What are business costs?
Costs are amounts incurred by the business in producing goods or services. A business has to keep a record of all the costs or expenses associated with its operations. Examples of costs include the cost of machinery, rent, insurance of building, interest on loan and cost of raw materials.
Why do businesses keep records of their costs?
Budgeting purposes
A business uses past cost data to estimate what costs would be in the future. Managers work towards not exceeding the budgeted cost in order to achieve the overall corporate objective.
Control purposes
A company would normally compare the actual cost incurred from the company’s records with budgeted costs to ascertain the variances. The reason for the variation is analysed and corrective actions are taken. For example, actual costs may exceed budgeted costs due to wastage from inefficient machines or unrealistic budget.
Profitability
The profitability of a product or the entire factory is ascertained by evaluating the difference between total sales revenue and total costs. The profit will assist investors to assess the return on their investment and determine whether it is worthwhile to invest in the business or explore alternative investment opportunities.
Pricing
The cost data help managers set a selling price by adding a targeted profit to the costs incurred. This method of adding a certain percentage to the cost to arrive at the selling price is known as cost-plus pricing. For example, the selling price of a product will be $11 if 10% is added to the total cost 0f $10, i.e. $10 + $1 (10% of $10 is $1).
Comparison with the past
It enables comparison with the past to determine the efficiency of a business, operation or product. Cost increases will, no doubt, depress profit margins; so a rising cost over time may require sourcing for cheaper materials, raising the selling price or embarking on other cost-cutting measures. Below-average profit margins discourage investment and can result in losses if not controlled in time.
Costs classification
Direct and indirect costs
Direct costs are costs that can be traced to a particular activity, department or equipment. These costs are involved directly in making a product and can be allocated to each unit produced. The three major types of direct costs are direct labour cost, direct material cost and direct expenses. Direct material cost is the cost of raw materials; wages of factory workers is an example of direct labour cost; direct expenses are identifiable with each unit of the product and are direct consequences of production, e.g. royalties, cost of hiring production machine, the maintenance cost of manufacturing equipment, etc.
Indirect costs cannot be traced to a particular activity, department, service or equipment. Indirect costs are also known as overheads. They are incurred in the production process but cannot be traced directly to each unit of the product produced, e.g., insurance, salaries of supervisors, and administrative expenses.
Fixed, variable and semi-variable costs
Fixed costs are costs that do not rise as output rises. They are the same and have no direct relationship with production, e.g., rent. Fixed costs are also known as overheads.
Variable costs are costs that rise as output rises. They will increase if production increases and decrease if it decreases, e.g., wages of workers directly involved in production and the cost of raw materials.
In reality, some costs are both fixed and variable; these are called semi-variable costs.
Fixed cost plus variable cost is the total cost. The average cost is the cost per unit and is obtained from the division of total cost by the number of units made. Marginal cost is the cost of producing an additional unit of a product, i.e. the change in total cost arising from manufacturing an extra unit of a product.