UNDERSTANDING EXPENSES Costs V. Expenses V.
Losses
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
Sales P xx increase profit
Less: Expenses (P xx) decrease profit
Profit (Loss) P xx increase - profit
(decrease - loss)
Traditional management accounting provides intelligent information
to managers in order to reduce expenses and increase profit.
● Reducing expenses requires a thorough understanding in
line with the planning and controlling functions of
management.
● This drives the development of standard costing systems
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 amounts of
money and resources having a long-term impact on 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:
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 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 research, 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.
● Future costs relate to the estimated quantification of the
amount of a prospective expenditure (i.e., estimated,
budgeted costs).
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
○ advertising
○ systems review and development
○ interest expenses
○ training
○ research and development
○ real estate property taxes
○ allocated depreciation of noncurrent assets.
Avoidable cost v. Unavoidable cost
Costs 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 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 vary from
organization to another.
Fig. 3.1. Sample Organizational Chart and Controllable Costs
Workers 1, 2 and 3 are controlled by managers, highlighted in the
presented 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
Vice-Presidents 1 and 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.
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:

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:
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.
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.
● 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 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 change in total in direct proportion to changes in the
level of production and sales but is constant on a per-unit basis.
● 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 Table 3.2. Costs Behavior and Control Drivers
supplies, indirect materials, indirect labor and
repairs. Costs Fixed Costs Variable Costs
○ Examples of variable expenses are delivery
expenses, salesmen’s commissions, packaging Total Cost Constant, regardless of Changes, in direct
costs, and supplies. levels of production and proportion to the
sales change in the level of
Fixed costs and variable costs are normally expressed in their constant production and sales
terms. Hence, fixed costs are normally expressed in total, and variable
costs are expressed on a per unit basis. Unit Cost Changes, decreases Constant, regardless
as production increases of levels of production
and vice-versa and sales

COSTS SENSITIVITY How to Increase production to Reduce unit variable

Control? reduce unit fixed costs, cost to reduce total
Sample Problem 3.2. Variable Costs and Fixed Costs that is why, fixed cost is variable costs, that is
Ndesign Company provides the following costs structure on its product related to volume why, variable cost is
Bigwigs: related to spending
Total fixed costs P 200,000.00
Unit variable costs P 20.00
Let us highlight the observation that total unit costs decrease as
What will happen to fixed costs and variable costs, per total and per production increases. This is the very essence of “economies of scale”.
unit, if production levels are zero, 5,000 units, 10,000 units and 15,000 That is, produce more units to reduce unit costs, offer lower unit sales
units. 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
Solutions/ Discussions: because of the unit fixed cost that tends to go down as the production
• The total variable costs and fixed costs as well as the variable cost shoots up.
rate and the fixed cost rate under varying level of sales are as follows:

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”.

Mixed costs could either be semi-variable costs, semi-fixed costs, or

Cost behavior in relation to different production and sales levels
● 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
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

• 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 Relevant Range
straight diagonal line in graph “f”. It start from P 200,000 at the fixed The behavior of costs is predictable within a relevant range.
costs amount and varies directly in relation to volume because of the
variable cost component. Relevant range is a band of activity (or stretch of activities) where the
• The summary of costs behavior may be expressed as follows: 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 Fig. 3.5. The Learning Curve Graph
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
Productivity rate increases 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. 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.

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: