total
variable costs change.

Mixed Costs
Mixed costs could either be semi-variable costs, semi-fixed costs, or step costs. Semi-
variable costs change in total but not in direct proportion to changes in the level of production
costs and sales. Semi-fixed costs are constant in a given level of activity but changes, not in a
Constant way, when a new level of activity is reached. Step costs are constant within a given
Semi-fixed costs range of activity and vertically shoots up as it reaches a given level of
activity. Then, it stays constant until it reaches a new level of activity, where it suddenly rises
anew, stays flat again until the next level of activity is reached, and so on.

Relevant Range
Relevant range is a band of activity (or stretch of activities) where the behavior of costs,
expenses, and revenues is valid. That is, total fixed cost, units sales price, and variable cost
rate are constant while the total variable cost changes in relation to the level of quantity.

Sample Problem

Solution:
The Learning Curve Theory
The Learning Curve Theory or “experience curve" is based simple idea that the time required
to perform a task decreases as the same person keeps on repeating the same task twice by
an average of twenty percent (20%) improvement. It results to a lower average time required
in every doubling of the same task. It is now a known as the 80-20 rule" or the "Pareto Law’

EXPENSE SEGREGATION TECHNIQUES

There are three (3) popular methods used in separating the fixed from variable costs of a
mixed account. All of them have their technical origin from the field of statistics.
They are the following:
1. High-low method
2. Scattergraph method
3. Least-squares method

The high-low method is the traditional method of costs segregation. In statistics, itis called
as the "range analysis." Variable cost rate is computed by dividing the change in costs over
the related change in base (e.g., unit of measure such as direct labor hours, direct labor costs,
machine hours, units of production, number of shipments, set-up time, and other activity
basis). After the variable cost rate is calculated, the total of fixed costs is determined by
getting the difference between the total costs and variable costs.

Formula for variable cost:

Formula for fixed cost:

Sample Problem

Solution:
Scattergraph method
Scattergraph or "visual fit analysis" shows the observation on a graph, gives a chance to
make an analysis on the plotted observation, and draws conclusions on the relationships a
‘between the "Y" (cost) and the “X" (base) variables. This method uses the principles found in
aregression line. A regression line is a straight line that depicts the relationship of two
variables — one is independent ("xX") and the other is dependent ("Y"). A regression line is
normally expressed in the equation:
Least-squares method
The least squares method extends the regression line to the other quadrants in the holistic
quadrant analysis. By doing so, additional two formulas are derived and to be used in
determining the values of “a” and “b”. The complete formulas used in the least-squares
method follow:

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MULTIPLE CHOICES
1. Inventoriable costs
a. Include only the prime cost of manufacturing a product.
b. Include only the conversion costs of manufacturing a product
c. Are expensed when products become part of finished goods inventory
 d. Are regarded as assets before the products are sold

2. Direct materials are

Conversion Manufacturing Prime
Cost Cost Cost
a. Yes Yes No
b. Yes Yes Yes
c. No Yes Yes
d. No No No

3. A fixed cost that would be considered a direct cost is

a. A cost accountant's salary when the cost objective is a unit of product.
b. The rental cost of a warehouse to store inventory, when the cost objective is the
Purchasing Department.
c. A production supervisor's salary when the cost objective is the Production
Department.
d. Board of directors’ fees when the cost objective is the Marketing Department.

4. Sunk costs
a. Are substitutes for opportunity costs
b. Are relevant to long-term decisions but not to short-term decisions.
c. Are relevant to decision making.
d. In the themselves are not relevant to decision making.

5. The salaries you could be earning by working rather than attending college are an
example of a. Outlay costs.
b. Sunk costs.
c. Misplaced costs.
d. Opportunity costs.

6. Costs that arise from periodic budgeting decisions that have no strong input-output
relationship are commonly called:
a. Committed costs
b. Discretionary costs
c. Opportunity costs
d. Differential costs

7. The term “discretionary costs" refers to

a. Costs that management decides to incur in the current period to enable the
company to achieve objectives other than the filling of orders placed by
customers.
b. Costs that are likely to respond to the amount of attention devoted to them by a
specified manager.
c. Costs that are governed mainly by past decisions the established the present
levels of operating and organizational capacity and that only change slowly in
response to small changes in capacity.
d. Amortization of costs that were capitalized in previous periods.
e. Costs that will be unaffected by current managerial decisions.

8. The difference between variable costs and fixed costs is

a. Variable costs per unit fluctuate and fixed costs per unit remain constant.
 b. Variable costs per unit are fixed over the relevant range and fixed costs per unit
are variable.
c. Total variable costs are variable over the relevant range and fixed in the long term,
while fixed costs never change.
d. Variable costs per unit change in varying increments, while fixed costs per unit
change in equal increments.

9. Which of the following best describes direct labor?

a. Prime cost

)by: Franklin T. Agamata

Page|
b. Period cost
c. Product cost
d. Both a product cost and a prime cost

10. Which one of the following costs is classified as a period cost?

a. The wages of the workers on the shipping docks who load completed products
onto outgoing trucks
b. The wages of a worker paid for idle time resulting from a machine breakdown in
the molding operation
c. The payments for employee (fringe) benefits paid on behalf of the workers in the
manufacturing plant
d. The wages paid to workers for rework on defective products

EXERCISES
1. The estimated cost for a company using absorption costing and planning to produce
and sell at a level of 12,000 units per month are as follows:

Direct Materials 32 Direct Labor

20
Variable MOH 15
Fixed MOH 6
Variable Selling 3 Fixed
Selling 4

a. How much is the total prime cost?

b. How much is the total conversion cost?
c. How much is the total variable cost per unit?

2. Cloud Glasses Company sells glasses that protect the wearer from supposedly
dangerous ultra-blue rays emitted by clouds. The company has the following
information: o Indirect materials used in products: 6,400 o Depreciation on
delivery equipment: 10,200 o Gas and oil for delivery trucks: 2,200 o
President's salary: 92,000 o Materials used in products: 120,000 o Labor costs of
assembly line workers: 110,000 o Factory supplies used: 24,000 o Advertising
expense: 25,000 o Property taxes on the factory: 45,000 o Repairs on office
equipment: 1,800 o Factory utilities: 39,000

a. Determine the total amount of product costs.

b. Determine the total amount of period costs.
3. Jackson Inc. is preparing a flexible budget for next year and requires a breakdown of
the cost of steam used in its factory into the fixed and variable elements. The following
data on the cost of steam used and direct labor hours worked are available for the last
6 months of this year.

a. Assuming that Jackson uses the high-low method of analysis, the estimated variable
cost of steam per direct labor hour is?

4. A learning curve of 80% assumes that production unit costs are reduced by 20% for
each doubling of output. What is the cost of the sixteenth unit produced as an
approximate percent of the first unit produced?