What is Incurred Cost: Meaning and How Do You Manage It?

Incurred Cost Meaning 

When looking at incurred cost meaning, you need to understand that incurred cost or costs incurred is an expense in accrual accounting that a company becomes liable for when it uses an asset or a resource or sustains a loss. Costs incurred or expenses incurred reflect for the period during which they have been consumed.

Costs incurred may include direct, indirect, production and operating expenses. It can also include prior period expenses.

The idea of costs incurred or expenses incurred is based on expense recognition under accrual accounting. Based on this principle, expenses are recognised in the period to which they relate to rather than when they are paid for. Even if your business does not receive the invoice for the expense, the accrual method of accounting demands that these expenses incurred are accounted for as soon as the asset is consumed.

Now that you understand cost incurred meaning, let's look at the difference between the cost incurred and cost paid, or expenses incurred and expenses paid — the difference between the two lies in whether an outstanding amount has been settled. Expenses incurred or costs incurred relate to costs that have been charged but not yet paid. In other words, the asset has been consumed but not paid for yet.

An expense paid, as the name suggests, has already been cleared. To understand cost incurred meaning better, let's look at an example. Say you have raw materials worth SGD 6,950.00 delivered to your factory in Kwai Chung. The raw materials are billed for, but the dues still need to be cleared. The raw materials are then used to manufacture your products. In this case, SGD 6,950.00 will be an incurred expense. Once the dues are settled, they will become a paid expense.

Once you understand incurred cost meaning, you also need to know how they are accounted for or recorded. Since cost incurred is an expense for the company, it is debited to the income statement.

Types of Incurred Expenses

There are different types of costs incurred for a business. The most common types of expenses incurred or costs incurred are:‍

Manufacturing Costs

Manufacturing costs refer to the costs incurred to change raw materials into finished goods. It includes the cost of materials, direct labour, and other direct expenses. It is debited to the trading account. 

Direct Costs

Direct costs are the expenses that are directly tied to making a product or providing a service. This includes things like the wages of workers who produce the items, the raw materials needed to create the product, and other similar costs that go into the actual production process. In short, if it's something that directly contributes to making your product or service, it's a direct cost.

Indirect Costs

Any expense incurred that does not relate directly to the manufacture of goods or rendering of services is classified as an indirect cost. These costs are incurred for the smooth functioning of the business and can include operating costs, administration costs, selling costs, distribution expenses, marketing costs, etc.

Fixed Costs

Fixed costs are costs incurred in the business's regular running that do not change over the short term. They are also not linked to the volume of goods manufactured. These costs must be paid regularly by the business and include costs such as salaries, rent, etc. ‍

Variable Costs 

Variable costs refer to the expenses incurred for selling the finished product in the market. These costs are linked directly to the volume of goods produced. 

Capital Costs 

Any expense incurred to purchase a capital asset is categorised as a capital cost. For instance, if you incur an expense to purchase manufacturing equipment, this will become an incurred capital cost. 

Operating Costs

Operating costs are the expenses a business faces every day just to keep things running smoothly. These are the costs needed for normal operations, like paying for the internet, buying office supplies, or covering travel expenses for employees. Essentially, if it’s something that helps the business function on a day-to-day basis, it's an operating cost.

Sunk Costs

Sunk costs are expenses that can’t be recovered once they're spent. Even though these costs can't be brought back, recognizing them is important because it can help businesses make better decisions. For example, money spent on research and development (R&D) or dealing with bad debts are sunk costs. 

Exit Costs

Exit costs are the expenses a business faces when it decides to shut down or stop its operations. This includes things like severance payments to employees, selling off company assets, or paying fees for ending leases on property. These costs are associated with winding down a business and are usually one-time expenses related to closing down operations.

To know more, you can check out our blog on expenses. 

Examples of Incurred Costs

Rentals 

Rentals refer to the rent you pay for your office or factory space. While you may pay it at the end of the month, it is a cost incurred at the beginning of the month.

Depreciation 

Depreciation is the gradual reduction in the value of an asset over a period of time. Even though it is a non-cash expense, it must be charged as a cost incurred.

Utilities 

Any cost incurred on utilities like electricity, water bills, and telecommunications services is an expense incurred. Even if you settle it at the month's or quarter's end, it must be charged to the Profit and Loss statement as an incurred expense.

Supplies 

Raw materials purchased for manufacturing goods and services are an expense incurred. It needs to be recorded as a liability on the Balance Sheet as soon as it is consumed.

MPF Contributions and Salaries

Salaries you pay to employees and workers are examples of cost incurred. They need to be debited to the accrued salaries account.

Let's illustrate incurred cost meaning further by expanding on these examples. 

Your company incurs the following costs for November 2022. You follow the accrual method of accounting.

• Of this, machinery was bought on 1st January 2022, with depreciation charged for 12 months. Raw materials bought on 1st November 2022, of which only two-thirds have been used.

How would you charge these expenses to the expense account for November 2022?

• Depreciation on machinery is SGD 13900.00 since it needs to be split equally over 12 months until December 2022.
• The cost incurred for rent for November 2022 would be SGD 6950.00.
• Salary is a fixed cost incurred by the company. Even though you will pay salary only in December, the benefit of employee work has already occurred in November. So, the cost of SGD 278000.00 needs to be included in the incurred cost of November 2022.
• Utilities are fixed administrative expenses incurred for the month. Although you pay only by the 15th, SGD 278.00 must be charged at the start of the month.
• Raw materials are a direct cost to the company. Although you have purchased raw materials worth SGD 33360.00, only two-thirds of them have been utilised. Therefore, only two-thirds of the cost of raw materials for November 2022 will be an expense incurred. This amounts to SGD 22240.00.

So, the total expenses incurred for your company for November 2022 would be as follows: Incurred costs = 13900.00 + 6950.00 + 278000.00 + 278.00 + 22240.00 = SGD 321368.00

Incurred Cost Analysis 

Incurred costs reflect how much a company owes every month. It is an important figure for accountants to determine the company's financial state. Knowing the amount of costs incurred helps understand a company's cost structure and narrow down areas of improvement. 

Accountants can then plan how to pay off the expenses incurred over the months. If a company incurs expenses higher than its income, management will need to analyse the state of affairs and re-evaluate expense management. Managing incurred expenses can help a company keep a better eye on its profit. 

The Use of Accrual Accounting and Expense Incurred 

Incurred expenses are recorded only in accrual-based accounting. This differs from cash-based accounting, wherein expenses are recorded at the time of payment as against when they are incurred. Supposing a company incurs rent of SGD 868.75 in November but pays only in December, accrual-based accounting would charge it in November, but cash-based accounting would charge it in December.

Accrual accounting acknowledges costs incurred and requires them to be documented in the reporting period. By doing so, accrual accounting enables you to estimate your profit and losses within the reporting period. 

A good thing about accrual accounting is that it accurately reflects the company's financial position for a period. However, one downside of accrual accounting is that it can reflect profit even before the cash has hit the account. This results in reporting profitability even if the company is cash-starved.

Paid Expenses and Incurred Costs – What’s the Difference?

To be able to differentiate between incurred costs and paid expenses, it is important to first understand what each principle denotes. Both are accounting principles that help businesses track their finances and cash flow. 

Incurred costs: These are expenditures that a business is liable for, regardless of payment status. These costs are incurred when obtaining any sort of service or goods. These are documented in the accounting system, regardless of whether the payment is made or not. 

Example: A business receives an invoice for SGD 25,000 in raw materials that were ordered in August. The expense is incurred in August, regardless of when it is paid.

Paid expense: Once the company has paid the amount of money owed to the provider of the products or services, an expense that was an incurred cost is now considered a paid expense. Since they drain cash, these expenses quickly affect the company's cash flow.

Example: A web designer is paid for his services after the task has been carried out, which transforms the cost incurred into a cost paid.

Here are the key differences between incurred costs and paid expenses

Why do these differences matter?

The difference between cash accounting and accrual accounting is that cash-based accounting only records expenses that have been paid as opposed to accrual accounting, which records costs that have been incurred.

Planning for finances requires understanding actual expenditures, which is helpful for creating a budget and estimating cash withdrawals. Costs incurred but not paid for reflect liabilities that must be settled in the future.

Disadvantage of Incurred Costs

Here are some disadvantages of incurred costs:

Large project costs
 
Incurred costs can be significant, especially when linked to a large project, and they can represent substantial expenditures. This could affect the profitability of the business and make it more challenging to reach financial goals.

 Hard to monitor
 
Incurred costs can be challenging to monitor and control since they involve numerous invoices from different vendors. Because of this, it may be difficult to distinguish between incurred and non-incurred costs.
 
Complex Financial Reporting
 
Incurred costs may complicate financial reporting if they are not assigned to the relevant accounting period. Businesses may also find timely accounting difficult, especially if they are working on several projects at once.
 
Affects Cash Flow
 
Due to their frequent upfront payment, incurred costs might affect cash flow. This might make it harder for a business to meet other financial obligations and drain its working capital.
 
Tax Repercussions
 
Because these expenses are frequently tax deductible, incurred costs may have specific tax repercussions. A firm should take this into account when making financial decisions, as it may affect its tax liability.

Why Does Incurred Cost Matter to Businesses?

To ensure compliance, financial planning, and profitability, businesses pay special attention to the expenses they have incurred. Even if these expenses have not yet been paid for, they are considered actual commitments that impact a business's financial health. Here are a few reasons why incurred costs are important to businesses:

Accurate Reporting of Finances

The financial statements should accurately reflect the organization's actual financial situation by recording incurred costs as liabilities. This way, stakeholders, investors, and auditors are better able to evaluate the company's commitments and overall profitability.

Improved Cash Flow Management

Organizations that are aware of their expenses can plan for prospective payments and avoid cash shortages. Businesses can maintain liquidity by strategically scheduling payments.

Cost Management and Financial Planning

Companies can better monitor spending patterns and prevent excessive expenses by tracking incurred costs. Businesses can make proactive adjustments to their budgets to minimize overpaying.

Better Vendor Management

Keeping a record of the incurred expenses enables you to prevent penalties for late payments, ensure timely payments, and maintain positive relationships with suppliers. When businesses know of their prospective liabilities, they are in a better position to negotiate payments with more favourable terms.

Profitability and Decision-Making Process

If businesses fail to account for their incurred costs, they may overstate their earnings, which can result in bad decision-making. Maintaining a record of expenditures guarantees precise assessments of the profit margin and long-term expansion of the business.

How Aspire Helps You Manage Your Business Costs 

Aspire's spend management product enables you to scale company spending with control and real-time visibility. You can create budgets for projects or specific timeframes and set spending limits that can help you prevent overspending.

You can also set up approval flows, create spending policies and manage expenses to get real-time visibility into your spending. Our accounting software also helps sync all spending with receipts, making it easier for you to close your books and comply with Singapore's accounting requirements.

Final Word 

In summary:

• Incurred cost refers to an expense that a company becomes liable for in exchange for consuming or otherwise profiting from the usage of an asset.
• Costs incurred are a concept based on accrual accounting.
• Incurred expenses can be direct, indirect, production, operating and selling, and distribution expenses.
• Incurred expenses calculation can help analyse a company's cost structure and help management identify areas for improvement.

Frequently Asked Questions

1. What are the different kinds of incurred costs?

There are numerous ways to classify incurred costs. The primary incurred costs are manufacturing costs (cost of material), indirect costs (marketing cost), fixed costs (salaries or rent), variable costs (labour), and capital costs (purchase of equipment).

2. How to calculate incurred costs?

To calculate incurred costs, add all the direct and indirect expenses during a specific accounting period. You will have to record the expenses as they happen, regardless of when they are paid for. This includes labour costs, material cost, and manufacturing overheads used in production during a specific period.

3. What are some ways to reduce incurred costs?

You can adopt several strategies to reduce incurred costs as a business owner. Some of them are reviewing current expenditures, optimizing procedures, outsourcing odd jobs to freelancers, maximizing workforce skills, negotiating with vendors and suppliers, reviewing subscriptions and cancelling those that aren't adding value, controlling supply expenses, inventory management, and automating tasks with technology.

4. What are the implications of incurring high costs?

Incurring high costs can significantly impact your company's profitability and financial viability, making staying afloat and accomplishing business objectives more challenging. These adverse effects can include reduced revenue margins, difficulty competing in the market, higher likelihood of losses, a limited capacity to invest in development, possible higher costs for customers, and pressure on cash flow.

5. How can incurred costs be controlled?

A company can use strategies like accurately calculating costs, closely watching expenses, making an adequate budget, negotiating with suppliers, improving processes to cut down on waste, using automation to make things run more smoothly, finding and fixing cost differences, and regularly checking spending against budget. It takes proactive planning and tracking of costs to control your incurred costs.

6. What is the difference between committed costs and incurred costs?

Incurred cost is any expense that the business has already made and is considered to have happened in the current period, even if it isn’t paid for yet. Committed cost refers to any expense that a business agrees to pay in the future based on a decision they took in the past, such as signing a contract. 

7. What are the repercussions on a company if it accrues excessive incurred expenses?

When a business has too many expenses, it concentrates on debt repayment and reducing recurrent costs. Filing for bankruptcy is another way for a corporation to bounce back. When all other options have failed, this is typically the last resort.