Determining Product Costs and Other Costs in Business

All businesses that sell products must know their product costs — in other words, the costs of each and every item they sell. Companies that manufacture the products they sell — as opposed to distributors and retailers of products — have many problems in figuring out their product costs.

Most production (manufacturing) processes are fairly complex, so product cost accounting for manufacturers is also fairly complex; every step in the production process has to be tracked carefully from start to finish.

Many manufacturing costs cannot be directly matched with particular products; these are called indirect costs. To arrive at the full cost of each product manufactured, accountants devise methods for allocating indirect production costs to specific products. Surprisingly, generally accepted accounting principles (GAAP) provide very little authoritative guidance for measuring product cost.

Manufacturing businesses have more than a little leeway regarding how to determine their product costs. Even businesses in the same industry — Ford versus General Motors, for example — may use different product cost accounting methods.

Accountants determine many other costs, in addition to product costs:

The costs of departments, regional distribution centers, and other organizational units of the business
The cost of the retirement plan for the company’s employees
The cost of marketing programs and advertising campaigns
The cost of restructuring the business or the cost of a major recall of products sold by the business, when necessary

Cost accounting serves two broad purposes: measuring profit and providing relevant information to managers for planning, control, and decision-making.

The phrase actual cost often gets tossed around without a clear definition. An actual cost depends entirely on the particular methods used to measure the cost. Many arbitrary choices are behind every cost number you see. 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.

The conundrum is that businesses need exact amounts for costs. In order to understand the income statement and balance sheet that managers use in making their decisions, they need to understand a little bit about the choices an accountant has to make in measuring costs. Some cost accounting methods result in conservative profit numbers; other methods boost profit, at least in the short run.