Defining and calculating product costs
In managerial accounting, and in the real world in a 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 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 firm. Costs are used to make decisions not only for small businesses but also for 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 firm earns 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 is called the net income or margin. It is very important to understand the difference between the two terms - price and cost.
There are many terms to learn surrounding 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 is tuition and books. The cost of the foregone alternative of working instead of going to school is the opportunity cost.
What are Product or Manufacturing Costs?
Only the costs in the production department are relevant in product costing. They are the direct and indirect costs of producing a product in a manufacturing firm or preparing a product for sale in a merchandising firm. Product costs are inventoried and remain in an inventory account until they are sold. At that time, they are transferred to cost of goods sold.
Product costs are composed 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
Total Product Cost $170,000
Per Unit Cost = $170,000/30,000 = $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.
What are Period Costs?
All the costs of running a company that are not product costs are called period costs. Super Bowl ads, for example, are period costs. So are salaries and wages and the costs of office supplies. Period costs do not appear as inventory on balance sheet. They appear as expenses on income statements. If a period cost is expected to generate an economic benefit beyond one year, then it can be capitalized and written off as depreciation rather than expensed. Examples would be company vehicles and expensive electronic equipment.
Period costs can be significant and can be further subdivided into selling costs and administrative costs.