Accountants, investors, business people, and market analysts all measure costs. Business expenses are indicators that explain past conditions and can be used to predict future conditions. Producers calculate costs to predict future business expenses and evaluate their performance. Accountants and investors are concerned with the tax implications of an asset's cost basis, which also helps inform future activity.

Key Takeaways:

  • Past business costs can be used to predict future business expenses and to evaluate performance.
  • Accountants and investors are concerned with the tax implications of an asset's cost basis, which also helps to inform future activity.
  • In most cases, production costs are calculated using the actual costs/actual output accounting method.
  • Other methods used are average cost; first in, first out; and specific identification.

Understanding Business Cost Calculation Methods

Depending on the context in terms of assets and actors, the term "cost" has slightly different meanings and may be calculated in different ways.

Calculating Costs: Producers

In most cases, calculating production costs is straightforward. The producer of a good or service normally uses the actual costs/actual output method of accounting. If a company incurs $100,000 in operating costs, and that leads to the production of 100,000 units of consumable goods, the producer realizes a simple $1:1 ratio of unit output.

Though simple, this figure helps to highlight both how efficiently a company operates and how well it has forecasted the future.

If producers have been extremely inefficient with material resources, or production is significantly less than capacity, other calculations are necessary when preparing an income statement. Otherwise, the actual costs/actual output is sufficient.

Calculating Costs: Cost Basis

Cost basis is the taxable amount paid for assets or investments and is particularly important for determining capital gains. The Internal Revenue Service allows for three separate methods of calculating costs for tax purposes: average cost; first in, first out (FIFO); and specific identification. Cost basis accounting varies depending on whether the items in question are stocks, bonds, mutual funds, capital equipment, or other assets.

For sake of brevity, the following descriptions are simplified and do not include several common variables, such as commissions paid or extra transaction fees incurred.

Average Cost

This is the most commonly used method for calculating cost basis on mutual funds and stocks. Here is the equation for average cost:

Average Cost per Share=Total Dollars InvestedTotal Number of Shares Held\text{Average Cost per Share} = \frac{\text{Total Dollars Invested}}{\text{Total Number of Shares Held}}Average Cost per Share=Total Number of Shares HeldTotal Dollars Invested

First In First Out

FIFO is a type of specific identification that forces the first purchased shares to be recorded as the first sold. For non-security items, the same logic is applied to inventory items; older items are recorded as being sold first. If no other method is specifically identified, FIFO is the default method used by the IRS.

Specific Identification

Specific identification is the most complicated—but sometimes the most tax-efficient—method for calculating costs. Here, accountants can select the specific shares or inventory items to be recorded when sales occur, allowing for transactions with the lowest tax basis to be chosen. There are many different types of specific identification.

The cost accounting method is selected based mostly on how well it can maximize tax efficiencies for financial transactions.