What Are Common Costs in Business and Accounting?

Understanding the various types of costs is fundamental for informed financial decisions. A cost represents an expenditure incurred to acquire or produce goods or services. These expenditures are central to financial understanding, serving as the foundation for analyzing performance and making strategic choices. Recognizing how different costs behave provides clarity in financial statements and operational analyses.

Basic Cost Classifications

Costs are categorized by how they behave in relation to changes in activity levels: fixed, variable, or mixed. Fixed costs are expenses that remain constant in total, regardless of the volume of goods produced or services rendered within a relevant range. Examples include monthly rent, annual insurance premiums, or depreciation of equipment.

Variable costs are expenses that change in direct proportion to the level of activity or production. Direct materials used in manufacturing, such as raw ingredients, and direct labor wages paid per unit produced are common examples. Sales commissions also exemplify variable costs because their total amount fluctuates with sales activity.

Mixed costs, sometimes called semi-variable costs, contain both a fixed and a variable component. A typical example is a utility bill, which might have a fixed service charge plus a variable charge based on consumption. Operating an automobile also presents mixed costs, where insurance might be fixed, but fuel varies with miles driven.

Costs by Business Function

Costs are categorized based on the specific function where they are incurred. Operating costs are expenses incurred in the normal course of business operations to generate revenue.

Cost of Goods Sold (COGS) is a primary operating cost for businesses that produce or sell goods. COGS includes direct costs attributable to the production of goods sold. Components include raw materials, direct labor, and manufacturing overhead. This cost is subtracted from revenue to determine gross profit.

Another major category of operating costs is Selling, General, and Administrative (SG&A) expenses. SG&A includes non-production costs related to selling products or services and managing the overall business. Examples range from marketing and advertising expenses to the salaries of administrative staff, office supplies, and rent for office spaces. These expenses are necessary to support the business but are not directly tied to the creation of the product itself.

Beyond core operating costs, businesses also incur non-operating costs, which are expenses not directly related to a company’s main business activities. These can include interest expense paid on borrowed funds or losses incurred from the sale of non-core assets. Research and Development (R&D) costs represent another functional category, encompassing expenses associated with innovation, product improvement, and the development of new products or services.

Costs by Traceability

Costs can also be distinguished by how easily and directly they can be assigned to a specific cost object, such as a product, service, or department. Direct costs are expenses that can be clearly and conveniently traced to a particular cost object. These costs would not be incurred if the specific product or service were not produced.

For instance, the cost of the raw materials that become a physical part of a finished product, like the wood for a furniture piece, is a direct cost. Similarly, the wages paid to a worker who directly assembles that furniture piece are considered direct labor costs. These costs are explicitly linked to the creation of the specific item.

Indirect costs, often referred to as overhead, are expenses that cannot be directly or easily traced to a specific cost object. Instead, they are incurred for the benefit of multiple cost objects or the overall operation of the business. These costs must be allocated among the various products, services, or departments that benefit from them.

Examples of indirect costs include the rent for an entire factory building, the utility bills for the entire plant, or the salaries of factory supervisors who oversee multiple production lines. While these costs are necessary for production, it is impractical to pinpoint exactly how much of the factory’s electricity or a supervisor’s salary is attributable to a single unit of product.

Costs by Accounting Treatment

The distinction between product costs and period costs is significant for financial reporting and inventory valuation, impacting how costs appear on financial statements. Product costs are all costs directly associated with the production of goods for sale. These costs are considered “inventoriable,” meaning they attach to the product as it moves through the production process and become part of the inventory’s value on the balance sheet.

Product costs include direct materials, direct labor, and manufacturing overhead. These costs are not expensed immediately but are recognized as an expense, specifically as Cost of Goods Sold (COGS), only when the related product is sold. This accounting treatment ensures that revenues are matched with the costs incurred to generate those revenues.

Period costs, conversely, are expenses that are not directly tied to the production process and are expensed in the accounting period in which they are incurred. Unlike product costs, they are not capitalized into inventory. These are typically non-manufacturing costs, such as selling, general, and administrative expenses.

Period costs are recognized on the income statement in the period they occur, regardless of when products are sold. For example, the rent for a company’s sales office or the salary of an administrative assistant are period costs. This classification impacts a company’s reported net income and the value of its inventory, providing a clear picture of operational versus production-related expenses.