What is an Underlying Cost
An underlying cost is a cost that is associated with normal, ongoing business operations or production that can be predicted as part of the budget planning process. Underlying costs are costs that the company knows it will incur and be required to pay out throughout the upcoming budget period. A budget period refers to any period for which a company sets a budget, such as a month, quarter or calendar year. A company's ability to remain in full operation under the budget period is heavily dependent upon correct forecasting of underlying costs of normal business operations.
BREAKING DOWN Underlying Cost
Underlying costs are predictable expenses that are incurred and need to be paid in the next budgetary period, for example in the next month or the next calendar year. These costs are considered standard and usual. Some of the more common underlying costs come from utilities needed to operate and mortgage payments or rent paid on real estate. Unexpected costs can arise from natural disasters, equipment malfunctions or employee strikes, for example. These unusual costs are not counted toward underlying costs and are not used when forecasting future underlying costs.
Example of an Underlying Cost
As an example, assume a company calculates it normally costs $1 to produce widgets, and forecasts underlying costs for production at $1 each widget for the upcoming month of August. However, an unusual plant shutdown due to a hurricane results in costs increasing to $2 per widget for August. Although the realized cost of production was $2 due to the unusual plant shutdown, the underlying cost would remain at $1. This is also what the company would continue to project in upcoming budgetary periods, since the unexpected costs do not affect the underlying cost of each widget.