Module 2: UNDERSTANDING EXPENSES
CONTROLLING EXPENSES
Management accounting is about
profit management that include
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 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.
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 the management. This
drives the development of standard
costing system leading 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.
COSTS CONCEPTS
The use of the term “costs” here
includes cost 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
perspective of accountants,
managers, and economist.
ACCOUNTANT’S PERSPECTIVES
CAPITAL EXPENDITURES V.
OPERATING EXPENDITURES
Capital expenditures are investing
outlays normally requiring large
amount of money and resources
having a long-term investment
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 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:
i. immediate recognition, such
advertising, salaries and
research
ii. Associating cost and effect
such as cost of sales
 Module 2: UNDERSTANDING EXPENSES
iii. Rational and systematic
allocation, such as
depreciation
COST V. EXPENSES V. LOSSES
Cost is 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 are
those incurred in producing goods
and services. Examples are direct
materials, direct labor and factory
overhead. Cost of goods sold are
production cost relating to the unit
are that 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
administration expenses.
Both cost 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
uncollectable.
PRODUCT COST VS. PERIOD COST
Product cost are those incurred in
the process of producing the
product. They are inventoriable and
are deferred as assets while the units
are unsold. Once sold, the cost of
inventory is transferred from the
asset classification to cover cost of
goods sold classification as
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
Cost is 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 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
expenses, training, research and
development, real estate property
taxes, and allocated depreciation
of noncurrent assets.
AVOIDABLE COST V, UNAVOIDABLE
COST
Cost may be classified in relation to
the occurrence of an activity.
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
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
Cost may be classified in relation to
the authority of the 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 decided or
influenced 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
one organization to another.
Noncontrollable costs are those
outside of the decision power or
influence of a given manager in a
specific situation.
Planned cost v. Actual cost
Cost may be classified in relation to
its incurrence in a future
undertaking.
Planned cost relate to future
occurrences and are referred to a
multifarious name such as projected
costs, estimated costs budgeted
cost, applied costs and standard
costs.
Projected costs are future values
derived from using forecasting
models such as profitability,
regression and causal models.
Estimated costs are those future
values derived out of normal
observations without the aid of
standards or any reliable 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.
 Module 2: UNDERSTANDING EXPENSES
Actual costs are expenditures
already incurred and recorded in
the accounting books. The
difference between the planned
costs and actual cost is called
planning gap or planning variance.
BUDGETED COST V. STANDARD COST
Cost may be classified in relation to
the level of activity being
considered for estimation.
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 cost and standard costs
use the same predetermined
standard rates. The difference
between the budgeted cost and
standard costs is called a capacity
variance. Budgeted costs refer to
the master budget while standard
cost is called flexible budgets.
SUNK COST V. FUTURE COST
Cost may be 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.
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
Cost may be classified according to
the manner on how they are
stipulated.
Explicit costs are those already
incurred or intended to be incurred.
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
 Module 2: UNDERSTANDING EXPENSES
beneficial alternative (or choice)
not followed but could had been
followed.
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
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
decision.
INCREMENTAL COST V. MARGINAL
COST
Cost may be classified in relation to
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
Cost 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 or
production sales.
Fixed costs are those that remain
constant regardless of the change
in the level of production and sales,
but inversely changes from unit basis
Fixed costs could be either
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 expenses, interest
expense, insurance expense,
executive salaries, depreciation
expense, patent amortization, real
estate, property taxes, and salaries
of production executives.
Discretionary fixed costs are costs
which incurrence is assured but the
amount may change depending on
the discretion of value judgment of
the manager. Examples are
advertising expense, research and
development costs, executive
training costs, salaries of the security
guard 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.
 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.