What is cost? The concept of cost
Cost is the money value of what is used up to make a product or give a service. It must be linked to the product and be a normal part of running the business.
- Cloth used in a bag is a cost.
- Wages of the stitching worker are a cost.
- Gifts given for charity, interest on a loan, or a loss by fire are not normal product costs. They are not added to the product.
Cost is not the same as price. Price is what the customer pays. Price = cost + profit.
Three cost elements: material, labour, expenses
All costs fall in three groups, called cost elements:
- Material: things that become part of the product (cloth, steel, flour).
- Labour: pay for people who work on the product.
- Expenses: everything else, such as power, rent, machine wear.
Each can be direct (easy to trace to one product, like the cloth in one bag) or indirect (shared by many products, like factory rent).
| Name | Meaning |
|---|---|
| Prime cost | Direct material + direct labour + direct expenses |
| Factory overhead | All indirect costs of the factory |
| Manufacturing cost | Prime cost + factory overhead |
| Total cost | Manufacturing cost + office, selling and distribution costs |
| Selling price | Total cost + profit |
Features of cost accounting
Cost accounting is the system that records, sorts and adds up costs, so the cost of each product is known. It is for the inside of the business. Main features:
- It gives the cost of each product, not only the total profit.
- It works for managers: to set prices, save money and plan.
- It uses rules and records that run all the time, not only at year end.
- It supports the financial books by giving the cost of goods made and sold.
Financial accounting tells owners and tax offices how the whole business did. Cost accounting tells managers what each product costs.
Structure: three steps of cost calculation
Cost calculation is done in three steps, one after the other:
- By cost element: find how much material, labour and expense was used.
- By department: share the indirect costs between departments, such as cutting and sewing.
- By product: add direct costs and a share of indirect costs to find the cost of each product or batch.
The following lessons study each step. A cost sheet is the table that shows all these layers in order.
Key formulas and definitions
- Prime cost = Direct material + Direct labour + Direct expenses
- Manufacturing cost = Prime cost + Factory overhead
- Total cost = Manufacturing cost + Office, selling and distribution costs
- Selling price = Total cost + Profit
Worked examples
1. Material 50, labour 30, expenses 20. Find manufacturing cost.
50 + 30 + 20 = 100.
2. Direct material 60, direct labour 40, direct expenses 10, factory overhead 30. Find prime cost and manufacturing cost.
Prime cost = 60 + 40 + 10 = 110. Manufacturing cost = 110 + 30 = 140.
3. Manufacturing cost 140, office cost 15, selling cost 25. Find total cost.
140 + 15 + 25 = 180.
4. Total cost is 180 and the owner wants 20% profit on cost. Find the selling price.
Profit = 20% of 180 = 36. Selling price = 180 + 36 = 216.
5. Total cost 216 for 12 bags. Cost of one bag?
216 ÷ 12 = 18 per bag.
6. A factory sells at 250 and its total cost is 200. Profit as % of selling price?
Profit = 50. 50 ÷ 250 × 100 = 20% of selling price (25% of cost).
Common mistakes
- Calling price and cost the same thing. Price includes profit.
- Adding interest or charity gifts to product cost. They are not normal product costs.
- Thinking prime cost includes factory rent. Rent is indirect, so it is overhead.
- Forgetting office and selling costs when finding total cost.