ACC 206 UNDERSTANDING EXPENSES Chapter 1

Module for

ACC 206

Understanding
Expenses
 Page 1
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 Avoidable cost v. Unavoidable cost
o systems review and o research and development
development o interest o real estate property taxes
expenses o allocated depreciation of noncurrent assets.
o training

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. Workers 1, 2 and 3 are not
controlled by Manager 1, Manager 3, and
Manager 1 Manager 2 Manager 3 Worker 1
Vice-Presidents 1 and 3.

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 13,200 15,840 P 10.00 P

costs 158,400

Standard 13,900 16,680 P 10.00 P

costs 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)
PRODUCTIO TOTAL TOTAL UNIT UNIT TOTAL UNIT
N LEVEL VARIABL FIXED VARIABL FIXED COSTS COSTS
E COST E COST COSTS
COSTS

0 P0 P P 20.00 n.a. P 200,000 n.a.

200,000

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 Changes Constant Constant Changes Increase Decrease

happened? directly, regardle inversely, s as s
increases ss decrease producti as
as of the s as on producti
productio levels of productio increase on
n productio n s increas
increases n increases due to es
. 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 Changes, in direct proportion to the

of production and sales change in the level of production and
sales

Unit costs Changes, decreases as Constant, regardless of levels of

production increases and production and sales
vice-versa

How to control? Increase production to reduce Reduce unit variable cost to reduce
unit fixed costs, that is why, total variable costs, that is why,
fixed cost is related to volume variable cost is 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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