COSTS

The word "cost" appears in many accounting, economics, and business terms with subtle distinctions in meaning. The word by itself rarely has a clear meaning. (Likewise the word "value" has no clear meaning. Avoid using "value" without a modifying adjective, such as "market," "present," or "book.") The word cost, without modifying adjectives, typically means the sacrifice, measured by the price paid or required to be paid, to acquire goods or services. Hence, the word often carries the meaning more precisely represented by the following:

Acquisition cost; historical cost. Net price plus all expenditures to ready an item for its intended use at the time the firm acquired the item. The other expenditures might include legal fees, transportation charges, and installation costs.

Accountants can easily measure acquisition cost, but economists and managers often find it less useful in making decisions. Economists and managers more often care about some measure of current costs, which accountants find harder to measure.

Current cost. Replacement cost or net realizable value.
Replacement cost. Acquisition cost at the date of measurement, typically the present, in contrast to the earlier date of acquisition.
Net realizable value. The amount a firm can collect in cash by selling an item, less the costs (such as commissions and delivery costs) of disposition.

Accountants most often refer to current costs as fair value.

Fair value. Price negotiated at arm's length between willing buyers and willing sellers, each acting rationally in their own self-interest. Sometimes measured as the present value of expected cash flows.

Accountants often contrast (actual) historical cost with standard cost.

Standard cost. An estimate of how much cost a firm should incur to produce a good or service. This measurement plays a role in cost accounting, in situations where management needs an estimate of costs incurred before sufficient time has elapsed for computation of actual costs incurred.

The following terms desegregate historical cost into components.

Variable cost. Costs that change as activity levels change. (The term "cost driver" refers to the activity that causes cost to change.) Strictly speaking, variable costs are zero when the activity level is zero. Careful writers use the term "semivariable costs" to mean costs that increase strictly linearly with activity but have a positive value at zero activity level. Royalty fees of 2 percent of sales are variable; royalty fees of __BODY__,000 per year plus 2 percent of sales are semivariable.

Fixed cost. A cost that does not change as activity levels change, at least for some time period. In the long run, all costs can vary.

In accounting for the costs of product or services or segments of a business, accountants sometimes desegregate total costs into those that benefit a specific product and those that benefit all products jointly produced.

Traceable cost; direct cost. A cost the firm can identify with a specific product, such as the cost of a computer chip installed in a given personal computer, or with some activity.
Common cost; joint cost; indirect cost. A cost incurred to benefit more than one product or activity, such as the cost of rent of a factory building in which the firm makes several different kinds of personal computers or the cost of a steer from which the firm manufactures leather and hamburger. Some restrict the term common cost to situations such as the first, where the firm chooses to produce products together, while restricting "joint costs" to situations, such as the second, where the firm must incur the cost simultaneously. The major problem in cost accounting is allocation of common and joint costs to individual products. Managers and regulators (e.g., the Securities and Exchange Commission and the IRS) often insist on such allocations, while economists and some accountants recognize that such allocations do not aid decision making.

Virtually all costs recorded by accountants require a cash outlay at some time. Analysts sometimes need to distinguish between costs associated with current or future cash expenditures and those where the expenditure already occurred.

Out-of-pocket cost; outlay cost; cash cost. An item requiring a current or future cash expenditure.
Book cost; sunk cost. A cost incurrence where the cash expenditure has already occurred, such as the cost of depreciation for a machine purchased several years ago. (In accounting, depreciation is an allocation of a previous expenditure, while in economics depreciation represents a decline in current value.)

In decision making, the cost concepts above often get further refined, as follows.

Incremental cost; marginal cost; differential cost; avoidable cost. The firm will incur (save) incremental costs if it carries out (or stops) a project. These four terms tend to have the same meaning, except that the economist restricts the term "marginal cost" to the cost of producing one more unit. Thus the next unit has a marginal cost; the next week's output has an incremental cost. If a firm produces and sells a new product, the related new costs would properly be called "incremental," not marginal. If a factory is closed, the costs saved are incremental, not marginal.
Unavoidable cost; inescapable cost; sunk cost. Unavoidable costs will occur whether the decision is made to go ahead or not, because the firm has already spent, or committed to spend, the cash. Not all unavoidable costs are book costs; consider a salary promised, but not yet earned, that the firm will pay if it makes a no-go decision. Sunk costs are past costs that current and future decisions cannot affect and, hence, are irrelevant for decision making (aside from income tax effects). For example, the acquisition cost of machinery is irrelevant to a decision of whether to scrap the machinery. In making such a decision, one should consider only the sacrifice of continuing to own it and the cost of, say, the electricity to run the machine, both incremental costs. Sunk costs become relevant for decision making when the analysis requires taking income taxes (gain or loss on disposal of asset) into account, since the cash payment for income taxes depends on the tax basis of the asset. Avoid using the ambiguous term "sunk costs." Consider, for example, a machine costing $100,000 with current salvage value of $20,000. Some would say that $100,000 is sunk; others would say that only $80,000 is sunk. Those who say $100,000 have in mind a gross cost, while those who say $80,000 have in mind a net cost—original amount reduced by current opportunity cost.

In deciding which employees to reward, management often cares about desegregating actual costs into those that are controllable and those not controllable by a given employee or division. All costs can be affected by someone in the firm; those who design incentive schemes attempt to hold a person responsible for a cost only if that person can influence the amount of the cost.

A firm incurs costs because it perceives that it will realize benefits. Careful usage of cost terms distinguishes between incurrences where the firm will enjoy the benefits in the future from those where the firm has already enjoyed the benefits. Accounting distinguishes costs that have future benefits by calling them assets and contrasting them with costs whose benefits the firm has already consumed, by calling them expenses. Other pairs of terms involving this distinction are unexpired cost versus expired cost and product cost versus period cost.

Economists, managers, and regulators make further distinctions between cost concepts, as follows.

Fully absorbed cost versus variable cost. Fully absorbed costs refer to costs where the firm has allocated fixed manufacturing costs to products produced or divisions within the firm as required by generally accepted accounting principles. Variable costs, in contrast, may be more relevant for making decisions, such as in setting prices or deciding whether a firm has priced below cost for antitrust purposes.
Fully absorbed cost versus full cost. In full costing, the analysis allocates all costs, manufacturing costs as well as central corporate expenses (including financing expenses), to products or to divisions. In full absorption costing, the firm allocates only manufacturing costs to product. Only in full costing will revenues, expenses, and income summed over all products or divisions equal corporate revenues, expenses, and income.
Opportunity cost versus outlay cost. Opportunity cost refers to the economic benefit forgone by using a resource for one purpose rather than another. If the firm can sell a machine for $200,000, then the opportunity cost of using that machine in operations is $200,000 independent of its outlay cost or its book cost or its historical cost.
Future cost versus past cost. Effective decision making analyzes only present and future outlay costs, or out-of-pocket costs. Optimal decisions result from using future costs, whereas financial reporting uses past costs.
Short-run cost versus long-run cost. For a given configuration of plant and equipment, short-run costs vary as output varies. The firm can incur long-run costs to change that configuration. This pair of terms is the economist's analogy of the accounting pair, above, variable and fixed costs. The analogy is inexact because some short-run costs are fixed, such as property taxes on the factory.
Imputed cost versus book cost. Imputed costs do not appear in the historical cost accounting records for financial reporting. The actual cost incurred is recorder and is called a book cost. Some regulators calculate the cost of owners' equity capital, for various purposes; these are imputed costs. Opportunity costs are imputed costs and are relevant for decision making.
Average cost versus marginal cost. This is the economic distinction equivalent to fully absorbed cost of product and variable cost of product. Average cost is total cost divided by number of units. Marginal cost is the cost to produce the next unit (or the last unit).
Differential cost versus variable cost. Whether a cost changes or remains fixed depends on the activity basis being considered. Typically, but not invariably, analysts term costs as variable, or fixed, with respect to an activity basis such as changes in production levels. Typically, but not invariably, analysts term costs as incremental, or not, with respect to an activity basis, such as the undertaking of some new venture. Consider the decision to undertake the production of food processors, rather than food blenders, which the manufacturer has been making. To produce processors requires the acquisition of a new machine tool. The cost of the new machine tool is incremental with respect to a decision to produce food processors instead of food blenders, but, once acquired, becomes a fixed cost of producing food processors. Consider a firm that will incur costs of direct labor for the production of food processors or food blenders, whichever the firm produces. Assume the firm cannot produce both. Such labor is variable with respect to production measured in units, but not incremental with respect to the decision to produce processors rather than blenders. This distinction often blurs in practice, so a careful understanding of the activity basis being considered is necessary for understanding of the concepts being used in a particular application.

Analysis of operating and manufacturing activities uses the following subdivisions of fixed (historical) costs. Fixed costs have the following components:

Capacity costs (committed costs) give a firm the capability to produce or to sell, while programmed costs (managed costs, discretionary costs), such as for advertising or research, may be nonessential, but once the firm has decided to incur them, they become fixed costs. The firm will incur standby costs even if it does not use existing capacity; examples include property taxes and depreciation on a building. The firm can avoid enabling costs, such as for a security force, if it does not use capacity. A cost fixed over a wide range but that can change is a semifixed cost or "step cost." An example is the cost of rail lines from the factory to the main rail line, where fixed cost depends on whether there are one or two parallel lines but are independent of the number of trains run per day. Semivariable costs combine a strictly fixed component cost plus a variable component. Telephone charges usually have a fixed monthly component plus a charge related to usage.

COSTS

BIBLIOGRAPHY