ACC 206 UNDERSTANDING EXPENSES Chapter 1

Module for

ACC 206

Understanding Expenses

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 ACC 206 UNDERSTANDING EXPENSES Chapter 1

Module 1
Understanding Expenses
Week 1

Controlling Expenses
Management accounting is about profit management that includes expenses as its vital component.
Expenses affect operating results, hence, should be understood and intelligently managed. The accounting
for the accumulation, preparation and presentation of expenses to serve as a basis for management
decisions is the pioneering area of management accounting.

The end-point of operating performance is to generate maximum profit out of the resources used .
Mathematically, profit increases when sales increase and expenses decrease, or both, as shown below:

Table 3.1. The Basic Strategy in Managing Operating Results

To increase profit
Sales P x

Less: Expenses x
Profit (loss) P x

Traditional management accounting provides intelligent information to managers in order to reduce

expenses and increase profit. Reducing expenses requires for its thorough understanding in line with the
planning and controlling functions of management. This drives the development of standard costing system
leading to the brilliant formulation of principles, techniques and processes governing the cost-volume-profit
analysis and profit planning, responsibility accounting, operational budgeting, segment reporting, and
variance analysis.

In the recent years, management accounting has been critically supplying relevant information to strategic
management thereby necessitating the accumulation, processes, and reporting of information not only that
of operating concerns but of the financing and investing activities, both quantitatively or otherwise.

To manage cost means to control or reduce it or to justify its priority of occurrence.

Costs Concepts
The use of the term “costs” here includes costs and expenses.

Managing costs means knowing their nature, behavior and other characteristics. Costs may mean differently
to different people. We will deal here with costs in the perspectives of accountants, managers, and
economists.

Accountant’s Perspective
Capital Expenditure v. Operating Expenditures

Capital expenditures (i.e. puhunan) are investing outlays normally requiring large amount of money and
resources having a long-term impact to business profitability . These expenditures would create probable
future economic value and benefit and are capitalized as assets. These costs are converted to expense once
their related income has been generated. Examples of capital expenditures are those used in long-term
projects and classified as long-term assets and become an expense once consumed in the production or sale
of a product.

Operating expenditures (i.e gastos) 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 reasons:

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i. Immediate recognition, such advertising, salaries, and research;

ii. Associating cause and effect, such as cost of sales; and
iii. 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.

Cost of goods manufactured are those incurred in producing goods and services. Examples are direct
materials, direct labor, and factory overhead. Cost of goods sold are production costs relating to the units
that are already sold.

Expenses are those incurred in distributing goods and managing a business. Marketing, promotions and
shipping expenditures are distribution expenses. Those relating to systems and control, government
compliance, and other corporate costs incurred to manage the business are referred to as administrative
expenses.

Both costs and expenses give benefits to the business.

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 sales of equipment, loss on inventory obsolescence, loss on
shortages, spoilage, and loss on uncollectibles.

Product Cost v. Period Cost

Costs may be classified as to their relation to the product.

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 from the asset
classification to cost of goods sold classification as an expense. Direct materials, direct labor, and factory
overhead are product costs. 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
directly related to the production activities. They are instantly expensed once incurred.

Direct product cost v. Indirect product cost

Costs are further classified as to their degree of relation to the product.

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 may be classified according to their use in the decision-making process.

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 relate to the estimated quantification of the amount of a prospective expenditure (i.e.,
estimated, budgeted costs).

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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 irrelevant.

Example:

Let us say, you are deciding on whether to make or buy a part of a product: if you buy, you pay for the
purchase price; if you make, you do not pay for the purchase price. Hence, the purchase price is a
differential cost and since it also relates to the future event, then the said cost is a relevant cost in this
particular decision. Let us say further that if we make the part, we have to pay the plant manager a monthly
salary of P 100,000, while if we buy the part we still have to pay the plant manager his salary. The plant
manager’s salary does not differ, and is therefore, an irrelevant cost in the decision of making or buying a
part.

Relevant costs are not only differential costs, they should be future costs as well. Those costs that are not to
be incurred in the future are irrelevant. Past costs, sunk costs, historical costs are irrelevant costs in making a
decision because they can no longer be changed. Management deals about the future not on the past. The
future could be influenced or directed, while the past cannot.

Direct segment cost v. Indirect segment cost

Costs may be classified as to their relation to the business segment or unit.

Direct departmental costs are those that are directly identified with the department, process, segment, or
activity. They may be variable or fixed costs.

Indirect departmental 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 departmental costs continuously persist despite thereof.

Examples of direct departmental costs

• salaries of a department manager

• salaries of personnel assigned to the department
• supplies purchased and used
• rental of equipment directly used in departmental activities
• utilities (e.g., electricity and water) which are directly identified with a department
• telecommunications
• indirect materials
• indirect labor, and
• depreciation of equipment used in the department.

Examples of indirect departmental costs (or allocated costs)

• salaries of executives in the central office

• other central administrative costs such as
o advertising o research and development
o systems review and development o real estate property taxes
o interest expenses o allocated depreciation of noncurrent assets.
o training
Avoidable cost v. Unavoidable cost

Costs may be classified in relation to the occurrence of an activity.

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Avoidable costs are those not incurred once an activity is not performed. They normally 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 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

Costs may be classified in relation to the authority of the given manager.

Another way of classifying costs relates to the degree of authority given to a manager. 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. The concept of controllability is related to the organizational structure of an
organization. The organizational structure reflects the manner on how the business strategy is to be
undertaken. Structures varies from organization to another.

An example of an organizational chart is presented on the following page:

Fig. 3.1. Sample Organizational Chart and Controllable Costs

Chief Executive Officer

Workers 1, 2 and 3 are controlled by
managers, highlighted in the presented
VP1 VP2 VP3 structure. They are controlled by the
Manager 2, Vice-President 2, and
eventually, the Chief Executive Officer.
Manager 1 Manager 2 Workers 1, 2 and 3 are not controlled by
Manager 3
Manager 1, Manager 3, and Vice-Presidents
1 and 3.
Worker 1 Worker 2 Worker 3

Noncontrollable costs are those outside of the decision power or influence of a given manager in a specific
situation.

Planned cost v. Actual cost

Costs may be classified in relation to its incurrence in a future undertaking.

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.

Projected costs are future values derived from using forecasting models such as probability, regression and
causal models. Estimated costs are those future values derived out of normal observations without the aid of
standards or any reliable bases. Budgeted costs are future values derived using standard quantities and
prices as bases. Applied costs are estimated values derived using the normal costing system. 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

Costs may be classified in relation to the level of activity being considered for estimation.

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Budgeted costs are those expected to be incurred at the level of activity used in preparing the master budget.
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.

Budgeted costs and standard costs use the same predetermined standard rates. The difference between the
budgeted cost and standard cost is called a capacity variance.

Sample Problem 1. Budgeted Costs v. Standard Costs

Samal Corporation uses the following standard costs in its production control processes, as follows:

Quantity Price Unit Cost

Direct materials 1.2 lbs P 10.00 P 12.00
Direct labor 0.4 hr 70.00 28.00
Variable overhead 0.4 hr 20.00 8.00
Fixed overhead 0.4 hr 40.00 16.00
Total P 64.00

The company’s normal capacity is 14,000 units or 5,600 hours (i.e., 14,000 units x 0.4 hr.). In July, the
company budgeted to produce 13,200 units and actually produced 13,900 units.

Required: Determine the following estimated costs for direct materials:

1. Budgeted costs.
2. Standard costs.

Solutions/Discussions:

The estimated costs are tabulated below:

Units Estimated Standard Estimated

Quantity Price Costs
Budgeted costs 13,200 15,840 P 10.00 P 158,400
Standard costs 13,900 16,680 P 10.00 P 166,800

The budgeted quantity is budgeted production times the standard materials per unit (e.g., 13,200 units x 1.2
lbs.). The standard quantity is actual production times the standard materials per unit (e.g., 13,900 units x
1.2 lbs.)

The budgeted materials costs may also be computed by multiplying the budgeted production by the
standard materials cost per unit (e.g., 13,200 units x P 12). The standard materials cost is also determined
by multiplying the actual production by the standard materials cost per unit (e.g., 13,900 units x P 12).

Budgeted costs refer to the “master budgets”. Standard costs are also called as: flexible budgets”.

Out-of-pocket cost v. Non-cash costs

Costs may be classified in relation to cash.

Out-of-pocket costs (OPCs) are those that are incurred and are paid in cash. OPCs require cash payments.
Those that are not paid in cash are non-cash costs.

Sunk cost v. Future cost

Costs may classified according to their period of incurrence.

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. They are
constant and not differential. They are historical and irrelevant in short-term decisions.

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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 planned costs, budgeted costs, or estimated costs.

Economist’s perspective
Explicit cost v. Implicit cost

Costs may be classified according to the manner on how they are stipulated.

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 good examples of implicit costs are opportunity costs
and imputed costs.

Opportunity cost v. Imputed cost

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. Say, a business is deciding
whether to invest an amount of P 1 million to Project X (with 15% return on investment) or Project Y (with
20% return on investment). Either way there is an opportunity cost. If the business decides to invest in
project X, its opportunity costs is the 20% benefit from investing in Project Y (i.e., P 200,000). If the
business decides to invest in project Y, its opportunity cost is the 15% benefit from investing in project X
(i.e., P 150,000).

Imputed costs are those not incurred but are implied in a given decision. Say, a business uses its own cash
in buying an equipment. If the business borrows from a bank to buy the equipment, it should pay an
interest rate of 15% per annum. The imputed rate of using its own money instead of borrowing is, clearly,
equivalent to the amount of the 15% interest rate that should have been paid had the money been
borrowed.

Opportunity costs and imputed costs are not recorded in the financial accounting system because they are
not actually incurred, they are only theoretical. But they are relevant in making a decision.

Incremental cost v. Marginal cost

Costs may be classified in relation to a particular product or activity.

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

Costs may be classified in relation to quantity or level of activity.

In the following discussions, we assume the level of production and sales to be equal.

Costs are classified as fixed or variable with regard to their behavior in relation to, and the changes in the
activity level of production and sales.

Fixed costs are those that remain constant regardless of the change in the level of production and sales, but
inversely changes on a per unit basis. 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 committed or discretionary. 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

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amortization, real estate, property taxes and salaries of production executives. 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 security guards and janitors, 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 level of production and sales. Hence, total
variable costs change. That is, if sales increase by 10%, total variable costs also change by 10%. If sales
decrease by 12%, total variable costs also decrease by 12%. Notice, that there is a direct (or complete)
proportion in the changes of variable costs and sales. 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. Examples of variable expenses are delivery expenses, salesmen’s
commissions, packaging costs, and supplies.

Fixed costs and variable costs are normally expressed in their constant terms. Hence, fixed costs are
normally expressed in total, and variable costs are expressed on a per unit basis.

Costs Sensitivity
Sample Problem 3.2. Variable Costs and Fixed Costs

Ndesign Company provides the following costs structure on its product Bigwigs:

Total fixed costs P 200,000.00

Unit variable costs P 20.00

What will happen to fixed costs and variable costs, per total and per unit, if production levels are zero,
5,000 units, 10,000 units and 15,000 units.

Solutions/ Discussions:

• The total variable costs and fixed costs as well as the variable cost rate and the fixed cost rate under
varying level of sales are as follows:

(A) (B) (C) (D) (E) (F) (G)

PRODUCTION TOTAL TOTAL UNIT UNIT TOTAL UNIT
LEVEL VARIABLE FIXED VARIABLE FIXED COSTS COSTS
COSTS COST COST COSTS
0 P0 P 200,000 P 20.00 n.a. P 200,000 n.a.
5,000 100,000 200,000 20.00 P 40.00 300,000 60.00
10,000 200,000 200,000 20.00 20.00 400,000 40.00
15,000 300,000 200,000 20.00 13.33 500,000 33.33
What happened? Changes Constant Constant Changes Increases as Decreases
directly, regardless inversely, production as
increases as of the decreases as increases production
production levels of production due to increases
increases. production increases variable
Etc. costs
The following computational guidelines are used in this sensitivity matrix:
(B) Total variable costs = Units produced x Unit variable costs (i.e., P 20)
(D) Unit fixed costs = Total fixed costs / Units produced
(F) Total costs = Total fixed costs + Total variable costs
(G) Unit costs = Unit fixed cost + Unit variable cost
Cost behavior in relation to different production and sales levels

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• The behavior of costs in relation to changes in the level of production and sales re graphically
presented below:

Figure 3.2 Graphical Representation of Costs Behavior on Varying Levels of Activity

• Clearly, total fixed cost is constant. While of special interest is the behavior of unit fixed costs where
it decreases as production increases, and it increases as production decreases. Unit fixed cost is
inversely related to volume, hence, a strategic control point of fixed costs is to increase the volume
of production.
• Total variable costs moves directly in relation to the changes in the level of quantity but is constant
on a per unit basis despite the changes in the activity levels, therefore independent of volume.
Variable costs are directly related to sales volume. That is, as the volume increases by 100%, the
total variable costs also decrease by the same rate of 100%. The diagonal line in graph “c” is the
slope representing the variable cost rate of P 2.00.
• Observe that the behavior of total cost is linear. That is, it depicts a straight diagonal line in graph
“f”. It start from P 200,000 at the fixed costs amount and varies directly in relation to volume
because of the variable cost component.
• The summary of costs behavior may be expressed as follows:

Table 3.2. Costs Behavior and Control Drivers

Costs Fixed Costs Variable Costs

Total costs Constant, regardless of levels of Changes, in direct proportion to the change
production and sales in the level of production and sales
Unit costs Changes, decreases as production Constant, regardless of levels of production
increases and vice-versa and sales
How to control? Increase production to reduce unit Reduce unit variable cost to reduce total
fixed costs, that is why, fixed cost is variable costs, that is why, variable cost is
related to volume related to spending

Let us highlight the observation that total unit costs decrease as production increases. This is the very
essence of “economies of scale”. That is, produce more units to reduce unit costs, offer lower unit sales
price, and secure a good share of the market. Total unit costs are reduced not because of the unit variable
costs, which is constant, but because of the unit fixed cost that tends to go down as the production shoots
up.

Mixed costs
There are costs which could not be perfectly classified as pure fixed costs nor pure variable costs. These
costs have the characteristics of both the fixed and the variable costs found in a given expense. They are
called “mixed costs”.

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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 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 in a given level of activity and changes, also in a constant way as new level of activity
is reached.

Examples of mixed costs are electricity, inspection, inter-department services, water and sewages,
maintenance and repairs, employer contributions to government agencies, and industrial relations expenses.

Mixed costs should be segregated as to their fixed and variable components to be of value in economics and
in the field of management accounting. The segregation techniques are discussed in Appendix 3.1.

Meanwhile, the graphical representations of these mixed costs are shown in the following diagrams:

Fig. 3.3. Graphical Representation of Mixed Costs

Relevant Range

The behavior of costs is predicable within a 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 is constant
and total variable cost changes in relation to the level of quantity. Relevant range covers only a short-range
of activity, as such, relevant range is applicable only for short-term analysis such as cost-volume-profit
analysis, short-term budgeting, standard costing and variance analysis, segment reporting and performance
evaluation, and other analytical techniques used in making decisions with short-range effects. Within the
relevant range, we expect total fixed costs, variable costs and total costs to behave the way they are
graphically presented in Fig. 3.2.

Long range analysis and relevant range

Economists and management practitioners know that costs do not really behave linearly. In the long run,
the behavior of sales and costs is not linear as shown below:

Fig. 3.4. The Relevant Range in Relation to Sales and Expenses

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Sales inch up slowly until it breaks the pioneering growth resistance level and tremendously move up in the
succeeding years after the product is introduced as inspired by a well-fuelled marketing and promotional
activities. Later on, sales decline as the product reaches the level of its maximum market acceptance. Now
comes the importance of technology and innovations to repackage the product and spur an upswing trend
in sales. And the process continues, sales go up, mature, decline, or move up anew.

The area of activity where the behavior of sales and costs depicts a straight line (or constant state) in relation
to the level of production and sales is the relevant range.

The discussions on the behavior of total costs as depicted in Fig. 3.4 follow in line with the assumptions
using the learning curve theory.

The Learning Curve Theory

The Learning Curve Theory or “experience curve” is based on the 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 is now popularly known as the “80-20 rule” or the “Pareto Law” leading to a
lower average time required in every doubling of the same task.

Total costs increase dramatically in the initial years of business or product operations. This is attributable to
the rate of learning of personnel in a system where they perform with a lesser degree of efficiency in the first
time (or batch) of business operations during which time people gain knowledge and experience on the
working of systems and processes. As the number of activities (or batches) doubles and experience is
gained, efficiency pays off and productivity heightens. This means lower cost per unit of output driven by
people’s productivity. As production continues people get tired, machines need more maintenance, and
new technology learned and adapted, total costs start to move up once more and the cost per unit is
pressured to move up. However, the power of the learning curve will show its existence and will curb down
costs anew. And so the process continues. The learning curve graph is presented in Fig. 3.5 as follows:

Fig. 3.5. The Learning Curve Graph

Productivity rate increase as production moves up. In general, productivity rate improves in the vicinity of
65% - 85% as production volume doubles until such time the best performance is attained.

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The learning curve also resembles that of the “law of diminishing returns” and “product life cycle”. If
applied to the behavior of total costs, it decreases by about 80% whenever production doubles.

Reference:

Franklin T. Agamata, MBA, CPA

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