What is Incurred Cost?

Incurred cost is an expense which a company becomes liable for in exchange for consuming or otherwise profiting from the usage of an asset.

The notion of incurred cost is based on the principle prescribed for expense recognition under the accrual accounting concept. The expense recognition principle of accrual accounting prescribes that expenses and receipts should be recognized as soon as they incur, rather than when cash is exchanged. Even if the actual invoice is not received from the supplier, the accrual accounting method calls for recognizing the expense as soon as the asset is consumed.

Since incurred cost is an expense for the company, it should be recorded on the debit side of the income statement. An incurred cost could be any kind of expense that a company incurs in the normal course of operation of the business and includes expenses such as direct, indirect, production, operating, and selling and distribution expenses.

For instance, say your utility company sends you an invoice for your electrical usage only in the following month, you still have to recognize the power bill as an expense for the current month rather than the next month. This is because you have already used the asset (electricity consumption) in the first month, so you are liable for that usage in the same month and not when you are making the usage payment (the following month).

Types of Incurred Cost

Some of the most common incurred costs include:

Manufacturing Costs

This refers to the direct expenses incurred in converting raw materials into finished goods and includes expenses such as direct labor, direct materials, and direct expenses.

Indirect Costs

This refers to the expenses incurred for the smooth functioning of the business such as operating, administration, selling and distribution expenses.

Fixed Costs

This refers to all the fixed expenses that need to be regularly paid by the company to run the business such as salaries, rent, and other similar expenses.

Variable Costs

This refers to expenses incurred in the selling of the finished product in the market

Capital Costs

This refers to the cost incurred for the purchase of a capital asset.

Incurred Cost Example

You have been provided with the following information from the books of ABC Ltd on 30th November 2019. The company follows the accrual method of accounting. Calculate the incurred cost for November 2019.

  1. Machinery worth $120000 purchased in January 2019 needs to be depreciated equally over 12 months.
  2. Salary due to employees for November 2019 is $200000
  3. Office rent prepaid for the entire year in January 2019 was $60000
  4. Telephone and internet bills for November 2019 will be received by the company on December 15th, 2019. The bill is constant at $200 per month
  5. Raw material inventory worth $24000 which was purchased on 1st November 2019 is now only one-third of the original purchased quantity

Let’s analyze each item of expense to find out the portion of incurred cost for July 2019.

  1. Machinery: Since the cost of machinery has to be depreciated equally over 12 months, the depreciation cost incurred for November 2019 would be (120000/12) $10000
  2. Salary: This is a fixed cost incurred by the company to keep the business running smoothly. Though salary is usually paid on the 1st of the following month (December 1st, 2019 in this case), the company has already been benefited by the work of its employees throughout the month of November 2019. Therefore, this cost of $200000 needs to be included as part of the November 2019 incurred costs.
  3. Prepaid office rent: Office rent is yet another fixed expense which the company incurs every month to keep the business running. Since it has already been prepaid in January 2019 for the entire year, the rent expense for November 2019 would be (60000/12) $5000.
  4. Telephone and Internet Bills: This is yet another administrative fixed expense that is incurred during the normal course of business. Since the bill of $200 is constant every month, the incurred cost for telephone and internet bills for November 2019 would be $200.
  5. Raw material Inventory: The purchase of raw materials is a direct cost to the company since it directly contributes to the production of finished goods. We will need to recognize only that portion of the raw material cost that has been utilized for the manufacture of finished goods during that particular accounting period as incurred cost. In this case, since the raw material inventory has reduced to one-third of the original amount, it means that two-thirds of the raw material has been utilized in the production process during November 2019. Therefore, we should recognize only two-thirds of the cost of raw material for November 2019 as incurred cost of raw materials. That amounts to $16000 (24000*2/3).

Therefore, the total incurred cost of ABC Ltd for November 2019 would be:

$$\text{Incurred Costs} = 10{,}000 + 200{,}000 + 5{,}000 + 200 + 16{,}000 = \$231{,}000$$

Incurred Cost Analysis

The calculation of incurred costs helps the company to analyze its cost structure and identify the areas of improvement. Such an analysis helps management in implementing cost-saving measures and create and execute other strategic growth plans for the future.

On the other hand, incurred cost also includes non-cash expenses such as depreciation and amortization. If the non-cash expenses for a particular accounting period are high, then it may present a distorted view of the company’s liquidity situation for that particular accounting period.

Incurred Cost Conclusion

To sum up:

  • Incurred cost is an expense which a company becomes liable for in exchange for consuming or otherwise profiting from the usage of an asset.
  • It is based on the accrued accounting concept of expense recognition.
  • Incurred cost is an expense for the company and is usually recorded on the debit side of the income statement.
  • Incurred cost includes expenses such as direct, indirect, production, operating, and selling and distribution expenses.
  • Incurred cost calculation helps in analyzing the cost structure of the company and allows management to identify areas of improvement.

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