Important terminologies of Cost Accounting
by Direct Cost
Direct costs can be easily identified as per the expenditure on cost objects. So, for example, if we pick how much expenditure a business has had on purchasing the raw materials inventory, we will be able to directly point out.
Indirect Cost
In the case of indirect costs, the challenge is that we can’t identify the costs as per the cost object. So, for example, if we try to understand how much rent is given for sitting the machinery in a place, we won’t be able to do it because the rent is paid for the entire space, not for a particular place.
The essential difference between direct costs and indirect costs is that only direct costs can be traced to specific cost objects. A cost object is something for which a cost is compiled, such as a product, service, customer, project, or activity. These costs are usually only classified as direct or indirect costs if they are for production activities, not for administrative activities (which are considered period costs).
Prime Cost
Prime costs are a firm’s expenses directly related to the materials and labor used in production. It refers to a manufactured product’s costs, which are calculated to ensure the best profit margin for a company. The prime cost calculates the direct costs of raw materials and labor that are involved in the production of a good. Direct costs do not include indirect expenses, such as advertising and administrative costs.
Prime cost = Direct raw materials + Direct labour
Production Cost
Production costs refer to all of the direct and indirect costs businesses face from manufacturing a product or providing a service. Production costs can include a variety of expenses, such as labor, raw materials, consumable manufacturing supplies, and general overhead.
Direct Labor Costs
Direct labor consists of the fully burdened cost of all labor directly involved in the production of goods. This usually means those people working on production lines or in work cells. Other types of production labor are recorded within the category of factory overhead costs.
Direct Material Costs
Direct materials consists of those materials consumed as part of the production process, including the cost of normal scrap that occurs as part of the process.
Factory Overhead Costs
Factory overhead consists of those costs required to maintain the production function, but which are not directly consumed on individual units. Examples are utilities, insurance, materials management salaries, production salaries, maintenance wages, and quality assurance wages.
Administration Cost
Administrative expenses refer to the costs incurred by a company or organization that include, but are not limited to, the salaries and benefits of the administrative workers within the company or organization, as well as rent and managerial compensation. Also known as General and Administrative expenses, the costs are categorized separately from Sales & Marketing and Research costs.
- Administrative Expenses
- Managerial team
- IT team
- Executive compensation
- Rent of equipment and buildings
- Non-Administrative Expenses
- Manufacturers
- Developers
- Engineers
- Sales Team
Selling and Distribution Cost
The term ‘distribution‘ is widely used in relation to the whole operation of getting goods into the hands of the consumer, and thus covers the two functions of sales promotion and delivery. The expression ‘distribution costs’, however, may be considered as relating only to delivery.
Selling Costs: The cost incurred in promoting sales and retaining customers. Selling expenses are those expenses which are incurred to promote sales and service to customers. Thus, selling overhead includes Salesmen’s Salaries, Commission, Travelling expenses, Cost of advertisement, Posters, Cost of price list and catalogue, Debt collection charges, Bad debts, Free gift, Showrooms expenses, After-sale service, Legal expenses for recovering debt, etc.
Distribution Costs: The cost of the process which begins with making the packed product available for dispatch and ends with making the reconditioned returned empty package available for re-uses. Distribution expenses, on the other hand, are those which are incurred for warehousing and storage, packing for goods sent and making the goods available for delivery to customers. So, in broader sense of the item, distributions expenses include- Cost of storing, Cost of warehousing, Cost of packing, Cost of delivery, and Cost of preparation of challan.
Fixed Cost
In accounting and economics, fixed costs, also known as indirect costs or overhead costs, are business expenses that are not dependent on the level of goods or services produced by the business. They tend to be recurring, such as interest or rents being paid per month. These costs also tend to be capital costs. This is in contrast to variable costs, which are volume-related (and are paid per quantity produced) and unknown at the beginning of the accounting year. Fixed costs have an effect on the nature of certain variable costs.
For example, a retailer must pay rent and utility bills irrespective of sales. As another example, for a bakery the monthly rent and phone line are fixed costs, irrespective of how much bread is produced and sold; on the other hand, the wages are variable costs, as more workers would need to be hired for the production to increase. For any factory, the fix cost should be all the money paid on capitals and land. Such fixed costs as buying machines and land cannot be not changed no matter how much they produce or even not produce. Raw materials are one of the variable costs, depending on the quantity produced.
Fixed cost is considered an entry barrier for new entrepreneurs. In marketing, it is necessary to know how costs divide between variable and fixed costs. This distinction is crucial in forecasting the earnings generated by various changes in unit sales and thus the financial impact of proposed marketing campaigns. In a survey of nearly 200 senior marketing managers, 60 percent responded that they found the “variable and fixed costs” metric very useful. These costs affect each other and are both extremely important to entrepreneurs.
Variable Cost
A variable cost is a cost that varies in relation to either production volume or the amount of services provided. If no production or services are provided, then there should be no variable costs. If production or services are increasing, then variable costs should also increase.
Types of Variable Costs
Direct materials are considered a variable cost. Direct labor may not be a variable cost if labor is not added to or subtracted from the production process as production volumes change. Most types of overhead are not considered a variable cost.
Semi-variable Cost
In such mixed cost, the fixed part will occur irrespective of the production level; even in the case of zero production activities, a fixed cost will still occur. However, the variable part of such costs is dependent on the level of production work carried by the entity and increases in proportion to the production levels. That means that semi-variable costs can be calculated by adding the fixed costs and the variable costs (based on the level of production).
Period Cost
Period costs are costs that cannot be capitalized on a company’s balance sheet. In other words, they are expensed in the period incurred and appear on the income statement. Period costs are also called period expenses.
Product Cost
Product cost refers to the costs incurred to create a product. These costs include direct labor, direct materials, consumable production supplies, and factory overhead. Product cost can also be considered the cost of the labor required to deliver a service to a customer. In the latter case, product cost should include all costs related to a service, such as compensation, payroll taxes, and employee benefits.
Product cost appears in the financial statements, since it includes the manufacturing overhead that is required by both GAAP and IFRS. However, managers may modify product cost to strip out the overhead component when making short-term production and sale-price decisions. Managers may also prefer to focus on the impact of a product on a bottleneck operation, which means that their main focus is on the direct materials cost of a product and the time it spends in the bottleneck operation.
Product Cost Calculation
The cost of a product on a unit basis is typically derived by compiling the costs associated with a batch of units that were produced as a group, and dividing by the number of units manufactured. The calculation is:
Product unit cost = (Total direct labor + Total direct materials + Consumable supplies + Total allocated overhead) ÷ Total number of units
Explicit Cost
Explicit cost is valuable if you’re trying to create long-term strategic goals for a company or simply assessing its profitability. Learning how this metric varies from implicit costs can help you understand, determine and establish the total economic cost. Explicit costs can be easily determined and invaluable for decision-making in a business or department.
Important
Calculating profit: Once a company pays all its explicit costs, the profit is the remaining monetary value on the general ledger.
Performing long-term strategic planning: Explicit cost helps calculate a company’s profitability. It’s a key metric for long-term strategic planning because it allows a business to predict its profits for a specific period.
Implicit Cost
In economics, an implicit cost, also called an imputed cost, implied cost, or notional cost, is the opportunity cost equal to what a firm must give up in order to use a factor of production for which it already owns and thus does not pay rent. It is the opposite of an explicit cost, which is borne directly. In other words, an implicit cost is any cost that results from using an asset instead of renting it out, selling it, or using it differently. The term also applies to foregone income from choosing not to work.
Implicit costs also represent the divergence between economic profit (total revenues minus total costs, where total costs are the sum of implicit and explicit costs) and accounting profit (total revenues minus only explicit costs). Since economic profit includes these extra opportunity costs, it will always be less than or equal to accounting profit.
Although implicit costs are non-monetary costs that usually do not appear in a company’s accounting records or financial statements, they are nonetheless an important factor that must be considered in bottom-line profitability. Implicit costs distinguish between two measures of business profits accounting profits versus economic profits.
- Accounting profits are a company’s profits as shown in its accounting records and financial statements (such as its income statement). However, accounting profits, which are calculated as total revenues minus total expenses, only reflect actual cash expenses that a company pays out – its explicit costs.
- Economic profits take into consideration both explicit and implicit costs. Therefore, while a company may show a positive net accounting profit, it may actually be a losing economic enterprise when its implicit costs are factored into the profitability equation
Historical Cost
Historical cost is the price paid for an asset when it was purchased. Historical cost is a fundamental basis in accounting, as it is often used in the reporting for fixed assets. It is also used to determine the basis of potential gains and losses on the disposal of fixed assets.
Historical Cost Adjustments
According to the accounting standards, historical costs require some adjustment as time passes. Depreciation expense is recorded for longer-term assets, thereby reducing their recorded value over their estimated useful lives. Also, if the value of an asset declines below its depreciation-adjusted cost, one must take an impairment charge to bring the recorded cost of the asset down to its net realizable value. Both concepts are intended to give a conservative view of the recorded cost of an asset.
Other Types of Costs
Historical cost differs from a variety of other costs that can be assigned to an asset, such as its replacement cost (what you would pay to purchase the same asset now) or its inflation-adjusted cost (the original purchase price with cumulative upward adjustments for inflation since the purchase date).
Historical cost is still a central concept for recording assets, though fair value is replacing it for some types of assets, such as marketable investments. The ongoing replacement of historical cost by a measure of fair value is based on the argument that historical cost presents an excessively conservative picture of an organization.
Current Cost
Current cost is the cost that would be required to replace an asset in the current period. This derivation would include the cost of manufacturing a product with the work methods, materials, and specifications currently in use. The concept is used to generate financial statements that are comparable across multiple reporting periods.
Future or Predetermined Cost
A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange.
The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires. The seller of the futures contract is taking on the obligation to provide and deliver the underlying asset at the expiration date.
These costs are computed in advance of the actual spending. And it usually includes all specifications with regards to the cost in question. In manufacturing firms, they are estimated for raw materials, labor and Overheads. When the actual costs are included during the period, the actual is compared with the predetermined to get the variance. A favorable variance means the actual cost is lower while an unfavorable variance implies that the actual cost was higher.
The term is also used in standard costing. In this situation, the standard cost is said to be the predetermined cost which is then compared with the actual cost. Variance is used to understand the cost item. So that adjustments can be made.
Using predetermined cost improves management efficiency. It also reduces the cost of production. Furthermore, it serves as a key performance indicator. A manager spending above the predetermined cost may imply that he or she is not performing well in terms of managing the entity’s finance.
Opportunity Cost
The opportunity cost of a particular activity is the value or benefit given up by engaging in that activity, relative to engaging in an alternative activity. More simply, it means if you chose one activity (for example, an investment) you are giving up the opportunity to do a different option. The optimal activity is the one that, net of its opportunity cost, provides the greater return compared to any other activities, net of their opportunity costs. For example, if you buy a car and use it exclusively to transport yourself, you cannot rent it out, whereas if you rent it out you cannot use it to transport yourself. If your cost of transporting yourself without the car is more than what you get for renting out the car, the optimal choice is to use the car yourself.
Formula and Calculation of Opportunity Cost
Opportunity Cost = FO−CO
Where:
FO=Return on best forgone option
CO=Return on chosen option
