Let's start with an example. Suppose you and your friend established a company that produces valves used in automotive industry and named this company Friends Corporation. How much should you charge for one valve in order to stay in business? How many valves should be sold in a given month at a given price to cover your costs?
These questions can be answered with the aid of cost information. Cost information can support managers in decision-making. Let us define a cost.
Cost is a payment of cash or its equivalent for the purpose of generating revenues.
In case of the valve production business we have purchased materials cost, labor costs, depreciation costs, rent costs, insurance costs, etc. All these costs are incurred for the purpose of generating profit from the product sales.
In financial accounting, costs and expenses are used interchangably. In managerial accounting, costs differ from expenses. Cost is the amount of resources given up in order to receive some good or service and represents future economic benefit to a company. An asset is a cost. As future economic benefit of an asset decreases, the original cost of the asset expires and the cost becomes an expense. Expenses are matched with revenues on the income statement. A good example for understanding a cost and expense would be a fixed asset. When it is purchased, it is a cost to an entity and is shown on the balance sheet. When the fixed asset is used, it is depreciated and a portion of the cost becomes a depreciation expense, which is included in the income statement and matched with the revenue generated during the period.
Costs are determined by the manufacturing process and primarily depend on the volume of production. Some costs change in proportion to units produced, some only slighly react to changes in production, and others don't change at all. The factors impacting changes in costs are cost drivers defined as follows:
Cost driver is any activity that causes change of costs over a given period of time. These activities are also called activity bases or activity drivers.
In our example of valve production, we would like to know how much material to buy to ensure uninterrupted production process. Common sense suggests that amount of material we will need to purchase is driven by the number of valves we produce. Therefore, the production level is the cost driver for material costs. Other examples of costs and their cost drivers are maintenance expense and number of hours equipment is used, or hourly labor costs and how many hours employees work per day.
