Table of Contents
What is the Cost?
It is defined as any expenditure, typically expressed in terms of monetary value, that has been spent by a company to produce a product or service. There are a few important key points to highlight.
The definition of cost is from the viewpoint of the producer/service provider. It can also be considered from the perspective of the consumer, something we commonly refer to as PRICE. Another important point to highlight is that the definition considers cost in terms of Monetary Value. There are other ways of counting costs, such as man-hours lost, opportunity costs, economic costs, certain kinds of debt, etc. Most of those items can be grouped under the umbrella term Implicit Cost, which refers to costs that can not be easily reported as cash outlays when balancing accounts.
Terms Associated with Costing
Fixed Cost
It refers to expenses that do not vary concerning output. Those costs are relatively stable and will occur even if the business is providing no good or service. For example, rent/property tax/utility bills/salaries, loan repayments, insurance, etc.
Variable Cost
The expenses vary in proportion to the output of the business. It means as the output of the business increases in terms of goods & services, so also do its variable costs. For example, the cost of raw materials, packaging, delivery & shipping expenses, transaction fees, etc. Those costs can vary significantly over both the short and long term. [Total Variable Cost=Total Quantity of Output * Variable Cost per Unit of Output]
Total Cost
It is the sum of all the expenses incurred in running a business enterprise. It is a combination of both fixed costs and variable costs, it is also called the total economic cost of production. Total costs are very important to owners who wish to make informed pricing, supply chain, logistics, and revenue decisions concerning the sustainability of their business model. [Total Cost=Total Fixed Cost+Total Variable Cost] OR [Total Cost=Average Fixed Cost/Unit + Average Variable Cost/Unit] * number of Units Produced
Direct Cost
It is a term used to describe expenses that are directly associated with the production of goods and services, as well as the maintenance of the business. It is also can be defined as incurred costs that can be directly attributed to a cost object, which is typically a good or service. Another name for direct costs is specific costs, they are usually variable costs. For example, labor wages, raw materials, manufacturing supplies, shipping fees, energy consumption, etc.
Indirect Cost
It is typically called administrative expenses/overhead costs since they are usually associated with maintaining or running the business. It refers to costs that are not directly related to the production of a good/service, but are also essential for the smooth running of the business. It also includes other expenses that are attributable to multiple activities and cannot be assigned to a single cost object. For example, accounting & legal expenses, administrative expenses, rent, security expenses, telephone bills, office supplies, and utility bills. It can be Fixed or Variable costs.
Marginal Cost
It is also known as incremental/differential cost, it refers to any expense incurred by a company if it produces one extra unit of output. it can be defined as the increase in total cost due to the cost associated with the production of additional products/services. Marginal cost is strongly associated with variable costs and direct costs. It’s very important since it is usually one of the first indicators that a business model is heading towards unprofitability. Sometimes a business model seems profitable on paper, but once its marginal cost exceeds its marginal profit, it is heading towards unsustainability. [Marginal Cost=chanage in cost/change in output]
Opportunity Cost
It can be defined as benefits lost when a business chooses one alternative over another. To properly evaluate opportunity cost, all the respective benefits, costs, and risks associated with each alternative should be carefully enunciated. Opportunity cost is strictly an internal cost used for resource allocation and management.
Sunk Cost
It is described as any expense that has already been incurred by a business entity and cannot be recovered. It should not be considered in future decision-making. It is always a fixed cost because the absolute value of sunk cost does not change concerning the volume of output. Other names for sunk cost include retrospective cost, past cost, embedded cost, prior year cost, sunk capital, or stranded cost.
Cost Allocation
It is a vital part of generating financial reports and comparing the actual cost of production with the estimated cost – a process known as variance analysis. It helps a business detect unaccounted or unexpected expenses that may be draining its revenue, leading to a drop in profits.
Cost Pool
It is an accounting term that is used to refer to a group of individual costs that are later broken down further during cost allocation. For example, a cost pool labeled ‘customer service’ will likely have various costs within it, such as phone bills, litigation fees, refunds, etc. A cost pool can help in the grouping of info into an actionable form for easier decision-making.
Cost Structure
It refers to the types and relative proportions of fixed and variable costs that a business incurs. In a nutshell, it is a well-outlined plan that demonstrates how a business spends resources – typically evaluated in monetary terms – to achieve its goals.
Cost Object
It is an accounting term that is used to refer to items or activities to which costs can be assigned. Cost objects are typically specific business items or processes such as equipment, labor bills, raw materials, etc.
Economies of Scale
It refers to a reduction in per unit cost that larger businesses enjoy as they increase their production volume. It decreases in cost per unit of production and encourages an increase in scale. It may achieved by buying raw materials in bulk, increased specialization, the ability to attract workers with advanced technical skills, or greater access to capital.
Economies of Scope
These are advantages a company enjoys due to varying its scope of operations. It is because these different products get to share the same resources & processes. It allows for greater flexibility, faster response rate shorter time to market changes, lower risk, reduced wastage, and more efficient use of software and hardware.
Costing
It can be simply understood as the process of estimating or evaluating the cost of producing an item or carrying out a particular activity. It also involves the presentation of this data in a suitably arranged manner for the purposes of price control and to guide the management in proper decision-making.
Why does a business enterprise carry out costing?
- To determine the unit cost of production of various goods/services, as well as identify the fixed and variable costs associated with the operation of that particular business model.
- To guide the determination of the selling price of the product, as well as guiding price policies. It is because for a business model to be sustainable and profitable, the marginal revenue must consistently exceed the marginal costs, as well as the overhead costs.
- It helps a business reduce the total cost of production by allowing them to identify areas that can be improved upon and increasing operational efficiency within the supply chain or production process.
- It helps determine workers’ salaries and productivity since an increase in marginal cost without an increase in marginal revenue is an early sign of reduced worker productivity.
- It helps a business identify the most profitable design when considering the production process. Costing allows an entity to accurately measure the respective marginal costs associated with each particular type of production process and choose the most profitable form, or make changes to the design of an already existing process to improve profitability.
- It is a vital part of creating financial reports and interacting with insurance firms.
- To compare the actual cost of production with the estimated cost. It helps a business detect unaccounted or unexpected expenses that may be draining its revenue, leading to a drop in profits.
Types of Costing
Absorption Costing
it is a costing system in which the full cost of manufacturing an item or providing a service is evaluated. Because it takes into account all costs involved in a business operation, it can also be referred to as full costing.
Historical Costing
It can be defined as an accounting method or form of cost allocation that takes into account the value of an asset based on the original cost of the item at the time of procurement/acquisition. This type of costing is usually applied to fixed costs.
Marginal Costing
It is a system of cost allocation which is typically used when measuring the cost of variable expenses. It involves the evaluation of the effect of variable expenses on the total cost of production concerning changes in the total volume of production. It allows a business to determine the effect of volume and individual variable costs on the overall profitability of the business and make decisions based on this info.
Standard Costing
It is mostly adopted by large-scale manufacturers, which helps a business determine the difference between the expected cost of production and the actual cost of production, a process that is also referred to as variance analysis.
Lean Costing
It is a form of cost allocation that assigns value-based prices to an item in contrast to historical costs or standard costs, which are not built on the current value of the cost object being evaluated. It gives a more accurate analysis of the cost structure of the business and in the day-to-day or short-term analysis of the price, it is one of the most important cost allocation systems adopted.
Activity-Based Costing
It is a form of cost allocation whereby overhead costs are assigned to specific activities associated with the production of goods/services within a business. Those activities are collectively referred to as cost drivers because they typically form the bulk of the total costs of production a business entity has to shoulder.
Direct Costing
In the direct costing method, a business entity pays key attention to direct costs associated with the production of a specific good or service. Most times direct costing does not take into account fixed costs as these do not change with output and remain relatively stable over time. Therefore, only direct variable costs are measured, which makes the method better suited for short-term decision-making.
What is a Cost Structure?
Two factors must be considered when analyzing a business “How does the business plan on Making Money” & “How does the business plan on Spending Money”. A cost structure is a part of a business development model that highlights the specific expenses incurred by a business while operating under an outlined business model to deliver the business’s value proposition – typically a good or service.
It is a well-outlined plan that demonstrates how a business spends resources – typically evaluated in monetary terms – to achieve its goals.
Cost-Driven Biz v.s. Value-Driven Biz
Cost-Driven
The primary interaction of this type of business with the issue of resource allocation is an attempt to minimize expenses as much as possible to maximize profits. Therefore, such businesses are driven by the aim of reducing costs as much as they can through various techniques.
Ways to achieve greater cost reduction: specialization, outsourcing, automation, and using low-price value propositions. Such businesses do not turn this aim into a price war, and prices should only be reduced as a response to greater efficiency and reduced internal expenses.
This model is more company-centered as against being consumer-centered. Some examples include things such as manufacturing industries with the large-scale production of low-budget items, the fast food industry, non-designer textile and fashion, etc.
Value-Driven
This model places more emphasis on its ability to create and provide value to its consumer base, instead of focusing primarily on the cost. Those types of businesses tend to be high-end, customizable which are designed to be consumer-centered and rather flexible. Some examples of this like racing car industry, high-end fashion, fine dining, resorts, and other luxury industries.
The model of this business has a high degree of customer retention and a deep consumer relationship with their customer base. It may be absent or not as important with cost-driven businesses, but there are some important exceptions to the rule on both sides.
Elements of the Cost Structure
Product Cost Structure
It is used to describe costs that are attributable to the direct production of the product/service. It generally includes both fixed costs [worker salaries, factory overhead] & variable costs [raw materials, shipping, and transaction fees].
Customer Cost Structure
The expenses that are incurred due to customer interactions with the business. It includes warranty claims, customer service fees, credit notes, return of goods, etc.
Service Cost Structure
It includes administrative fees, taxes, legal fees, licensing, etc.
How is Cost Modeling Done?
Segmenting the Expenses
The first step is noting all your expenses and categorizing them in terms of any standard accounting format. They can also be grouped as fixed costs, variable costs, direct costs, and indirect costs.
Identifying Cost Drivers
A cost driver can be defined as an activity that triggers a change in cost. They are typically variable costs because their value changes in changes in output. Variable cost drivers are usually more important than fixed costs when it comes to profitability. Fixed costs are relatively stable over short periods, but variable costs can vary more widely over the short term and are better determinants of short-term profitability.
Focus on Total Cost of Ownership
The total cost of ownership is an accounting term used to refer to the cost of buying something plus the cost of operating it over its useful life. It is important to group these costs into logical groups that can be used for future policymaking and decision-making.
Allocate Costs to Each Supplier
It is a wide decision to segregate costs among the different suppliers. It is especially important for large manufacturers which typically make use of numerous vendors, each of which offers different benefits in terms of costs, reliability, and other features. It helps in future decision-making, especially when it comes to changing vendors.
Create a Standard Costing System
Use the above information to craft a standard, reproducible, and flexible cost structure that the business can utilize as a framework for mapping out any current and future costs. Even if minor changes are made in the company’s operational structure, these modifications can easily be applied to this costing model without too much difficulty.
Factors to Consider When Creating a Cost Structure
- What are the baseline costs that you expect to encounter due to your business model?
- Is your business more cost-oriented or value-oriented?
- Which Key Resources & Key Activities can be a heavy expense for the business, as well as how do they generate these costs?
- Do these Activities and Resources correspond to the value propositions of your business?
- How are your variable and fixed costs affected when you reconfigure your business model?
Conclusion
Costs are just as important as revenue when it comes to running a successful business. Having a well-designed cost-allocation system is vital for the success of any business, irrespective of the industry, size, and type of cost structure. It helps in decision-making, planning, growth monitoring, and the determination of an accurate pricing model.