To make a profit, a business needs to run its operations smoothly. In the process of running a business, it will incur expenses. Often, a company may incur expenses and make payments later, just like a credit card payment. For accounting purposes, these are charged in the period they relate to. These expenses are called incurred expenses or costs incurred.
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 recognized 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 5,000 delivered to your factory. 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 5,000 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.
There are different types of costs incurred for a business. The most common types of expenses incurred or costs incurred are:
Manufacturing costs refer to the costs incurred to change raw materials into finished goods. It includes the cost of materials, direct labor, and other direct expenses. It is debited to the trading account.
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 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 refer to the expenses incurred for selling the finished product in the market. These costs are linked directly to the volume of goods produced.
Any expense incurred to purchase a capital asset is categorized as a capital cost. For instance, if you incur an expense to purchase manufacturing equipment, this will become an incurred capital cost.
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 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.
Any cost incurred on telephone bills 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.
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.
Salaries you pay to employees and workers are an example 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.
How would you charge these expenses to the expense account for November 2022?
So, the total expenses incurred for your company for November 2022 would be as follows:
Incurred costs = 10,000 + 5,000 + 200,000 + 200 + 16,000 = SGD 231,200
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 analyze the state of affairs and re-evaluate expense management. Managing incurred expenses can help a company keep a better eye on its profit.
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 5,000 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.
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