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Cost v. Cash Outflow
A challenge for managers is to understand the difference between 1) a cost and 2) a payment or cash outflow. These concepts are not the same (and the terms cannot be used interchangeably), but they often arise at the same time and from the same transaction, and thus are easily confused. This page describes the difference between a cost and a cash outflow; much of the explanation also can be used to describe the difference between an income statement (exit this site) and a cash flow statement (exit this site). The explanation begins by defining the concepts and then presenting several examples to illustrate their differences and similarities. This explanation relies on examples from production agriculture (i.e., farming and ranching), but the concepts also apply to other businesses.
Confusion over these concepts is further complicated by income tax law, especially income tax law for production agriculture that de-emphasizes the difference between cost and cash outflow. This page does NOT address income tax law but instead, describes these concepts as they need to be understood by managers for non-tax (managerial) purposes.
Definitions
Cost -- the value of inputs used to produce a product (output). A cost may or may not require a cash outflow.
A cost may not include a cash outflow. For example, fuel purchased and paid for last year, and stored in inventory until it was used this year, is a cost of this year because it was used in this year's production. The cash outflow occurred last year when the fuel was purchased, received and paid for. It is not a cost until it is used.
Likewise a piece of equipment is not a cost until it is used. A truck purchased and paid for in the past was a cash outflow at that time, but it is not a cost until it is used. Depreciation is the concept that a portion of the cost of the truck needs to be recognized as a cost against the product produced at this time with the use of the truck and many other inputs. Until the truck is used, the purchase of the truck merely changed the form of the business asset from cash to equipment. It is only when the truck is used and it has less value because it has been used that the business has incurred a cost.
This example of how depreciation relates to cost and cash outflow is based on defining depreciation for management purposes, not for income tax purposes.
Cash outflow -- a payment of cash to some entity outside the business. A cash outflow may or may not be considered a cost.
Consistent with the previous example, a cash outflow will also be a cost only if the purchased and paid for item is used to produce a product during the same time period in which it was paid for. If the item is paid for and then stored for use during a subsequent production period, the payment is only a cash outflow.
Cash outflows also include principal payment on a debt or return of capital to the business owner. These two cash outflows are examples of non-cost items.
Related Terms
Revenue -- value of product produced during a particular time period, perhaps one quarter or one year.
The produced product may or may not result in cash inflow during the period when it is produced. For example if the product is sold immediately after production and the buyer immediately pays the purchase price, the producer will receive a cash inflow in the same period the product was produced. The revenue and cash inflow will have occurred during the same period.
However if the product is placed into inventory (rather than sold immediately) or the product is sold on credit with the understanding the the buyer will make the payment at a later time, there will be no cash inflow resulting from the production of the product during the period in which the product was produced. In this case, the revenue and cash inflow would not occur in the same period.
The lack of cash inflow does not change the reality that the value of the product is considered revenue in the period in which the product is PRODUCED.
The definition of revenue reflects accrual accounting (as opposed to cash accounting); that is, revenue is the value of production, whether or not it is immediately sold and whether or not it is immediately paid for.
The amount of revenue can be calculated (often by accountants) as the amount of sales during a time period adjusted by change in inventory of the product from the beginning of the period (or end of previous period) to the end of the current period.
With today's information technology, will managers be able to directly track the quantity produced? Would the accountant's calculation be a way to confirm the accuracy of the manager's direct counting of production?
Would a similar process of direct observation and documentation of inputs used in production be a way to determine cost? Would the accounting process of calculating cost be a means of confirming the accuracy of the manager's direct observation of production inputs?
Will information technology alter the process by which manager measure revenue and cost?
Profit -- the difference between the value of product produced during a time period and the value of the inputs used to produce the product during that time period.
Profit is calculated by preparing an income statement for the business or an enterprise analysis for a portion of the business.
Cash inflow -- the amount of cash flowing into a business; the cash inflow could be due to payments received from the sale of product, but it also could be due to capital contributions from the business owners or loans from lenders.
Available cash or cash balance -- the amount of cash held by the business; the balance will change during a period depending whether the cash inflows exceed or a less than cash outflows for the period.
A cash flow statement is prepared to track cash outflows, cash inflows and cash balance.
Assets -- value of all properties owned by the business on a particular day
Debt -- amount of all obligations owed by the business on a paricular day
Equity or Net worth -- the difference between the value of assets and amount of debt on a particular day.
Equity is calculated by preparing a balance sheet.
The focus of the discussion now returns to cost and cash outflow.
Transactions that are both a cost and cash outflow
Many production costs require a cash outflow. An example is fuel; the business manager uses cash to purchase fuel which will be used within a short time to produce the business' output or product. Purchasing fuel, seed, fertilizer, or pesticide in late winter that will then be used within the next several months to plant and grow the crop are examples of both cash outflows and costs. As a result of these everyday transactions, a manager may conclude there is no difference between a cost and a cash outflow, but that is not correct.
Cash Outflows that are not Costs
Businesses regularly make cash payments for items that are not considered a cost. For example, a business that purchases land by withdrawing cash from a savings account to pay the seller is incurring a cash outflow; and in the case of a land purchase, it is probably a substantial cash outflow. This cash outflow would be reported on the business cash flow statement (exit this site). However, the land purchase will not be considered a cost when the business prepares its next income statement (exit this site).
Purchase of Asset is Not a Cost
One way to understand that a land purchase is not a cost is to consider the impact the purchase will have on the business' assets, liabilities, and equity. If the business prepared a balance sheet (exit this site) immediately before the land purchase and another one immediately after the land purchase, the difference between the two statements would be a decrease in cash assets and an increase in land assets. Total assets, liabilities, and equity would NOT change (assuming that the value of the land equals the purchase price -- a reasonable assumption). Thus the purchase of this capital asset with cash could be described as "changing the form of the business assets from cash to land." It was not a cost, even though it involved a cash outflow (money was taken from savings and paid to the seller).
| Purchase v. Use The two-step process of purchasing and using a production input may be more obvious if the fuel example is slightly modified -- assume the fuel was purchased one year, held in the business' inventory, and used the next year. The business' financial statements would report the following transactions.
|
Use of an Asset is a Cost
This explanation could also be applied to the previous example of purchasing fuel. If the purchase and use of the fuel were considered separate transactions, the first transaction (buying and paying for the fuel) would be a cash outflow and a change of asset from cash to fuel -- similar to the land purchase. The second transaction would occur when the fuel is taken from the business' inventory and consumed in the production process. This second transaction does not require a cash outflow but is a "cost;" that is, the fuel was used or consumed as part of the production process.
Business managers may not recognize the two-step process because fuel is often purchased and consumed within the same recording keeping or production period. Despite the closeness in time between the purchase and the use of the fuel, managers who understand the transaction as involving two-steps are "on-track" to recognize the difference between a cash outflow and a cost, even though their business financial statements do not explicitly reveal both steps.
Other Examples of Cash Outflows that are not Costs
The previous examples illustrate cash outflows that are not expenses; such as the purchase of 1) land or 2) a production input that will be stored in inventory and used in a subsequent production period. Other examples of cash outflows that are not costs include
- The
principal portion of debt payments; these
payments also can be described as "changing the form of the asset
from cash to less debt." Restated, on the balance sheet,
a principal payment reduces total assets and total liability by an equal
amount, and thus does not change the owners' equity in the business.
- The interest portion of the payment is a cost and treated differently. That is, the interest portion of the payment is the cost of using someone else's capital during the production period.
- Owners draw is their reward for investing their labor and other assets in the business; like any other cash, business owners may use this revenue as they desire to meet living expenses or invest in other opportunities.
- The
purchase of equipment, like the example of
purchasing inventory items or land, will not be totally consumed during
the production period when it was purchased. Instead, it will
be consumed during subsequent production periods.
- Unlike land (which presumably cannot be consumed), equipment will be "consumed" as it is used, so the cost of the equipment will be considered production cost at some time.
- Unlike an inventory item that is fully consumed during one future production period, equipment will likely be used during several production periods. Accordingly, the equipment cost needs to be allocated among those production periods (see depreciation).
These examples lead to several other observations.
- An item that is purchased and totally consumed during a single production period results in both a cost and cash outflow. The fuel in the first example illustrates a situation when cash outflow and cost for the production period would be identical; the land and the fuel in the second example illustrates when there will be a difference between cash outflow and cost.
- The cash purchase of an asset that is NOT fully consumed during the production period in which it is purchased can be considered as changing the form of the business assets. The change will be recorded on 1) the asset side of the business balance sheet, 2) the business cash flow statement as a cash outflow, and 3) business income statement only to the extent the asset is consumed in the production process for the period covered by the income statement.
Costs that do not Require Cash Outflow
The previous section focused on cash outflows that are not considered costs, such as principal payment of debt, capital purchases, and owners draw. This section briefly addresses costs that do not require a cash outflow. The examples will be familiar because they will be the "opposites" of the previous examples.
- A business incurs a cost (but not a cash outflow) when it uses inputs from its inventory; for example, a farm business will recognize the value of seed that was purchased in a previous year and held in the business inventory but is now being planted this year, as a cost in producing this year's crop.
- Using
equipment that had been previously purchased is a cost
for this year to the extent the equipment is "consumed" by
this year's production process. The concept of depreciation
explains how a manager can allocate the cost of the equipment among
the several production periods during which the equipment is used.
Relating Depreciation Cost to Debt Repayment
As previously described, owning equipment requires a cash outflow when the equipment is purchased. If the purchase price is borrowed, there is an offsetting cash inflow from the lender, followed by cash outflows as the debt is paid in subsequent time periods. In this case, there will be some cash outflows (principal payments) in subsequent years at the same time that the cost is recognized as depreciation. However, it would be only a coincidence if the principal payments and the depreciation allowances were equal each production period.
- Hopefully, the principal payments (cash outflows) will be larger than the depreciation allowances and the debt will be repaid before the equipment is fully depreciated (for non-tax purposes). Otherwise, both the lender and the business manager may become concerned if the equipment is fully consumed before the debt for the purchase is fully repaid.
The interest portion of each payment to the lender is a cost of using someone else's capital to complete the equipment purchase. The interest cost will equal the cash outflow as long as the interest expense is fully paid each time a payment is due. If the interest cost is not fully paid when due, the business and lender may again have a reason for concern.
The amount of equity and debt associated with a depreciable asset changes each time a portion of debt principal is paid and each time the asset depreciates due to use, age and obsolesce. The attached spreadsheet provides an example of cash outflow and cost for a hypothetical depreciable asset.
Relating Depreciation Cost to Establishing a Reserve Fund
A frequent suggestion is for managers to set aside an amount of cash equal to depreciation to build a reserve with which to purchase replacement equipment when the current equipment is fully consumed. This suggestion gives depreciation the appearance of being a cash cost; but it is not. Instead, the suggestion urges managers to anticipate and prepare for future needs. The suggestion is based on an assumption that the business will be continued into the future. Heeding the suggestion also guards against the potential trap of "living off of depreciation."
In some situations, it may be difficult to adhere to the suggestion. For example if the capital to purchase the asset had been borrowed, the manager may need to use the cash to repay the loan principal rather than accumulate a cash reserve (again, giving a misleading appearance that depreciation is a cash cost). An alternative for an indebted business is to accumulate at least the amount of depreciation attributable to the original equity in the asset.
A manager also needs to consider what would be the best use for the cash; should it be retained in a savings account or used to operate the business. A consideration in making that decision maybe which alternative provides the best return.
Although depreciation can be a measure for establishing a cash reserve or for repaying debt on the depreciable asset, the relationship between depreciation and cash is created by the manager; it is not a relationship based on the concept of cost.
Which should a Manager Consider -- Cost or Cash Outflow?
Both measures are important, both need to be considered. Consider the concept the manager is thinking about at the time; it may be both. Managers need to understand the difference between cash flow and profitability; recognize how they differ and their similarities. Managers must be able to recognize which concept they are thinking about at the moment and be able to shift between the two concepts.
Last Updated December 5, 2010
Email: David.Saxowsky@ndsu.edu
This material is intended for educational purposes only. It is not a substitute for competent professional advice. Seek appropriate advice for answers to your specific questions.
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