What is Notional cost?

Notional means imaginary, speculative or conceptual i.e. something that has no actual existence and is mere imagination.

Same way a notional cost is an imaginary cost which is sometimes included in the cost units and cost centers to make costing estimates more realistic or simply more challenging especially when the performance of cost unit and cost center is in question in comparison with such other competitors which are not enjoying the same level of benefits.

Let’s understand it with an example.

An entity owns one piece of land which is vacant. Management is planning to install the machinery of a new product which is expected to be available in the market in coming months. As this piece of land was available for installing the machinery and later produce the inventory, no cost of hiring a land i.e. rental costs will be included in the product. But assume that majority of other producers in the market have hired the land and thus including rental cost as production overheads.

In such situation if management wants to compare its production cost with the production cost of the competitors then it must include “market rent” of this land in the product. As management is not actually paying any rent therefore, any amount included in the production cost towards imaginary rent is notional cost. This will help management to benchmark their performance and cost standards. If management had the opportunity of vacant land and not paying the rent then this opportunity must be taken as an added competitive edge and must not be wasted by making poor cost standards as management has more margin of incurring costs on other aspects.

For example, if an entity is manufacturing a particular product and its per unit cost is $20 whereas its competitor is also producing the same product and its per unit cost of production is also $20 then it might seem that entity is doing a good job by producing at same cost level.

However, if we are told that competitor has installed its production facility on rental land and thus incurring rental cost which is included in the production cost of inventory. Whereas entity has installed the production facility on its own land and not paying any rent. Then the production cost of $20 is not justified as competitor is managing a $20 /unit mark including rental cost whereas entity’s production cost does not include rental cost which in other words mean that competitor is working much more efficient ly whereas entity is unable to cash on its additional facilities which should have been a competitive edge leading towards lesser per unit cost.

The situation will become clearer when entity includes the same amount of rent (notional cost), as being paid by the competitor, includes in the production cost which will surely reveal that entity’s production cost is higher then its competitor.

However, students should not confuse notional costs with opportunity costs as both very different concepts and have different implications.