Question

3. Explain the difference between locked in costs and costs incurred. Which of these types of costs does a traditional accounting system emphasize? At which stage of the value chain are most costs locked-in? At which stage of the value chain are most costs incurred? What implication does this have for good cost management?

Answer 1

Answer :

Locked in Costs :

Locked-in costs are costs not incurred yet, but based on decision that have already been made, will be incurred in the future. Locked in costs are those payments or investments made by a company which it cannot reverse, not at least before a certain period of time. E.g. If a company invests its money and buy machines, employ labors and officers and begin manufacture, then until time of sales, this investment becomes their locked in cost.

Cost Incurred :

A cost incurred is a cost for which a business has become liable, even if it has not yet received an invoice from a supplier as documentation of the cost. This is an accrual accounting concept. For example, a manufacturing operation uses a large amount of electricity during the month of January, after which the local power company bills it $25,000 for the electricity usage, which the company receives in February and pays in March. The company incurs the cost of the electricity in January, so it should record the related expense in January. If the company had instead been using the cash basis of accounting, the cost incurred concept would not apply, and so the entity would not record the cost until it paid the invoice in March. This would introduce a two-month delay in expense recognition.

Incurred costs (Costs as they happen) is the type of cost that emphasizes traditional accounting system.

At Design stage and Research and Development stage(R&D) of the value chain are most costs are locked-in.

At Manufacturing stage of the value chain most costs are incurred.

Implications : Pay attention to costs in the design stage cause later it will be locked-in.