COSTS

Costs are the necessary expenditures that must be made in order to run a business. Every factor
of production has a cost associated with it: labor, fixed assets, and capital, for example. The cost
of labor used in the production of goods and services is measured in terms of wages. The cost of
a fixed asset used in production is measured in terms of depreciation. The cost of capital used to
purchase fixed assets is measured in terms of the interest expense associated with raising the
capital.

Businesses are vitally interested in measuring their costs. Many types of costs are observable and
easily quantifiable. In such cases there is a direct relationship between cost of input and quantity
of output. Other types of costs must be estimated or allocated. That is, the relationship between
costs of input and units of output may not be directly observable or quantifiable. In the delivery
of professional services, for example, the quality of the output is usually more significant that the
quantity, and output cannot simply be measured in terms of the number of patients treated or
students taught. In such instances where qualitative factors play an important role in measuring
output, there is no direct relationship between costs incurred and output achieved.

DIFFERENT WAYS TO CATEGORIZE COSTS

Costs can have different relationships to output. Costs also are used in different business
applications, such as financial accounting, cost accounting, budgeting, capital budgeting, and
valuation. Consequently, there are different ways of categorizing costs according to their
relationship to output as well as according to the context in which they are used. Following this
summary of the different types of costs are some examples of how costs are used in different
business applications.

FIXED AND VARIABLE COSTS The two basic types of costs incurred by businesses are fixed and
variable. Fixed costs do not vary with output, while variable costs do. Fixed costs are sometimes
called overhead costs. They are incurred whether a firm manufactures 100 widgets or 1,000
widgets. In preparing a budget, fixed costs may include rent, depreciation, and super-visors'
salaries. Manufacturing overhead may include such items as property taxes and insurance. These
fixed costs remain constant in spite of changes in output.

Variable costs, on the other hand, fluctuate in direct proportion to changes in output. Labor and
material costs are typical variable costs that increase as the volume of production increases. It
takes more labor and material to produce more output, so the cost of labor and material varies in
direct proportion to the volume of output. The direct proportionality of variable costs to level of
output may break down with very small and very large production runs.

In addition, some costs are considered mixed costs. That is, they contain elements of fixed and
variable costs. In some cases the cost of supervision and inspection are considered mixed costs.
DIRECT AND INDIRECT COSTS Direct costs are similar to variable costs. They can be directly
attributed to the production of output. The system of valuing inventories called direct costing is
also known as variable costing. Under this accounting system only those costs that vary directly
with the volume of production are charged to products as they are manufactured. The value of
inventory is the sum of direct material, direct labor, and all variable manufacturing costs.

Indirect costs, on the other hand, are similar to fixed costs. They are not directly related to the
volume of output. Indirect costs in a manufacturing plant may include supervisors' salaries,
indirect labor, factory supplies used, taxes, utilities, depreciation on building and equipment,
factory rent, tools expense, and patent expense. These indirect costs are sometimes referred to as
manufacturing overhead.

Under the accounting system known as full costing or absorption costing, all of the indirect costs
in manufacturing overhead as well as direct costs are included in determining the cost of
inventory. They are considered part of the cost of the products being manufactured.

PRODUCT AND PERIOD COSTS The concepts of product and period costs are similar to direct and
indirect costs. Product costs are those that the firm's accounting system associates directly with
output and that are used to value inventory. Under a direct or variable cost accounting system,
only direct or variable costs are charged to production. Indirect costs such as property taxes,
insurance, depreciation on plant and equipment, and salaries of supervisors are considered period
costs. Period costs are charged as expenses to the current period. Under direct costing, period
costs are not viewed as costs of the products being manufactured, so they are not associated with
valuing inventories.

If the firm uses a full cost accounting system, however, then all manufacturing costs—including
fixed manufacturing overhead costs and variable costs—become product costs. They are
considered part of the cost of manufacturing and are charged against inventory.

OTHER TYPES OF COSTS These are the basic types of costs as they are used in different
accounting systems. In addition, other types of costs are used in different business contexts. In
budgeting it is useful to identify controllable and uncontrollable costs. This simply means that
managers with budgetary responsibility should not be held accountable for costs they cannot
control.

Financial managers often use the concepts of out-of-pocket costs and sunk costs when evaluating
the financial merits of specific proposals. Out-of-pocket costs are those that require the use of
current resources, usually cash. Sunk costs have already been incurred. In evaluating whether or
not to increase production, for example, financial managers may take into account the sunk costs
associated with tools and machinery as well as the out-of-pocket costs associated with adding
more material and labor.

Financial planning also utilizes the concepts of incremental, opportunity, and imputed costs.
Incremental costs are those associated with switching from one level of activity or course of
action to another. Incremental costs represent the difference between two alternatives.
Opportunity costs represent the sacrifice that is made when the means of production are used for
one task rather than another, or when capital is used for one investment rather than another.
Nothing can be produced or invested without incurring an opportunity cost. By making one
investment or production decision using limited resources, one necessarily forgoes the
opportunity to use those resources for a different purpose. Consequently, opportunity costs are
not usually factored into investment and production decisions involving resource allocation.

Imputed costs are costs that are not actually incurred, but are associated with internal
transactions. When work in process is transferred from one department to another within an
organization, a method of transfer pricing may be needed for budgetary reasons. Although there
is no actual purchase or sale of goods and materials, the receiving department may be charged
with imputed costs for the work it has received. When a company rents itself a building that is
could have rented to an outside party, the rent may be considered an imputed cost.

Variable Costs Variable costs change in total in proportion to the

level of activity. For example if a carmakers
production increases by 5%, its tire costs will

increase by about 5%.

Fixed Costs A fixed cost remains unchanged in total as the level
of activity varies. For example, the property tax on
a rental apartment is the same regardless of the

number of building occupants.

Direct Costs A direct cost is the cost of direct labor and material
used in making the product or delivering the

service.
Indirect Costs/Overhead Costs Indirect costs are costs of an activity which are not
easily associated with the production of specific

goods or services.
Opportunity Costs The benefit that is sacrificed when the choice of one

action precludes an alternative course of action.

Sunk Costs Costs that have been incurred in the past and cannot

be changed by current actions.

BUSINESS APPLICATIONS USE DIFFERENT TYPES OF COSTS

Costs as a business concept are useful in measuring performance and determining profitability.
What follows are brief discussions of some business applications in which costs play an
important role.
FINANCIAL ACCOUNTING One of the major objectives of financial accounting is to determine
the periodic income of the business. In manufacturing firms a major component of the income
statement is the cost of goods sold (COGS). COGS is that part of the cost of inventory that can
be considered an expense of the period because the goods were sold. It appears as an expense on
the firm's periodic income statement. COGS is calculated as beginning inventory plus net
purchases minus ending inventory.

Depreciation is another cost that becomes a periodic expense on the income statement. Every
asset is initially valued at its cost. Accountants charge the cost of the asset to depreciation
expense over the useful life of the asset. This cost allocation approach attempts to match costs
with revenues and is more reliable than attempting to periodically determine the fair market
value of the asset.

In financial accounting, costs represent assets rather than expenses. Costs only become expenses
when they are charged against current income. Costs may be allocated as expenses against
income over time, as in the case of depreciation, or they may be charged as expenses when
revenues are generated, as in the case of COGS.

COST ACCOUNTING Cost accounting, also sometimes known as management accounting,

provides appropriate cost information for budgeting systems and management decision making.
Using the principles of general accounting, cost accounting records and determines costs
associated with various functions of the business. This data is used by management to improve
operations and make them more efficient, economical, and profitable.

Two major systems can be used to record the costs of manufactured products. They are known as
job costing and process costing. A job cost system, or job order cost system, collects costs for
each physically identifiable job or batch of work as it moves through the manufacturing facility
and disregards the accounting period in which the work is done. With a process cost system, on
the other hand, costs are collected for all of the products worked on during a specific accounting
period. Unit costs are then determined by dividing the total costs by the number of units worked
on during the period. Process cost systems are most appropriate for continuous operations, when
like products are produced, or when several departments cooperate and participate in one or
more operations. Job costing, on the other hand, is used when labor is a chief element of cost,
when diversified lines or unlike products are manufactured, or when products are built to
customer specifications.

When costs are easily observable and quantifiable, cost standards are usually developed. Also
known as engineered standards, they are developed for each physical input at each step of the
production process. At that point an engineered cost per unit of production can be determined.
By documenting variable costs and fairly allocating fixed costs to different departments, a cost
accounting system can provide management with the accountability and cost controls it needs to
improve operations.

BUDGETING SYSTEMS Budgeting systems rely on accurate cost accounting systems. Using cost
data collected by the business's cost accounting system, budgets can be developed for each
department at different levels of output. Different units within the business can be designated
cost centers, profit centers, or departments. Budgets are then used as a management tool to
measure performance, among other things. Performance is measured by the extent to which
actual figures deviate from budgeted amounts.

In using budgets as measures of performance, it is important to distinguish between controllable

and uncontrollable costs. Managers should not be held accountable for costs they cannot control.
In the short run, fixed costs can rarely be controlled. Consequently, a typical budget statement
will show sales revenue as forecast and the variable costs associated with that level of
production. The difference between sales revenue and variable costs is the contribution margin.
Fixed costs are then deducted from the contribution margin to obtain a figure for operating
income. Managers and departments are then evaluated on the basis of costs and those elements of
production they are expected to control.

COST OF CAPITAL Capital budgeting and other business decisions—such as lease-buy decisions,
bond refunding, and working capital policies—require estimates of a company's cost of capital.
Capital budgeting decisions revolve around deciding whether or not to purchase a particular
capital asset. Such decisions are based on an estimate of the net present value of future revenues
that would be generated by a particular capital asset. An important factor in such decisions is the
company's cost of capital.

Cost of capital is a percentage that represents the interest rate the company would pay for the
funds being raised. Each capital component—debt, equity, and retained earnings—has its own
cost. Each type of debt or equity also has a different cost. While a particular purchase or project
may be funded by only one kind of capital, companies are likely to use a weighted average cost
of capital when making financial decisions. Such practice takes into account the fact that the
company is an ongoing concern that will need to raise capital at different rates in the future as
well as at the present rate.

OTHER APPLICATIONS Costs are sometimes used in the valuation of assets that are being bought
or sold. Buyers and sellers may agree that the value of an asset can be determined by estimating
the costs associated with building or creating an asset that could perform similar functions and
provide similar benefits as the existing asset. Using the cost approach to value an asset contrasts
with the income approach, which attempts to identify the present value of the revenues the asset
is expected to generate.

Finally, costs are used in making pricing decisions. Manufacturing firms refer to the ratio
between prices and costs as their markup, which represents the difference between the selling
price and the direct cost of the goods being sold. For retailers and wholesalers, the gross margin
is the difference between their invoice cost and their selling price. While costs form the basis for
pricing decisions, they are only a starting point, with market conditions and other factors usually
determining the most profitable price.

COST STATEMENTS
An indispensable part of any system of accounting is programmed of periodical statements and
reports to inform management of the current financial position of the business and of the
progress made by, and the costs incurred for, each process, department and division. The number
of statements and reports and their characters differ according to the requirements of
management of each business enterprise. The following statements and supporting cost reports
are commonly prepared for the management;

(1) balance sheet,

(2) profit and loss statement or income statement supported by statement of cost of goods
manufactured and sold. Balance sheet is a statement of assets and liabilities which reveals the
financial position of the business. A balance sheet prepared for a manufacturing enterprise is
similar in form and contents to the balance sheet of concerns engaged in merchandising
activities, with the exception that it requires three inventory accounts i.e., raw materials, work in
process and finished goods. The income statement of a manufacturing company and a
merchandising company reflects the basic difference in operations of these two types of
enterprises.

The manufacturing company transforms raw material into finished goods through the use of
labor and factory facilities (for example, a company manufacturing furniture from wood or
timber). A merchandising company, such as a retail furniture store which buys finished furniture
and sells it in the same form i.e., sells the goods it buys without changing the basic form. The
income statement which is prepared by a merchandising concern needs no calculations of cost of
goods manufactured. But the income statements prepared by the manufacturing concern requires
the calculations for the cost of goods manufactured. The income statement or condensed
statement of profit and loss shows the profit or loss of the business, while the cost of goods
manufactured and sold
statement reveals the cost to make and sell. The cost of goods sold section of the income
statement of a manufacturing business can be divided into five distinct parts:

(1) Direct materials section; it comprises of beginning inventory, purchases and purchases
returns and allowances and ending inventory.

(2) Direct labor section; it includes the cost of employees whose work can be identified directly
with the product manufactured.

(3) Factory overhead; it comprises of all those costs that assist in an indirect manner in the
manufacturing of the product e.g., indirect materials, indirect labor, depreciation of plant and
machinery, depreciation of building, rent of factory building, repairs and insurance of factory
plant and machinery etc. It is to be noted that with regard to factory overhead recording, there
may be three possibilities:

(A) Only actual factory overhead incurred are given.

(B) Only applied factory overhead are provided.

(C) Both actual and applied factory overhead are given. When both actual and applied factory
overhead are known then the difference is analyzed which is known as under or over applied
factory overhead which is shown in the cost of goods sold or income statement. Under or Over
Applied Factory Overhead is the difference of actual factory over head and applied factory
overhead. I applied factory overhead are less than actual factory overhead, the variance is known
as under applied factory overhead. On the other hand when applied factory overhead are more
than the actual factory overhead, the variance is called over applied factory overhead. Under
applied overhead are added while over applied overhead are deducted from cost of goods sold at
normal.

(4) Work in process inventories; these represent the costs in process at the beginning and costs
still in process at the end of the fiscal period.

(5) Finished goods inventories; These represent the cost of finished goods inventories present at
the beginning and at the end of the fiscal period. The income statement is based upon the sales or
revenue, costs and expenses of manufacturing, selling or marketing, administrating, other income
and expense items. The income statement is the complementary to the balance sheet.