What Is Cost in a Business Firm?

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In managerial accounting, and in a real-world business firm, one of the most important concepts is that of cost. Managers have to be able to determine the costs of the products or services they offer for sale. They also have to be able to determine the cost of a customer. There are many types of costs, such as direct and indirect costs that a manager must understand to effectively manage a business. Costs affect profit, and they're used to make decisions for both small and large businesses.

The Difference Between Cost and Price

Is cost the same as price? No. We have a tendency to confuse those two terms. The revenue that a business charges customers per unit of the product or service it sells is called price. The amount it takes for a company to produce the product or service it sells is called the cost. The difference between price, the amount charged to the customer, and cost, the expense to produce the item, is called the profit, or net income, or margin. It is very important to understand the difference between price and cost.

Many terms surround the word "cost" in a business firm. The term cost object is important in business. It refers to a product produced by a company for which a separate measure of cost is desired. It is a little more complex than that because it can also refer to a service, a customer, or a project and is used when allocating direct or indirect costs. As an example, if you take a course in college, that course is the cost object. The cost itself is that of tuition and books. The cost of the foregone alternative of working instead of going to school is the opportunity cost.

Product or Manufacturing Costs

Only the costs in the production department are relevant in product costing. They consist of direct and indirect costs of producing a product in a manufacturing firm or preparing a product for sale in a merchandising firm. Products are inventoried, and costs are recorded in an inventory account until the units are sold. At that time, the costs to produce those units get transferred to the cost of goods sold account.

Product costs consist of direct materials, direct labor, and manufacturing overhead. The total product cost is the sum of the three. Indirect materials and indirect labor are included in overhead. Here is an example of calculating total product cost and total per unit cost:

Troy Corporation manufactures widgets at the rate of 30,000 per week. Last week, direct materials were $50,000, direct labor was $40,000, and overhead was $80,000. Using this information, we can calculate the total product cost and the per unit cost.

Direct materials $50,000

Direct labor $40,000

Overhead $80,000

Total product cost $170,000

Per-unit cost = $170,000/30,000 units = $5.67 per widget

Prime Costs and Conversion Costs

Product costs are often grouped into two groups: prime costs and conversion costs. Prime costs include direct materials plus direct labor. Conversion costs include direct labor cost and manufacturing overhead cost. In other words, conversion costs are the costs of converting the raw materials into the final product.

Period Costs

All the other costs of running a company aside from product costs are called period costs. Super Bowl ads, for example, are period costs. Other examples include salaries and wages, and the costs of office supplies. Period costs do not appear as inventory on the balance sheet. They appear as expenses on the income statement.

If a period cost is expected to generate an economic benefit beyond one year, then it can be capitalized, or recorded as an asset on the company's balance sheet, and written off as depreciation over a few years, rather than being expensed all in one year. Examples would be purchases of company vehicles and expensive electronic equipment. Period costs can be significant and can be further subdivided into selling costs and administrative costs.