10 Types of Costs In Business You Must Know

Types of Costs In Business.Cost accounting is concerned with the calculation of actual product costs for stock valuation and profit measurement.Conventional cost accounting data collection systems accumulate costs by products to meet the financial accounting requirements of allocating manufacturing costs incurred during a period between cost of sales and inventories. Such data collection systems are not designed to accumulate product costs for decision-making purposes.

Therefore costs derived from the data accumulation system should not normally be used for decision-making purposes. Additional costs and revenue classifications can be developed to facilitate an evaluation of various alternative actions for decision-making and planning, and we shall now discuss the following classifications:

1. costs behaviour in relation to volume of activity;

2. relevant and irrelevant costs;

3. sunk costs;

4. avoidable and unavoidable costs;

5. opportunity costs;

6. incremental and marginal costs/revenues.


Discover The Types of Costs In Business.

1.Cost behavior.

A knowledge of how costs will vary with different levels of activity (or volume) is essential for decision-making. Activity or volume may be measured in terms of units of production or sales, hours worked, miles travelled, patients seen, students enrolled or any other appropriate measure of the activity of an organization.

Within shorter time periods, costs will be fixed or variable in relation to changes in activity. The shorter the time period, the greater the prob-ability that a particular cost will be fixed. Consider a time period of one year. The costs of providing a firm’s operating capacity such as depreciation and the salaries of senior plant managers are likely to be fixed in relation to changes in activity. Decisions on the firm’s intended future potential level of operating capacity will determine the amount of capacity costs to be incurred. These decisions will have been made previously as part of the capital budgeting and long-term planning process.

Relevant and irrelevant costs and revenues.

For decision-making, costs and revenues can be classified according to whether they are relevant to a particular decision. Relevant costs and revenues are those future costs and revenues that will be changed by a decision, whereas irrelevant costs and revenues are those that will not be affected by the decision. For example, if one is faced with a choice of making a journey by car or by public transport, the car tax and insurance costs are irrelevant, since they will remain the same whatever alternative is chosen. However, petrol costs for the car will differ depending on which alternative is chosen, and this cost will be relevant for decision-making.

Avoidable and unavoidable costs.

Sometimes the terms ‘avoidable’ and ” costs are used instead of relevant and irrelevant costs. Avoidable costs are those costs that may be saved by not adopting a given alternative, whereas unavoidable costs cannot be saved. Therefore only avoidable costs are relevant for decision-making purposes. Consider the example that we used to illustrate relevant and irrelevant costs. The material costs of £100 are unavoidable and irrelevant, but the conversion costs of 000 are avoidable and hence relevant. The decision rule is to accept those alternatives that generate revenues in excess of the avoidable costs.

Sunk costs.

These costs are the cost of resources already acquired where the total will be unaffected by the choke between various alternatives. They are costs that have been created by a decision made in the past and that cannot be changed by any decision that will be made in the future. The expenditure of £100 on materials that were no longer required, referred to in the preceding section, is an example of a sunk cost. Similarly, the written down values of assets previously purchased are sunk costs. For example, if a machine was purchased four years ago for £100000 with an expected life of five years and nil scrap value, then the written down value will be 00000 if straight line depreciation is used.

This written down value will have to be written off, no matter what possible alternative future action might be chosen. If the machine was scrapped, the U0000 would be written off; if the machine was used for productive purposes, the 120 000 would still have to be written off. This cost cannot be changed by any future decision and is therefore classified as a sunk cost. Sunk costs are irrelevant for decision-making, but they are distin-guished from irrelevant costs because not all irrelevant costs are sunk costs. For example, a comparison of two alternative production methods may result in identical direct material expenditure for both alternatives, so the direct material cost is irrelevant because it will remain the same whichever alternative is chosen, but the material cost is not a sunk cost, since it will be incurred in the future.

Opportunity costs.

Some costs for decision-making cannot normally be collected within the accounting system. Costs that are collected within the accounting system are based on past payments or commitments to pay at some time in the future. Sometimes it is necessary for decision-making to impute costs that will not require cash outlays, and these imputed costs are called opportunity costs. An opportunity cost is a cost that measures the opportunity that is lost or sacrificed when the choice of one course of action requires that an alternative course of action be given up.

Incremental costs and revenues are similar in principle to the econ-omist’s concept of marginal cost and marginal revenue. The main dif-ference is that marginal cost/revenue represents the additional cost/ revenue of one extra unit of output, whereas incremental cost/revenue represents the additional cost/revenue resulting from a group of additional units of output. The economist normally represents the theoretical rela-tionship between cost/revenue and output in terms of the marginal cost/revenue of single additional units of output. We shall see that the accountant is normally more interested in the incremental cost/revenue of increasing production and sales to whatever extent is contemplated, and this is most unlikely to be a single unit of output.

Every company has different types of costs. These are a great way to assess a company’s expenses and how they impact its operations, efficiency and profits. If you think about studying accounting or administration, knowing each of its types will undoubtedly be very useful for your career.

For this reason, in the following article we will explain what the types of cost are in a company and the role that each of these plays in its operation.

In general, the various types of costs in accounting are classified as follows:/Types of Costs In Business

 Direct costs

These are the costs that arise from the production of a good or service. This category also includes the money invested in the acquisition of raw materials, the payment corresponding to the labor force, etc. Those expenses can be easily traced back to a certain product, department or project.

Let’s graph the above with an example: A company that develops automobiles needs three people to spend eight hours taking care of the tasks associated with building a car. Then, the direct costs for the development of the product would be the wages of the three workers and the cost of auto parts.

 Indirect costs

On the other hand we have the indirect costs which are not related to the production of goods or services. As these are expenses that are not associated with a specific department, their allocation is not direct as in the previous case. To better graph them, let’s extend the example from the previous section.

The same automobile company would have as direct costs what it invested in the tires or the steel of each vehicle. However, the electricity that was used to power the factory, which is essential for the company, intervenes indirectly in the production of the vehicles. As you can imagine, there is no product whose origin can be traced back to the electricity bill.

Fixed costs

These are expenses that will vary no matter how many goods or services the business produces in the short term. For example, suppose that, in order to function properly, a company needs to rent machinery for its production for a period of twenty years.

Said company must pay 7,000 soles per month to cover the rental of the machines. Regardless of whether the level of production of the company increases or decreases, the payment of the rental of that machinery is an expense that will not change.

It may interest you: Learn what cloud accounting software is

Variable costs

In opposition to fixed costs, these are expenses that are directly linked to the level of production of a company and fluctuate according to all its possible variations. These will go up if the company starts producing more products and vice versa.

For example, a company that manufactures toys must package each of its items before sending them to stores. This is considered a type of variable cost, since as the volume of production increases or decreases, the expenses related to packaging will also rise or fall.

 Operating costs

Also known as operating costs, they include all expenses associated with the daily activities of the company, but are not directly related to goods or services. For example, this category usually includes the rent and profits involved in running a factory.

It is true that these are expenses that the company assumes day by day, but they are classified separately from the indirect costs that we mentioned earlier, since they are linked to production to a certain extent. Investors can calculate the operating expense ratio, which shows how efficiently the company is managing its money to generate sales.

6.- Opportunity costs

These are the benefits of an alternative which is passed up when a change of choice is made. Therefore, these are expenses that are more relevant in mutually exclusive events. At the time of making an investment, these represent the difference in income between a chosen alternative and another that was passed up.

For companies, the opportunity costs are not shown in the financial statements, but they are useful in the planning that is done from the administration. Take, for example, a company that decides to buy rather than rent new equipment to manufacture its products.

In that case, the opportunity cost would be the difference between the investment in equipment and the subsequent improvement in productivity versus how much money could have been saved if the money had been used to pay off some debt.

 Controllable costs

These are expenses that the administration can control, so from there they can be increased or decreased. They are generally classified as short-term costs that can be adjusted quickly. Clear examples of them are the controlled acquisition of office supplies, payment for advertising, bonuses for employees and donations to charity.

Very well, now you know what types of costs there are and what their importance is in an organization. We recommend you delve into the concepts related to accounting and business by choosing a career that allows you to guide your interest in a productive way.

by Abdullah Sam
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