What Is Cost in a Business Firm?

Definition & Examples of Cost in a Business Firm

Inventory stored in a warehouse
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Cost in a business firm is an expense that the business takes on in an effort to sell a product or service. These costs include things like rent for a retail space, investments in replenishing inventory, and wages paid to employees.

Consider these details to give you a better idea of what cost is, in terms of a business firm, and why it differs from price.

What Is Cost in a Business Firm?

In managerial accounting, and in a real-world business firm, one of the most important concepts is that of cost. Cost in a business firm can be thought of as an investment in the business, but it's a specific kind of investment that goes toward efforts to sell a product or service.

If a retail clothing business uses some of its profits to invest in stocks, that isn't considered a cost, because the business isn't trying to sell those stocks as a part of its primary business model. On the other hand, investing in a billboard ad would be considered a cost, since it's attempting to drive customer traffic to the store.

Since there are many different ways that a company may try to sell its unique goods or services, concepts of cost are similarly varied. There are many types of costs, such as direct and indirect costs, that a manager must understand to effectively manage a business.

How Does Cost in a Business Firm Work?

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. Costs affect profit, and they're used to make decisions for both small and large businesses.

Here are some examples of common costs that affect a business firm.

Product or Manufacturing Costs

Only the costs in the production department are relevant to product costing. They consist of the 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. Upon sale, 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 those three costs. Indirect materials and indirect labor are included in overhead.

For example, imagine that XYZ 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, you 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 total cost / 30,000 units = $5.67 per unit

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 costs and manufacturing overhead costs. 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. Assets on the balance sheet can be written off with 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.

Cost Object

The term cost object refers to a product, service, customer, or project to which cost is assigned. For example, if you're a college student, each course is a cost object. The cost itself is that of tuition and books for that course. The cost of foregone alternatives, like working instead of going to school, is the opportunity cost.

Cost vs. Price

Cost vs. Price
Cost Price
Amount of an investment into a good or service Amount charged to customer for a good or service
Paid to a vendor or service provider Paid by a customer

There's a tendency to confuse cost with price, and they're often used interchangeably in informal conversations, but they aren't the same.

The amount that a business charges customers per unit of the product or service it sells is called the price. The amount it takes for a company to produce the product or service it sells is called the cost.

It is important to understand the difference between price and cost so that you can turn a profit. The difference between price, the amount charged to the customer, and cost, the expense to produce the item, is called the profit, net income, or margin.

Price and cost are both relative terms. To understand whether an amount being paid is a price or a cost, you have to define who you're talking about. For instance, a t-shirt manufacturer sets a price for a wholesale t-shirt. That price is paid by a retailer, but to the retailer, that price is actually a cost—it's the cost of acquiring inventory for the retail store. After acquiring the t-shirt, the retailer will put it out on the sales floor. A customer who wants to buy it will pay the price charged by the retailer, which is usually the retailer's cost plus an extra amount to bolster the retailer's profits.

Key Takeaways

  • Cost in a business firm is any cost that's incurred in pursuit of profits.
  • A cost can be thought of as a form of investment, but it's a specific kind of investment—one intended to help sell a product or service.
  • Cost and price are similar but distinct concepts.