Cost - definition and examples

What is Cost?

This is a term that confuses many students and other concerned parties. Why the confusion? This is because although the term is a common one in academia and in the industry, the definition is pegged on the demand-supply point of view. Cost may mean a different thing depending on which side of the market we are addressing. On the side of supply, the players refer this term as cost of production. On the side of demand, the players call the term price. In this article, we are going to look at this term from the two sides and draw a common understanding of the term “COST”

 

Supply Side Of The Market

Supply side of the market refers to the production side and production means creating a good or service or making it available to the end users. This then implies that supply may imply

-Actual production/manufacture of a product or

-Purchase of finished goods or services from a supplier to make it available to the consumer.

For the good or service to be availed to the consumer, the resources forgone to possess this good or service is what is referred to as cost.

If the resources forgone was with the intention of creating a good or service, then this is referred to as production cost

If the resources forgone was with the intention of purchasing a good or service, then this is referred to as purchasing cost/price. Therefore, on the side of supply;

 

If producer or manufacturer

Cost is defined as the resources forgone by the producer to create or manufacture a finished good or service. The resources may be either in monetary or non-monetary form. For example, the manufacturer or producer of good X may forgo $200 to facilitate production of the good or service. The $200 is the cost or cost of production.

 

If purchase of finished good/service from the supplier

Cost is defined as the resources forgone by a firm or individual to purchase/acquire a finished good or service. The resources may be either in monetary or non-monetary form. For example, the buyer of good X may forgo $200 to facilitate purchase of the good or service. The $200 is the cost or the purchases cost. However, the purchase cost has one challenge, it is composed of the actual cost of producing the good/service plus some profit margin for the seller of the finished good. Therefore, the $200 is a combination of the cost of production/manufacturing plus some profits.

 

In the context of cost accounting, cost refers to case “a” which entails the actual cost incurred or paid in creating/manufacturing the finished good or service. So, it is crystal clear that in cost accounting, “COST” refers to forgone resources to enable production of a finished good or service ready for distribution to the market. Further, when we talk of “COST” we are addressing the supply side of the market.

 

The cost value is a derivative value for the amount stated above of $200 is not just one resource which was forgone but a variety such as raw materials, direct labor, direct expenses and production overheads. All these components are referred to as cost elements and may entail and not limited to

-Direct Raw Materials

-Direct Labor

-Direct Expenses

-Overhead Costs

So, the cost of producing for example, product X may be $200 which is broken down to the following cost elements;

Demand Side Of The Market

Let us look at the side of demand. This is the side where we have dominance of the buyers of goods and services especially for final consumption. The players of the market here acquire goods and services by forgoing some resources. Even if the buyers on this side intent to re-sell the goods or services they have acquired from the supply side, they forgo some resources to acquire the finished goods or services. The resources they forgo are commonly referred to as purchase price or cost of purchase. Let us assume that the buyers on this side are purchasing the same goods produced on the supply side by the manufacturers or producers. They will achieve their objective by forgoing some resources with a greater value as compared to what suppliers/producers on the supply side sacrificed. Yet the goods or the services are the same. This is because the suppliers on the supply side have to transfer the goods or services at the production cost plus some profit margin. Such that the consumers on the demand side will have to forgo a higher resource value such as $220.

Therefore, although the goods/services being exchanged is the same, consumers on the demand side are sacrificing more resources, that is the $220. This amount cannot be termed as the cost. It is purchasing price/cost.

 

In Conclusion

In the context of cost accounting, one; cost is the forgone resources by the manufacturers/producers to create or produce a finished good or service. Two, the cost amount is made up of pure production cost and no element of profit margin.

NB1: It is the cost value that is used by the cost accountant to establish the profit margin to set for transferring purposes in the market.

NB2: Cost is the forgone resources-financial or non-financial. This means that cost does not necessarily imply actual cash outflow from the business as the manufacturer/producer try to acquire the prerequisites needed to create the good or service. That is, if a product is produced using free raw materials, free direct labor, and overheads, the producer cannot assume that the cost of the product is zero (0). The rational thing to do is to value each cost element using the appropriate rates.

Cost Elements

What is cost element?

Definition

Cost element is the various types of resources that the producer or manufacturer has forgone to produce or manufacture a unit of a product. This is a common term in cost accounting. The nature of the good or service being created determines the type of elements or components forming the cost elements. The following 5 examples of products dictate the nature of resources used as cost elements for the production of that particular product.

Note that example 1 to 5 represents diverse cost elements that compose production of a unit of a product. Also note that when we talk of a product, this is a general term referring to either a physical good as it is in the example 1-4 or service provision such as example 5 which is a unit of entertainment. As a learner/entrepreneur, you will realize that the cost elements vary in nature or type depending on the type of product being created. This implies that since there are numerous organizations dealing with a variety of products supplied in the market, different criterion is used to classify cost elements. In the next sub-topic in this article, we will discuss the classification of cost elements as explained hereunder.

Classification Of Cost Elements

What is cost classification? Why is it necessary to classify costs in to its simplified form? These are two questions which are very important to you as a scholar or as an entrepreneur.

 

Definition 1: Cost classification is the analytical process of separating or breaking down the cost drivers of a product in to distinct components (i.e., cost elements) using a certain criterion.  The nature of the cost elements derived at is determined by the nature of the product in question. This implies that there are numerous cost elements across the different industries in an economy.

 

Definition 2:

The second question is about the reason why it is necessary to classify the cost elements. The justification of classifying costs is to ensure full disclosure of the cost structure making up the product. This approach aid in decision making by the management such as setting of the pricing policy. Cost classification is commonly based on the following criterion;

 

Visibility Percentage in the Product Criteria

This criterion advocates that cost elements that comprise of a particular product is normally traced physically in the product or assumed to have a certain percentage of contribution towards production of the good or service. So, if the cost element carries a big percentage of the product, it will be visible in that product hence termed as direct cost. On the other hand, if the cost element is least traceable on the product, then it is referred to as indirect cost. So, in summary, this criterion classifies cost elements in to

  • Direct cost
  • Indirect cost

Direct Cost

Direct cost is cost element or cost driver that is directly associated with the production of that product. The tangible evidence is that the cost driver or component can physically be seen as part of the product. Example of these type of cost is direct raw materials, direct labor and direct expenses. These costs are also referred to as prime costs and they are directly charged to the product itself. They are also characterized by being able to vary with output.

Indirect Cost

Indirect cost is cost element or cost driver that is not directly associated with the production of that product. The tangible evidence is that the cost driver or component cannot be physically seen as part of the product. Example of these type of cost is factory supervisor salary, factory building security cost and factory electricity costs. These costs are also referred to as overheads and are either allocated or absorbed in the product. they are characterized by being fixed or constant in nature over different levels of output.

 

Activity Based Behavior Criteria

This criterion advocates that the monetary value of the cost element that comprise of a particular product may change or may not change when the production volumes change. Such that in some cases, the cost element may remain constant even when output of a product is varied or may change in a certain manner or proportion. Under this criterion, we have three categories of costs

i). Variable cost

ii). Semi-variable

iii). Fixed costs

Variable Cost

Variable cost is the cost element of a product that has a behavior of changing such that when the volumes of production change, the cost element change even if not at the same proportions. A good example is packaging materials, direct raw materials and direct labor.

Semi-Variable Cost

Semi-variable cost is the cost element of a product that has a behavior of remaining constant or fixed when a certain level of production is maintained and then if the level is changed, the cost element value will also vary and again remain constant in the new production level. Example of such type of cost element is electricity costs for $100 may be charged per month as an outstanding charge just to keep the lights on and building functioning at a minimal level. However, if production doubled and additional machines are run using more electricity, the cost may be $180 for the month.

Fixed Cost

Fixed cost is the cost element of a product that has a behavior of remaining constant or unchanging character such that when the volumes of production change, the cost element remain the same. in other words, its value is fixed. Examples are monthly salary, rent expenses etc.

NB: Many students or scholars think fixed costs are just constant. This is not true for if we consider the aspect of decision making by the management, the so referred to as fixed cost also vary based on discretion criterion.

Before we consider each category of fixed cost, let us look at the meaning of this term “Discretion”

The term “Discretion” means at one’s will. Its upon one’s judgement to make a particular decision. In other words, one is at liberty to choose to or not to. So, on this basis, fixed cost may remain fixed or vary. With this kind of criterion, fixed cost can be further classified in to three categories;

i). Committed Costs

ii). Discretionary Costs

iii). Step Costs

Committed Costs

This is cost element made up of a constant cash out flow from the business to meet some expenses arising from an agreement between firm and a supplier of certain services. The management cannot avoid it. For example, hire purchase installment contributions which are constant/fixed all through the set period.  

Discretionary Cost

Discretionary cost is cost element that can be avoided by the management without interfering with the operations of the business. In other words, expenditure of this nature can be tolerated and at the same time the management can do away with it for this cost is not related to the operations and can be controlled by the management. Examples of such costs are entertainment costs and hotel served meals or tea expenses during tea break.

Step Cost

Step cost is a cost element that is fixed at some point then changes to some level and again stagnates at the new level. This trend continues as long as production is continuing. Such costs are constant for a given level of output and then increase by a fixed amount at a higher level of output. So, at that level when it is constant, output will be changing but the cost is fixed. Then all over a sudden the fixed cost shifts to another level and remain there again.

Firm Value Addition criteria

 This classification of cost elements is based on the specific activities that take place as the product value is being added before it reaches the final consumer. So, cost elements are grouped on the basis on the primary function impacted on the product channel. Under this criterion, the following are the costs;

  1. Pre-production cost
  2. Manufacturing/production Costs
  3. Administration Costs
  4. Selling and Distribution Cost
  5. Research and Development Costs
  6. Capital cost
  7. Revenue cost
  8. Controllable costs
  9. Uncontrollable costs
  10. Opportunity Cost
  11. Sunk Costs
  12. Total Cost
  13. Differential Cost
  14. Joint Costs
  15. Imputed Costs
  16. Uniform Costs: Marginal Costs
  17. Replacement Costs
  18. Conversion Cost

Pre-Production Cost

The cost element is classified based on the pre and post incorporation period of the organization. So, we have pre-production costs which are resources forgone by the business before the company is opened formally. These costs are referred to as pre-incorporation cost or preliminary expenses. In financial accounting discipline which is a branch of accounting, they are referred to as fictitious assets and are gradually written off over time. Examples of such costs are salaries paid before the firm is made operational.

Manufacturing Costs

The cost element is based on the initial stage of actual production of the product which involves direct or prime and overhead costs that are involved in production of the good or service. It includes the cost of direct raw materials, direct labor wages, direct expenses, packing (primary) cost and all overhead expenses relating to creation.

Administration Costs

The cost element is based on the step where overall administration activity is needed to ensure that the value of the product is maintained. For example, once the goods or services are complete, there is need to factor in the formulation of a policy or policies that will direct the organization towards safeguarding the value of the product such as good storage and pricing. Such administrative costs are salaries for strategic managers. 

Selling And Distribution Cost

The cost element is based on the step or stage where the goods or services are ready for being transferred to the market. So, the costs are classified as selling and distribution which is the resources used to create and arouse demand. Such costs are such as advertisements, market research etc.

Research And Development (R&D) Costs

The cost element is based on the step or stage when the good or service has reached the maturity stage where by the chances of the product declining from the market is high. So, at this stage, research and development resources are utilized to identify new product designs that can be acceptable in the market by making the product more appealing. Such costs are classified as research and development costs and examples are the cost of discovering new ideas, process, products by experiment and implementing such results on a commercial basis.

 

Capital-Revenue Expenditure Criterion

Cost elements in this case is based on the intention of spending the organization’s resources. Under this criterion, the costs fall under two categories, namely;

  1. Capital cost
  2. Revenue cost

Capital Cost

Cost elements are named after the intention of expenditure incurred on the finished good. For capital cost, the intention of cost incurred is to acquire an asset for long-term accruing benefits. For instance, when the organization purchases fixed assets which will be used for day-to-day operations of the business. In other words, the intention of such cost is to acquire assets not for re-selling. Examples of such costs are motor vehicles for transport purposes, machine for production activities. Such that if you consider a proprietor with a private school, he or she may buy a school bus for children transportation purposes. Yes, the asset is a fixed one and it is for furthering business activities.

Revenue Cost

Cost elements are classified after the intention of expenditure incurred on the finished good. For revenue cost, the intention of cost incurred is to acquire an asset for short-term accruing benefits. For instance, when the organization purchases current assets for trading purposes such as inventory. In other words, the intention of such cost is to acquire assets for re-selling. Examples of such costs are motor vehicles for reselling if the firm is a motor vehicle dealer. Another example is where machines are bought for reselling purposes especially where the firm deals with buying or manufacturing of machines for reselling purposes. 

Controllability Criterion

  • Cost elements under this criterion are two;
  • Controllable costs
  • Uncontrollable costs

Controllable Cost

Cost elements under this criterion is based on the characteristic of the element being adjustable as per the management decisions. That is the cost element is not rigid. The Chartered Institute of Management Accountants defines controllable cost as “cost which can be influenced by its budget holder. Example is all variable costs such as raw materials, direct labor, direct expenses and variable overheads. Also referred to as avoidable costs.

Non-Controllable Cost

Cost elements under this criterion is based on the characteristic of the element of not being adjustable as per the wishes of the management. That is the cost element is rigid. Examples of such cost elements are fixed costs. Also referred to unavoidable cost.

 

Critical Decision Based Criterion  

Cost elements under this criterion is pegged on the critical decision management has to make. It is at appoint when the management is at the cross-road and the decision made will result to key turn of events. Under this criterion we have;

  1. Opportunity Cost
  2. Sunk Costs
  3. Total Cost
  4. Differential Cost
  5. Joint Costs
  6. Imputed Costs
  7. Uniform Costs: Marginal Costs
  8. Replacement Costs
  9. Conversion Cost

 Opportunity Cost

Opportunity cost is the benefit of the next best alternative forgone. This scenario is common where the resources are scarce and production of a product need to be allocated on the basis of the benefits derived from that product. So, if the producer chooses one product, he or she has to forgo production of another product which a competitor. So, opportunity cost of the product being produced is the forgone benefits which are associated to the other competing product which was declined.

Sunk Costs

Sunk cost is the historical cost. Cost which has already occurred and not needed to decide on the next level of production. Example is insurance or investment of cash in a project. Such cost does not guide the decision maker to decide to produce an additional unit of a particular product.

 

Total Cost

Cost elements are classified on the basis of summation of all costs directly associated with the production of the final good or service. The total cost here is referred to as prime cost and entails, material, labor and overhead.

Differential Cost

Cost element is derived from the additional total cost of a product. For example, one need to consider the total cost of production of product X in this week and that of the following week and establish the difference between the two values. This term in other words is what Economists refer to marginal cost. For your information, in Economics, for a profit maximizing firm an organization should produce efficiently and effectively at a point where differential cost is equal to differential revenue. In other words where marginal cost is equal to marginal revenue (MC=MR).

Joint Costs

Cost elements are classified on the basis of cost or resources that are commonly used to produce two or more products which within a certain stage or process remain twins or joint until past the point of split-off. So, the costs paid or incurred within this section of production is referred to as joint. Otherwise after that stage, each product consumes its own resources separately. You should not that after split point, there may arise one good being main and other one being minor (i.e., by-product) in that order.  

Replacement Costs

Cost elements are classified on the market price to be forgone or paid to the seller of the asset to be replaced. As the name suggests, when an old asset is considered for replacement, the replacement price which becomes relevant to this transaction is the market price of a similar asset which may either be higher or lower than the current one. Therefore, in this case, the cost referred to as replacement cost is the purchasing price of the new asset net of the cash proceedings realized from the old asset.

Conversion Cost

Cost elements in this classification is associated with the resources that were directly used to add form utility to the raw materials. Such resources aid in transforming the row form of raw materials to useful form of a product. Hence these resources forgone are referred to as conversion cost. They comprise direct labor wages, and manufacturing overhead. In other words, conversion cost is the prime cost less direct raw material cost for we should not forget that it is the raw materials which are being converted by the other direct inputs during production. You should also note that other conversion costs will include any normal wastages and gains during the conversion process such as gains and losses in weight or volume of direct material arising due to formation process.

Summary Of List Of Cost Elements

The following diagrammatic illustration is a summary of all the cost elements that are found in different organizations. You should not that the summary factors the overlapping of some of the terms used in this article where by one cost element as afore discussed may belong to several classifications. Further the advancement in explaining the cost element details in our article we will only focus what is in this diagram as per Figure 1.1

About the Author - Dr Geoffrey Mbuva(PhD-Finance) is a lecturer of Finance and Accountancy at Kenyatta University, Kenya. He is an enthusiast of teaching and making accounting & research tutorials for his readers.