Are Costs Really That Important?

Without good cost information, a business operates in the dark. Cost concepts and cost measurement methods apply to all businesses. There’s no one-size-fits-all definition of cost, and there’s no one correct and best-in-all-circumstances method of measuring cost.

Cost data is needed for the following purposes:

  • Setting sales prices: The common method for setting sales prices (known as cost-plus or markup on cost) starts with cost and then adds a certain percentage. If you don’t know exactly how much a product costs, you can’t be as shrewd and competitive in your pricing as you need to be.

    Even if sales prices are dictated by other forces and not set by managers, managers need to compare sales prices against product costs and other costs that should be matched against each sales revenue source.

  • Formulating a legal defense against charges of predatory pricing practices: Many states have laws prohibiting businesses from selling below cost except in certain circumstances. And a business can be sued under federal law for charging artificially low prices intended to drive its competitors out of business. Be prepared to prove that your lower pricing is based on lower costs and not on some illegitimate purpose.

  • Measuring gross margin: Investors and managers judge business performance by the bottom-line profit figure. This profit figure depends on the gross margin figure you get when you subtract your cost of goods sold expense from your sales revenue. Gross margin (also called gross profit) is the first profit line in the income statement.

    If gross margin is wrong, bottom-line net income is wrong — no two ways about it. The cost of goods sold expense depends on having correct product costs.

  • Valuing assets: The balance sheet reports cost values for many (though not all) assets. To understand the balance sheet you should understand the cost basis of its inventory and certain other assets.

  • Making optimal choices: You often must choose one alternative over others in making business decisions. The best alternative depends heavily on cost factors, and you have to be careful to distinguish relevant costs from irrelevant costs.

In most situations, the historic book value recorded for a fixed asset is an irrelevant cost. Say book value is $35,000 for a machine used in the manufacturing operations of the business. This is the amount of original cost that has not yet been charged to depreciation expense since it was acquired, and it may seem quite relevant.

However, in deciding between keeping the old machine or replacing it with a newer, more efficient machine, the disposable value of the old machine is the relevant amount, not the undepreciated cost balance of the asset.

Suppose the old machine has an estimated $20,000 salvage value at this time; this is the relevant cost for the alternative of keeping it for use in the future — not the $35,000 book value that hasn’t been depreciated yet.

To keep using it, the business forgoes the $20,000 it could get by selling the asset, and this $20,000 is the relevant cost in this decision situation. Making decisions involves looking forward at the future cash flows of each alternative — not looking backward at historical-based cost values.

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