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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
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.
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.
-- 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.
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.
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.
that are both a cost and cash outflow
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.
Outflows that are not Costs
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).
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).
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.
first transaction would appear in the business' financial statements
at the end of the first year as 1) a reduction in cash and an
increase in the business fuel inventory on the balance sheet;
and 2) a cash outflow on the cash flow
statement. The business' total assets, liabilities, and
equity would not change. Because the fuel was not consumed
as part of the first year's production process, the fuel would
not be considered a cost.
- The second
transaction would appear on the business' financial statements
at the end of the second year as 1) a reduction in the business
fuel inventory on the balance sheet, and 2) a production cost
on the business' income statement for the value of the consumed
fuel inventory. If the business places no value on the growing
crop (assuming the crop has not yet been harvested at the time
the second set of financial statements are prepared), the business'
assets and equity will decrease. The use of the fuel would
not appear on the business' cash flow statement because it did
not require a cash payment during the second year.
an Asset is a Cost
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.
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.
Examples of Cash Outflows that are not Costs
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
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.
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.
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
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.
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.
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).
lead to several other observations.
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.
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.
that do not Require Cash Outflow
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.
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.
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.
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.
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.
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
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
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.
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
should a Manager Consider -- Cost or Cash Outflow?
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.
December 5, 2010