TEORIA Y PRINCIPIOS PEDAGOGICOS

C

The business John Smith Accountants takes out a 12-month insurance cover for $12,000 at the beginning of the current month. The cost of insurance was $12,000.

At the end of the first month, the company has used up 1/12thof the

insurance cover but still has the economic benefit of 11/12th of the insurance cover. So, in accounting terms, at the end of the first month, the business will record an expense of $1,000 but will record the remaining cost of the

insurance as an asset of $11,000.

So the cost of insurance consisted of unexpired and expired portions, with the expired portion being the expense.

So while cost is defined as the monetary value of the utility (or benefit), expense is defined as the monetary value of the utility that has already expired in business activities, provided those activities are directed towards generating income.

This means that a cost when utilised becomes an expense.

So, the $1,000 mentioned above would appear as Insurance Expense in John Smith Accountants’ Income Statement (Statement of Financial Performance) and the $11,000 would appear as Prepaid Expense in the Current Asset section of the Balance Sheet (Statement of Financial Position).

The used, utilised or expired portion of the insurance cost was expensed while the unused or unexpired cost of the insurance is recorded as an asset because it has future economic value.

CONFUSION WITH THE TERMS COST AND EXPENSE IN ACCOUNTING As mentioned previously, significant confusion surrounds the use and meaning of the terms cost and expense. This is because not only do some accountants, teachers and authors use the terms interchangeably, but also so does the accounting system itself.

Let’s consider the 500-year-old and embedded accounting phrase cost of goods

sold. Is the term cost here consistent with the definitions we have given above.

Unfortunately, we cannot prevent words used in common language changing in meaning over time, even if the terms used in accounting do not.

Other cost terms that are really expenses include:

 finance costs (expenses applicable to financing companies which offers loans and deposit services)

 cost of services (expenses relating to the costs of services that are direct costs attributable to the revenue gained from providing services)

 direct costs (expenses that can be linked directly to a good/service being sold)

 indirect costs (expenses that cannot be linked directly to a good/service being sold)

 fixed costs (expenses that do not change in relation to any changes in business activity)

 variable costs (expenses that change proportionally in relation to any changes in business activity).

WHAT ARE OVERHEADS IN ACCOUNTING?

Overheads in accounting are important when trying to calculate product costs in the manufacture of goods or the provision of services. Overheads are those expenses that do not relate directly to a specific product and so must be shared equitably between all products produced by the business. Typical examples of overheads in accounting include rent, insurance and utilities. Overheads in accounting may also be known as indirect costs, fixed expenses or burden cost.

BACKGROUND TO OVERHEADS IN ACCOUNTING

The concept of overheads is used in both the manufacturing and distribution/sale of a product. In manufacturing, cost accountants use overheads to establish the actual cost of a product. In selling, cost accountants use overheads to establish the gross profit achieved and to calculate the contribution to overheads achieved from the sale of products.

As explained in the matching principle, accountants try to match revenue with the expenses incurred in earning that revenue for a given period. Cost

accountants try to do the same for a given product when calculating the actual cost of the product. Some expenses can be easily linked to a product like the raw materials that were used in the product’s production. Other expenses like

overheads cannot be easily matched with the production or sale of a particular product because— like rent, insurance and utilities—they relate to all products produced or sold.

Expenses that can be directly matched with a particular product would include the raw materials, direct labour and specific expenses (like freight) used in the production/sale of the product. There is no accounting standard that clearly identifies what expenses should be classified as overheads because overheads

vary from industry to industry. Most businesses separate their overheads from their total expenses in order to help business decision makers in areas such as:

 cost valuation of finished goods and work-in-progress  pricing

 budgeting

 the analysis of financial performance or profitability of products and cost centres.

The Income Statement is an example of overheads being separated from the total costs. For example, the direct costs (cost of goods sold) are subtracted from the sales to calculate the gross profit. Overheads (indirect costs) are then

subtracted from the gross profit to calculate the net profit. Gross profit is an important key performance indicator for most businesses when monitoring and setting their selling prices.

Identifying and allocating overheads is an important aspect of a cost

accountant’s work. Overheads are often seen as a ‘bad’ expense because they do not directly relate to the production/sale of the business products. Still, a certain amount of overheads are needed to run a business effectively. Businesses will generally, however, want to separate out the overheads and monitor them carefully. The concepts of cost and expense are often used interchangeably in this area of accounting.

TYPES OF OVERHEAD

Overheads are a special type of expense. In accounting, expenses are all the resources consumed in pursuit of revenue. While direct expenses (materials, labour) relate specifically to the products being produced and sold, overheads (indirect expenses) are those expenses that relate generally to all products being sold and do not naturally link to a specific product.

Administration/ office salaries Administration/

office salaries

Stationery and

office expenses_{office expenses}Stationery and Accounting/ audit Accounting/ audit fees_fees

Brand advertising and some selling

expenses (e.g. travel, accommodation) Brand advertising

and some selling expenses (e.g. travel, accommodation) Depreciation of fixed assets Depreciation of

fixed assets InsuranceInsurance

Interest of loans_{Interest of loans} Legal fees_{Legal fees} Rent_Rent

Taxes_Taxes Utilities costs_{Utilities costs}