Types of Cost Data in Businesses - dummies

Types of Cost Data in Businesses

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.

Cost distinctions to consider are

  • Direct versus indirect costs

  • Fixed versus variable costs

  • Relevant versus irrelevant costs

  • Actual, budgeted, and standard costs

  • Product versus period costs

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.

Direct versus indirect costs

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, or one source of sales revenue, or 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 that a book is printed on; this cost can be attached to one particular phase of the book production process.

  • Indirect costs: Cannot be attached to specific products, organizational units, or activities. A book publisher’s phone bill is a cost of doing business but can’t be tied down to one step in the book editorial and production process. Businesses must determine a method of allocating indirect costs to different products, sources of sales revenue, organizational units, and so on.

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. 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. Fewer units manufactured or sold result in variable costs going down.

  • Fixed costs: Remain the same over a relatively broad range of sales volume or production output. Fixed costs are like a dead weight on the business. Its total fixed costs for the period are a hurdle it must overcome by selling enough units at high enough margins per unit in order to avoid a loss and move into the profit zone.

Relevant versus irrelevant costs

Not every cost is important to every decision 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 would incur, or bring upon yourself, depending on which course of action you take.

    For example, say that you want to increase the number of books that your business produces next year in order to increase your sales revenue, but the cost of paper has just 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 sales 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 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.

Generally speaking, fixed costs are irrelevant when deciding on a future course of action, assuming that they’re truly fixed and can’t be increased or decreased over the short term. Most variable costs are relevant because they depend on which alternative is selected.

Actual, budgeted, and standard costs

The actual costs a business incurs may differ from its budgeted and standard costs:

  • Actual costs: Historical costs, based on actual transactions and operations for 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.

  • 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 than variable costs.

  • 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.

Product versus period costs

Some costs are linked to particular products, and others are not:

  • Product costs: Manufacturing 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.

  • Period costs: Costs that are not attached to particular products. These costs do not 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.