By Consumer Dummies

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.

Two examples of manufactured products are a new Cadillac just rolling off the assembly line at General Motors and a copy of the latest bestseller, hot off the printing presses.

Most production (manufacturing) processes are fairly complex, so product cost accounting for manufacturers is likewise 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, established accounting standards in the United States, called generally accepted accounting principles (GAAP), provide little authoritative guidance for measuring product cost. Therefore, 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, cost 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

A common refrain among accountants is “different costs for different purposes.” True enough, but at its core, cost accounting serves two broad purposes: measuring profit and providing relevant information to managers for planning, control, and decision-making.

People may be inclined to take cost numbers for granted, as if they were handed down on stone tablets. 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. These cost measurement methods have more in common with the scores from judges in an ice skating competition than the times clocked in a Formula One auto race. 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, in spite of the inherent ambiguity in determining costs, you do need exact amounts for costs. To understand the income statement and balance sheet that managers use in making their decisions, they should understand 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.