Accountants, investors, businessmen and market analysts alike are all faced with the task of measuring costs. The expenses of business activity act as signals to economic actors, explaining past conditions and predicting the future ones. Producers need to calculate costs to predict future business expenses and evaluate their own performance. Accountants and investors are concerned with the tax implications of an asset's cost basis, which also helps to inform future activity.
Depending on about which assets and for what actors you are discussing, "cost" has slightly different meanings and may be calculated in different ways.
Calculating Costs: Producers
In most cases, production costs are straightforward to calculate. 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 been able to forecast 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, actual costs/actual output is sufficient.
Calculating Costs: Cost Basis
Cost basis represents 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 and specific identification. Cost basis accounting varies depending on if 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.
This is the most commonly used method for calculating cost basis on mutual funds and stocks. Here is the equation for average cost:
Total Dollars Invested ÷ Total Number of Shares Held = Average Cost per Share
First In First Out
FIFO is technically 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 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 take place, allowing for transactions with the lowest tax basis to be chosen. There are many different types of specific identification.
The most significant purpose for selecting different methods of cost accounting is to maximize tax efficiency for financial transactions.