Cost and price are often used interchangeably, however, the two words mean something different when it comes to accounting and financial statements. When conducting financial analysis or making investment decisions, it's important to understand the difference between cost and price and how they impact 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 a company sells. The cost to manufacture a product might include the cost of raw materials used. The amount of cost that goes into producing a product can directly impact its price and profit earned from each sale.
Price is the amount a customer is willing to pay for a product or service. The difference between price paid and costs incurred is profit. If a customer pays $10 for a product that costs $6 to make and sell, the company earns $4 in profit.
Some companies will list the total cost to make a product under cost of goods sold (COGS) on their financial statements. COGS is the total of 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 salaries for sales associates in their costs. For items sold through a website rather than physical store, the expense of operating the website might be included in 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 equilibrium, whereby the quantity of goods or services provided matches the market demand and its ability to acquire the goods or service. The concept allows for price adjustments as market conditions change.
For example, suppose that market forces determine 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 $5 as 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 example, 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.