A comprehensive understanding of cost can be used by managers to identify all of the relevant costs of an organisation. With this knowledge one is better positioned to forecast future cost and revenue.
What is the basis for measuring cost?
A cost unit is the unit of measurement used to express the cost of a product or service.
Here are some examples:
| Product or service | Cost unit |
| Selling chemicals | Chemical per litre |
| Shipping goods | Tonne per kilometer |
| Restaurant | Meal served per customer |
How to categorise cost
To help understand all the costs in a business, all cost objects need to be mapped to cost centres. Cost objects are all the individual items for which a cost can be quantified. Cost centres can be thought of as categories for collecting related cost objects under a heading.
Finance leaders decide what the cost centres will be. Cost objects are then collected under cost centres like back office processing, HR, IT, research and development, or compliance and risk. Cost centre names will usually follow a company’s structure, functions or activities.
Costs need to quantified
For both goods and services, costs are mapped directly or indirectly to cost elements (material, labour or expenses).
Direct costs can be directly mapped to each good produced or in the service sector, each job, service hour or transaction per client. Prime cost is the sum of all the direct production costs. Indirect costs (also known as overheads) are usually shared costs that can’t be directly traced to a single unit. Indirect costs for example, are incurred by shared administrative labour types like supervision.
Relevant and irrelevant cost
In decision making, only the relevant cost should be considered as any irrelevant costs will not be relevant to the decision.
Relevant costs relate to the future, are incremental and involve the movement of cash flows.
Irrelevant costs are sunk costs, committed costs that cannot be avoided, similar costs under different scenarios and non-cash flow related costs such as depreciation.
What about opportunity costs?
The value of the next best alternative foregone does not involve any cash flows so these are noted by management and used in decision making. Opportunity cost is usually a positive value as it’s the benefit that is given up for investing in one project over another. The one not invested in may have generated more revenue.
Fixed, variable and semi-variable costs
Fixed cost are all of the costs that are unaffected regardless of how activity changes within a relevant range.
Variable cost changes based on the level of activity.
Semi-variable cost has a fixed and variable cost. An example of this would be a data service which has a fixed rental and activation fee with per usage fees.
These concepts are crucial because once fixed cost and variable costs are known, the sales price can be calculated for the desired level of profit.
Marginal cost
Marginal cost is the sum of all the variable cost of producing a single unit.
Example
| Illustrative category | Cost | |
| Materials | ||
| Cost per unit | Direct and variable (ingredients) | $5,00 |
| Cost per unit | Indirect and variable (consumables) | $1,00 |
| Labour (Required labour hour per unit produced = 1) | ||
| Labour cost per hour | Direct and variable (Operational staff) | $2,00 |
| Fixed cost per unit when producing 1000 units | Fixed costs are usually indirect – think of rent or shared labour. Usually expressed as a total but can be calculated per unit. | $2,00 |
| Non-production expenses | ||
| Selling expenses | Usually indirect but in this case we have commission to pay so it’s direct and variable | $0,50 |
| Prime cost (direct production cost only) | $7,00 |
| Marginal cost | $8,50 |
| Total production cost | $10,00 |
| Total cost | $10,50 |
