What is cost?

Cost Definition

Cost is the sacrifice made, usually measured by the resources given up, to achieve a particular purpose. A sacrifice made in order to obtain some goods or services

  • Costs are not always Expenses.
  • Some costs are Assets, other costs are Expenses
  • Expenses are Expired (Used up) Costs

Eventually, costs will become expenses.


Cost measurement and allocation are a significant aspect of financial and management accounting. Cost measurement and allocation techniques are used not only to assign incurred costs to products or services but also to plan future activities.

In accounting, the term cost has a variety of meanings and a variety of cost concepts and measurement techniques are needed for internal planning and control.

The purpose of this article is to analyze the cost classifications and behavior patterns that are widely used in management accounting. Such an analysis would specifically help the management accountant specifically when he is supplying information for planning and decision-making purposes.

Types of cost

Cost may be defined as the amount measured in terms of money, paid in consideration of goods and services received or to be received. Accountants and managers use many different cost concepts and these different costs are used for different purposes. It is the classification of cost which indicates to the managers how the term is being used and whether they can do anything about the cost or not. Below are important types of cost.

Product cost

It is cost assigned to goods either purchased or manufactured for resale. Costs that are incurred for
producing or buying a product. Product costs are initially identified as part of the inventory on hand. (Raw materials, Work-in-process, Finished goods).

Inventoriable cost

It is another name for product cost, and it is stored as the cost of inventory until the goods are sold. Become expenses (Cost of goods sold) when the product is sold.

Period cost

Period costs are expensed during the time period in which they are incurred. Costs that are treated as expenses of the period in which the costs are incurred.


An expense is the consumption of assets for the purpose of generating revenue.

Direct cost

Cost that can be traced to specific segments of operations

Indirect cost

Cost that cannot be identified with particular segments. Common costs, Shared by multiple segments.


Segments = Plastic chairs (P) & Wood chairs (W)

Cost and its types - Example

Manufacturing cost

Product costs consisting of:

Direct material (DM)
Direct labor (DL)
Manufacturing overhead (MOH, OH)

Manufacturing cost formula:

Manufacturing costs = DM + DL + MOH

Direct material (DM)

It is raw material that is physically incorporated into the finished product.

Direct labor cost

It is the cost of salaries, wages, and fringe benefits for personnel who work directly on the manufactured products.

Manufacturing overhead

Manufacturing costs other than direct material and direct labor costs.

  • Indirect material
    These are required for the production process but do not become an integral part of the finished product.
  • Indirect labor
    It is the cost of personnel who do not work directly on the product. but whose services are necessary for the manufacturing process.

Conversion cost

Conversion costs are direct labor costs plus manufacturing-overhead costs.

Prime costs

These are the costs of direct material and direct labor.

Non-manufacturing cost

Period costs (expenses) incurred in and Administrative activities.

Variable cost

A variable cost changes in total in direct proportion to a change in the level of activity.

Fixed cost

It does not change in total as activity changes.

Marginal cost

Extra cost incurred in producing an additional unit is called marginal cost.

Incremental cost

These types of costs are the difference between costs for the corresponding items under each alternative
being considered. For example, incremental cost increasing output from $1 000 to $1 100 units per week is the additional cost of producing an extra 100 units per week.

Difference between marginal and incremental cost

The main difference is that marginal cost represents the additional cost of one extra unit of output whereas incremental cost represents the additional cost resulting from a group of additional units of output.

Sunk cost

These are the 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. Written down values of any asset previously purchased are the examples of sunk costs.

Opportunity cost

It 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. It is important to note that opportunity cost only applies to such resources that have some alternative uses. If no alternative use of resources exists then the opportunity cost is zero.

Cost of goods sold

It is the expense measured by the cost of the finished goods sold during a period of time.

Work in process

Partially completed products not yet ready for sale.

Finished goods

Completed goods available for sale.

Elements of Cost

The elements of cost are as under:

  1. Material
  2. Labor
  3. Factory Overhead

1. Materials

These are the principal substance used in production that are transformed into finished goods by the addition of labor and factory overhead. The cost of materials may be divided into direct and indirect materials as follows:

(a). Direct Materials

Direct material is all that materials which can be identified in the product and can be conveniently measured and directly charged to the product, or, all materials that can be identified with the product, that can be easily traced to product and that represents a major material cost of producing that product. Example of a direct materials are wood in furniture, iron in fans, clay in bricks, leather in shoes and wheet in flour, etc.

(b). Indirect Materials

All materials involved in the production of a product that are not direct materials. For example, nails and glue used in the manufacturing of a table, etc. In other words, these materials cannot directly identified or traced out.

2. Labor

labor is physical or mental effort expended in the production of a product. Labor costs may be divided into direct and indirect labor as follows:

(a). Direct Labor

all labor directly involved in the production of a finished product; that can be easily traced to the product; and that represents a major labor cost of producing that product. The work of machine operators in a manufacturing concern would be considered direct labor.

(b). Indirect Labor

All labor involved in the production of a product that is not considered direct labor. The work of the plant supervisor in a manufacturing concern would be considered indirect labor.

3. Factory Overhead

This is all the cost other than direct materials and direct labor of producing a product. Because the cost of any product equals the cost of direct materials, direct labor and factory overhead. Indirect material and indirect labor are also included in Factory Overhead because they can not be identified with a specific product. Other example of factory overhead cost besides indirect materials and indirect labor are rents, light and heat for the factory and depreciation of factory equipment. Factory overhead cost can be further classified as fixed, variable and semi-variable costs.

by grouping the above elements of cost, the following divisions of costs are obtained:

  1. Prime cost = Direct Material + Direct Labor
  2. Conversion cost = Direct labor + Factory Overhead
  3. Factory Cost = Direct Materials + Direct Labor + Factory overhead.

Leave a Comment