Definition: Out of pocket costs in managerial accounting are expenses that could be incurred or avoided depending on management’s decisions. In other words, an out-of-pocket cost is a potential future outlay of cash that management needs to decide whether or not to make. Said another way, it’s an expense that requires a future disbursement of cash.
What Does Out-of-Pocket Expense Mean?
This may sound like common sense, but out of pocket costs are relevant to the management decision-making process. Management must decide whether it has enough cash to support an out of pocket expense in the future.
A good example of an out of pocket cost is the purchase of new equipment. Company management plans for new equipment purchases well into the future, sometimes even years into the future. Future outlays of cash could bring company expansion and new business or they could stretch the company too thin and force it into bankruptcy.
You might ask, “Aren’t all equipment purchases future outlays of cash?” Most of the time this is true, but not all the time. Companies often trade in old equipment for new equipment and don’t pay any cash out of pocket. Vehicles are the most common example of this. Many companies trade in two or three older company vehicles in exchange for a single new vehicle. In this case, management does not have to consider out of pocket costs in its decision making process. It’s only concerned with the opportunity costs of losing multiple vehicles while gaining a new one.
Companies often trade assets for other assets for tax purposes. This is referred to in the tax code as a like kind exchange. A company can trade an asset to another company in exchange for a like asset in nature or value. The IRS does not require companies to recognize gains on a like kind exchange.