Incurred cost

Incurred cost
See also
Normal cost Fixed budget Absorbed costs Cash Budget Differential cost Variable Cost Ratio Allocated cost Cost per unit Cost element

Incurred cost is an accounting term used in cost accounting process which refers to a moment in the company's operating cycle, when an asset or a resource is used and an expenditure is registered in the company's accounting books. To simplify this term, incurred cost occurs when a firm's asset is used or the company becomes liable for the usage of this particular asset in the production process. Such assets are not recognized as a resource anymore and become an expense. The concept of accrual accounting demands from the companies to register expenses in the accounting books not on the date of payment, but when they are incurred. Thanks to this solution, the expenses and connected to them revenues are posted in the same accounting period. In accounting, such theory is called the matching principle. Under GAAP (Generally Accepted Accounting Principles) requirements, matching principle shall be used in every company's financial accounting and financial statement to present the reliable financial data.

Incurred cost in cost accounting

In order to fully understand the incurred cost term, a definition of cost accounting has to be described. Cost accounting is the process used to classify costs and to be able to analyze expenses, which will allow the total cost of each unit of production to be determined with appropriate level of accuracy and, in the meantime, to present precisely how such total cost is established. That is why cost accounting is used for classification, recording and proper distribution of incurred costs in order to correctly determine the costs related to services or products, and for the presentation of appropriately organized data for the purpose of management's control and guidance. More precisely, cost accounting is a procedure, which starts with recording revenue and expenses in the accounting books and finishes when the statistical data are arranged. This formal mechanism helps to determine and control incurred costs related to products and services. Cost accounting enables to analyze and classify expenses, what allows to determine the total cost of any given service or product with honest level of certainty, and in the meantime, to show precisely how the total cost is established. As an example, for the management it is not enough to know what is the incurred cost of production of one pencil, but they also want to know how much does the material used cost, what was the cost of labor and other related to this product, incurred costs in order to control and - if possible - reduce the cost of production. Cost accounting allows to calculate appropriate budgets and costs, such as:

• actual cost of operations,
• product cost,
• department cost,
• processes cost.

It also helps to analyze the profitability, deviations and use of funds by the society. That is why cost accounting is a method which enables to:

• collect,
• interpret,
• summarize,
• classify,

information used to determine the costs of product, control and operation planning and decision making.

Examples of Incurred cost

1. Raw Materials: Raw materials are the basic inputs which are used to create a product or deliver a service. The cost of the raw materials used in the production process is an incurred cost.
2. Labor Cost: Labor cost is the amount paid to the employees for their services. This cost is incurred when the company hires employees for production activities and pays them for their work.
3. Overhead Costs: Overhead costs are the costs associated with running the business, such as rent, utilities, insurance, etc. These costs are incurred when the company incurs expenses to maintain its operations.
4. Depreciation: Depreciation is an accounting method used to spread out the cost of a long-term asset over its useful life. This cost is incurred when the company purchases a long-term asset and allocates the cost over its useful life.
5. Interest Expense: Interest expense is the cost of borrowing money from a financial institution. This cost is incurred when the company borrows money from a lender and pays interest on it.

Advantages of Incurred cost

Incurred cost is an important concept in cost accounting and has several advantages:

• It helps businesses to accurately record expenses in their financial statements. This helps companies to better understand the financial position of the organization and make informed decisions.
• It allows companies to track and analyze the cost of production which helps them to identify areas of improvement in the production process.
• It helps to identify any discrepancies in the cost of production and helps to make adjustments accordingly.
• It allows companies to more accurately estimate future costs that may be incurred in the production process.
• It helps to ensure that the costs are being appropriately allocated to the right departments in the company.

Limitations of Incurred cost

• One of the limitations of incurred costs is that it does not take into account the value of the assets used in the production process. Incurred costs only provide information about the cost associated with the use of the assets and not the actual value of the assets themselves.
• Another limitation of incurred costs is that they do not consider the opportunity cost of using the assets. Opportunity cost refers to the value of the assets that could have been used in other areas or activities, but were not due to their use in the production process.
• Incurred costs are also limited by the inability to accurately predict future costs associated with the use of the assets. Incurred costs are based on current usage and do not take into account potential costs associated with the use of the assets in the future.
• Additionally, incurred costs do not consider the value of the assets over time. As the asset is used, its value may decrease, but incurred costs do not account for this depreciation.
• Finally, incurred costs do not consider any revenue that may be generated by the use of the assets. This means that incurred costs are only concerned with the cost associated with the use of the asset and not any potential benefits that may be generated by its usage.

Other approaches related to Incurred cost

One other approach related to incurred cost is Activity-Based Costing (ABC). ABC is a method of costing that assigns cost to activities and then to products or services. This approach allows for the cost of each activity to be assigned to the products or services that require them. By doing so, the organization can better determine which activities are adding value and which ones are not.

Another approach related to incurred cost is Target Costing. This approach sets a target cost for a product or service before the design process begins. The goal is to design a product that can be produced within the target cost. This approach is often used to ensure that products are competitively priced when they come to market.

A third approach related to incurred cost is Throughput Accounting. This approach is based on the idea that costs can be reduced by increasing throughput. Throughput is the rate at which products are produced. By increasing throughput, organizations can reduce their costs and increase profits.

In summary, incurred cost is an accounting term used to refer to the moment in the company's operating cycle when an asset or resource is used and an expenditure is recorded. Other approaches related to incurred cost include Activity-Based Costing, Target Costing, and Throughput Accounting. Each of these approaches helps organizations better manage their costs and maximize profitability.

References

• Anbarasu J.(2008), Basics of Cost Accounting, Bishop Heber College, p.1
• Directorate of Studies The Institute of Cost Accountants of India (2018), Cost accounting, Kolkata, p. 2
• The Institute of Company Secretaries of India (2014),Cost and Management Accounting, The Institute of Company Secretaries of India, p. 21

Author: Justyna Piekorz