The words "cost" and "price" are often used interchangeably, however, when it comes to accounting and financial statements, both words mean something different. When conducting any financial analysis, before making any investment decisions, it's important to understand the difference between the two and how they play a part in a company's financial profile.
- Cost is typically the expense incurred for making a product or service that is sold by a company.
- Price is the amount a customer is willing to pay for a product or service.
- The cost of producing a product has a direct impact on both the price of the product and the profit earned from its sale.
Cost vs. Price
Cost is typically the expense incurred for creating a product or service being sold by a company. The costs involved in manufacturing might include the raw materials used in making the product. The amount of cost it takes to produce a product can have a direct impact on both the price of the product and the profit earned from its sale.
Price is the amount a customer is willing to pay for a product or service. The difference between the price paid and the costs incurred is the profit. If a customer paid $10 for an item that cost $6 to produce and sell, the company earned $4 in profit.
For some companies, the total costs of making a product are listed under the cost of goods sold, which is the total of the direct costs involved in production. These costs might include direct materials, such as raw materials, and direct labor for the manufacturing plant.
On the other hand, a retail store might include a portion of the building's operating expenses and the sales associate's salary in their costs. For the items sold through the company's website rather than the physical store, the expenses of designing and operating the website might be included in the costs.
Every company must determine the price customers will be willing to pay for their product or service, while also being mindful of the cost of bringing that product or service to market.
The appropriate price of a product or service is based on supply and demand. The two opposing forces are always trying to achieve an equilibrium where the quantity of the goods or services provided matches the demand of the corresponding market and its ability to acquire the good or service. The concept allows for price adjustments as market conditions change.
For example, suppose that market forces determine that a widget costs $5. A widget buyer is, therefore, willing to forgo the utility in $5 to possess the widget, and the widget seller perceives that $5 is a fair price for the widget. This simple theory of determining prices is one of the core principles underlying economic theory.
Supply is the number of products or services the market can provide, including tangible goods, such as automobiles, or intangible goods, such as the ability to make an appointment with a skilled service provider. In each instance, supply is finite—there are only a certain number of automobiles and appointments available at any given time.
Demand is the market’s desire for the item, tangible or intangible. The number of potential consumers available is always finite as well. Demand may fluctuate depending on a variety of factors, such as an item's perceived value, or affordability, by the consumer market.
The Bottom Line
Though similar in everyday language, cost and price are two different but related terms. The cost of a product or service is the monetary outlay incurred to create a product or service, whereas the price, determined by supply and demand in a free market, is what an individual is willing to pay and a seller is willing to sell for a product or service.