Bookkeeping All-in-One For Dummies
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Business managers must understand important cost distinctions when making decisions and exercising control based on different types of cost data. These cost distinctions help managers better appreciate the cost figures that accountants attach to products that are manufactured or purchased by the business.

The importance of correct product costs can’t be overstated (for businesses that sell products, of course). The total cost of goods (products) sold is the first, and usually the largest, expense deducted from sales revenue in measuring profit. The bottom-line profit amount reported in a business’s income statement depends heavily on whether its product costs have been measured properly during that period. Also, keep in mind that product cost is the value for the inventory asset reported in the balance sheet of a business.

Direct versus indirect costs

You might say that the starting point for any sort of cost analysis, and particularly for accounting for the product costs of manufacturers, is to clearly distinguish between direct and indirect costs. Direct costs are easy to match with a process or product, whereas indirect costs are more distant and have to be allocated to a process or product. Here are more details:
  • Direct costs: Can be clearly attributed to one product or product line, one source of sales revenue, one organizational unit of the business, or one specific operation in a process. An example of a direct cost in the book-publishing industry is the cost of the paper on which a book is printed; this cost can be squarely attached to one particular step or operation in the production process.
  • Indirect costs: Are far removed from and can’t be naturally attached to specific products, organizational units, or activities. A book publisher’s telephone and Internet bills are costs of doing business, for example, but they can’t be tied to one step in the book editorial and production process. The salary of the purchasing officer who selects the paper for all the books is another example of a cost that’s indirect to the production of particular books.

Each business must determine methods of allocating indirect costs to different products, sources of sales revenue, revenue and cost centers, and other organizational units. Most allocation methods are far from perfect and, in the final analysis, end up being arbitrary to one degree or another. Business managers should always keep an eye on the allocation methods used for indirect costs and take the cost figures produced by these methods with a grain of salt.

Fixed versus variable costs

If your business sells 100 more units of a certain item, some of your costs increase accordingly, but others don’t budge one bit.

fixed cost illustration ©By OpturaDesign/

This distinction between variable and fixed costs is crucial:

  • Variable costs: Increase and decrease in proportion to changes in sales or production level. Variable costs generally remain the same per unit of product or per unit of activity. Additional units manufactured or sold cause variable costs to increase in concert. Fewer units manufactured or sold result in variable costs going down in concert.
  • Fixed costs: Remain the same over a relatively broad range of sales volume or production output. Fixed costs are like dead weight on the business. Total fixed costs for the period are a hurdle that the business must overcome by selling enough units at high enough margins per unit to avoid a loss and move into the profit zone.
Note: Understanding the distinction between variable and fixed costs is the heart of understanding, analyzing, and budgeting profit.

Relevant versus irrelevant costs

Not every cost is important to every decision that a manager needs to make, hence, the distinction between relevant and irrelevant costs:
  • Relevant costs: Costs that should be considered and included in your analysis when deciding on a future course of action. Relevant costs are future costs — costs that you’d incur depending on which course of action you take. Suppose that you want to increase the number of books that your business produces next year to increase your sales revenue, but the cost of paper has shot up. Should you take the cost of paper into consideration? Absolutely. That cost will affect your bottom-line profit and may negate any increase in sales volume that you experience (unless you increase the sale price). The cost of paper is a relevant cost.
  • Irrelevant (or sunk) costs: Costs that should be disregarded when deciding on a future course of action. If they’re brought into the analysis, these costs could cause you to make the wrong decision. An irrelevant cost is a vestige of the past; that money is gone. For this reason, irrelevant costs are also called sunk costs. Suppose that your supervisor tells you to expect a slew of new hires next week. All your staff members use computers now, but you have a bunch of typewriters gathering dust in the supply room. Should you consider the cost paid for those typewriters in your decision to buy computers for all the new hires? Absolutely not. That cost should have been written off and is no match for the cost you’d pay in productivity (and morale) for new employees who are forced to use typewriters.

Generally speaking, most variable costs are relevant because they depend on which alternative is selected. Fixed costs are irrelevant assuming that the decision at hand doesn’t involve doing anything that would change these stationary costs. But a decision alternative being considered might involve a change in fixed costs, such as moving out of the present building used by the business, downsizing the number of employees on fixed salaries, or spending less on advertising (generally, a fixed cost). Any cost, fixed or variable, that would be different for a particular course of action being analyzed is relevant for that alternative.

Furthermore, keep in mind that fixed costs can provide a useful gauge of a business’s capacity — how much building space it has, how many machine-hours are available for use, how many hours of labor can be worked, and so on. Managers have to figure out the best way to use these capacities. Suppose that your retail business pays an annual building rent of $200,000, which is a fixed cost unless the rental contract with the landlord also has a rent escalation clause based on your sales revenue. The rent, which gives the business the legal right to occupy the building, provides 15,000 square feet of retail and storage space. You should figure out which sales mix of products will generate the highest total margin — equal to total sales revenue less total variable costs of making the sales, including the costs of the goods sold and all variable costs driven by sales revenue and sales volume.

Actual, budgeted, and standard costs

The actual costs that a business incurs may differ (though I hope not too unfavorably) from its budgeted and standard costs:
  • Actual costs: Costs based on actual transactions and operations during the period just ended or going back to earlier periods. Financial statement accounting is mainly (though not entirely) based on a business’s actual transactions and operations; the basic approach to determining annual profit is recording the financial effects of actual transactions and allocating the historical costs to the periods benefited by the costs. But keep in mind that accountants can use more than one method for recording actual costs. Your actual cost may be a little (or a lot) different from my actual cost. A business that sells products can chose to use the First In, First Out method (FIFO) or the Last In, First Out method (LIFO), for example. The resulting numbers for cost-of-goods-sold expense and inventory cost can be quite different.
  • Budgeted costs: Future costs for transactions and operations expected to take place over the coming period, based on forecasts and established goals. Fixed costs are budgeted differently from variable costs. If sales volume is forecast to increase by 10 percent, for example, variable costs will increase accordingly, but fixed costs may or may not need to be increased to accommodate the volume increase.
  • Standard costs: Costs, primarily in the area of manufacturing, that are carefully engineered based on detailed analysis of operations and forecast costs for each component or step in an operation. Developing standard costs for variable production costs is relatively straightforward because most of these costs are direct costs. By contrast, most fixed costs are indirect, and standard costs for fixed costs are necessarily based on more arbitrary methods. Note: Some variable costs are indirect and have to be allocated to specific products to come up with a full (total) standard cost of the product.

Product versus period costs

Some costs are linked to particular products:
  • Product costs: Costs attached directly or allocated to particular products. The cost is recorded in the Inventory Asset account and stays in that asset account until the product is sold, at which time the cost goes into the cost-of-goods-sold expense account.

The cost of a new Ford Escape sitting on a car dealer’s showroom floor, for example, is a product cost. The dealer keeps the cost in its Inventory Asset account until you buy the car, at which point the dealer charges the cost to the cost-of-goods-sold expense.

  • Period costs: Costs that aren’t attached to particular products. These costs don’t spend time in the “waiting room” of inventory. Period costs are recorded as expenses immediately; unlike product costs, period costs don’t pass through the Inventory account first. Advertising costs, for example, are accounted for as period costs and recorded immediately in an expense account. Also, research and development costs are treated as period costs (with some exceptions).
Separating product costs and period costs is particularly important for manufacturing businesses.

About This Article

This article is from the book:

About the book authors:

Lita Epstein, who earned her MBA from Emory University’s Goizueta Business School, enjoys helping people develop good financial, investing and tax-planning skills.
While getting her MBA, Lita worked as a teaching assistant for the financial accounting department and ran the accounting lab. After completing her MBA, she managed finances for a small nonprofit organization and for the facilities management section of a large medical clinic.
She designs and teaches online courses on topics such as investing for retirement, getting ready for tax time and finance and investing for women. She’s written over 20 books including Reading Financial Reports For Dummies and Trading For Dummies.
Lita was the content director for a financial services Web site,, and managed the Web site, Investing for Women. As a Congressional press secretary, Lita gained firsthand knowledge about how to work within and around the Federal bureaucracy, which gives her great insight into how government programs work. In the past, Lita has been a daily newspaper reporter, magazine editor, and fundraiser for the international activities of former President Jimmy Carter through The Carter Center. John A. Tracy is a former accountant and professor of accounting. He is also the author of Accounting For Dummies.

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