Definition of Cost
Cost refers to the expenditure incurred on goods and services necessary for running an organization’s operations. This can include manufacturing expenses, employee salaries, and utility costs, among others. In accounting, there are various methods to define and calculate costs, each serving a specific purpose in financial reporting and management.
Types of Cost
1. Average Cost
Average cost is calculated by dividing the total cost of goods available for sale by the total number of units available for sale. It is useful for understanding the cost per unit of inventory.
2. First-in-First-Out (FIFO) Cost
Under the FIFO method, it is assumed that the first items added to the inventory are the first ones to be used or sold. This method can be useful in an inflationary environment as it may lower taxable income.
3. Historical Cost
Historical cost is the original monetary value of an asset or expenditure as recorded on the financial statements. It doesn’t reflect the market value but provides a consistent measure for accounting purposes.
4. Last-in-First-Out (LIFO) Cost
The LIFO method assumes the last items added to the inventory are the first ones to be used or sold. It can provide better matching of current costs with current revenues but might not be allowed under certain accounting standards like IFRS.
5. Replacement Cost
Replacement cost is the current cost that would be incurred to replace an asset. This valuation method can provide insight into the cost needed to maintain service capacity.
Examples
- Average Cost: If a company manufactures 100 units at a total cost of $1,000, the average cost per unit is $10.
- FIFO Cost: A retailer with an inventory purchased in January for $10/unit, in February for $12/unit, and in March for $14/unit would sell the January inventory first under this method.
- Historical Cost: A piece of machinery bought for $50,000 would be recorded at that cost for accounting purposes.
- LIFO Cost: For the same retailer as above, the March inventory at $14/unit would be sold first under this method.
- Replacement Cost: If a used machinery piece bought for $50,000 now costs $60,000 to replace, the replacement cost is $60,000.
Frequently Asked Questions
Q: What is the difference between fixed cost and variable cost? A: Fixed costs do not change with the level of output, such as rent or salaries. Variable costs fluctuate with production volume, like raw material costs.
Q: Why are there different cost methods in accounting? A: Different cost methods are used to provide varying information, such as historical perspective, current replacement needs, or tax advantages, enabling better decision-making and financial reporting.
Q: Is the LIFO method allowed under all accounting standards? A: No, LIFO is not allowed under the International Financial Reporting Standards (IFRS) but is permitted under Generally Accepted Accounting Principles (GAAP) in the United States.
Related Terms with Definitions
- Fixed Cost: A cost that remains constant, irrespective of the level of production or sales.
- Marginal Cost: The cost of producing one additional unit of output.
- Opportunity Cost: The cost of forgoing the next best alternative when making a decision.
Online References
Suggested Books for Further Studies
- “Cost Accounting: A Managerial Emphasis” by Charles T. Horngren
- “Accounting Principles” by Jerry J. Weygandt, Paul D. Kimmel, & Donald E. Kieso
- “Managerial Accounting” by Ray Garrison, Eric Noreen, & Peter Brewer
Accounting Basics: “Cost” Fundamentals Quiz
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