MAC3761_ STUDY SUMMARY
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TOPIC 1
Cost Objects
A cost object is any activity for which a separate measurement of costs is desired. In other words, if
the users of accounting information want to know the cost of something, this something is called a
cost object. Examples of cost objects include the cost of a product, the cost of rendering a service to
a bank customer or hospital patient, the cost of operating a particular department or sales territory
or indeed anything for which one wants to measure the cost of resources used.
We shall see that the cost collection system typically accounts for costs in two broad stages:
1. It accumulates costs by classifying them into certain categories such as by type of expense
(e.g. direct labour, direct materials and indirect costs) or by cost behaviour (such as fixed and
variable costs).
2. It then assigns these costs to cost objects.
In this chapter we shall focus on the following cost terms and concepts:
direct and indirect costs;
period and product costs;
cost behaviour in relation to volume of activity;
relevant and irrelevant costs;
avoidable and unavoidable costs;
sunk costs;
opportunity costs;
incremental and marginal costs.
Manufacturing, Merchandising and Service Organizations
To provide a better understanding of how different cost terms are used in organizations it is
appropriate to describe the major features of activities undertaken in the manufacturing,
merchandising and service organizations. Manufacturing organizations purchase raw materials from
suppliers and convert these materials into tangible products through the use of labour and capital
inputs (e.g. plant and machinery). This process results in manufacturing organizations having the
following types of inventories:
Raw material inventories consisting of purchased raw materials in stock awaiting use in the
manufacturing process.
Work in progress inventory (also called work in process) consisting of partially complete
products awaiting completion.
Finished goods inventory consisting of fully completed products that have not yet been sold.
Merchandising companies such as supermarkets, retail departmental stores and wholesalers sell
tangible products that they have previously purchased in the same basic form from suppliers.
Therefore they have only finished goods inventories. Service organizations such as accounting firms,
insurance companies, advertising agencies and hospitals provide tasks or activities for customers. A
major feature of service organizations is that they provide perishable services that cannot be stored
for future use. Therefore service organizations do not have finished goods inventory but some
service organizations do have work in process. For example, a firm of lawyers may have clients whose
work is partially complete at the end of the accounting period.
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Direct and Indirect Costs
Direct materials
Direct labour
Indirect costs
Distinguishing between direct and indirect costs
Assigning direct and indirect costs to cost objects
Costs that are assigned to cost objects can be divided into two broad categories – direct and indirect
costs. Both categories can be further divided into direct and indirect materials and direct and indirect
labour costs.
Direct materials
Direct material costs represent those material costs that can be specifically and exclusively
identified with a particular cost object. In manufacturing organizations where the cost object is a
product, physical observation can be used to measure the quantity consumed by each individual
product and the cost of direct materials can be directly charged to them. In other words, direct
materials become part of a physical product. For example, wood used in the manufacture of different
types of furniture can be directly identified with each specific type of furniture such as chairs, tables
and bookcases.
The term direct material is normally not applicable to merchandising and service organizations. The
equivalent term in a merchandising organization is the purchase cost of the items that are for resale.
For example, with a departmental store where the cost object is a department (e.g. televisions and
DVD players, computers, clothing and furniture departments) the purchase cost of the goods from
the suppliers will be directly charged to the appropriate department that resells the goods. Some
service organizations do purchase materials or parts to provide a service. For example, a garage may
purchase parts for vehicle repairs. These parts can be identified with the repair of each customer's
vehicle (i.e. the cost object) and thus are equivalent to direct materials.
Direct labour
Direct labour costs are those labour costs that can be specifically and exclusively identified with a
particular cost object. Physical observation can be used to measure the quantity of labour used to
produce a specific product or provide a service. The direct labour cost in producing a product
includes the cost of converting the raw materials into a product, such as the costs of the machine
operatives engaged in the production process in the manufacture of televisions. The direct labour
cost used to provide a service includes the labour costs in providing a service that can be specifically
identified with an individual client or with a specific instance of service. The direct labour costs for a
departmental store are the labour costs of the staff that can be attributed specifically to a
department.
Indirect costs
Indirect costs cannot be identified specifically and exclusively with a given cost object. They consist
of indirect labour, materials and expenses. In a manufacturing organization where products are the
cost object, the wages of all employees whose time cannot be identified with a specific product,
represent indirect labour costs. Examples include the labour cost of staff employed in the
maintenance and repair of production equipment and staff employed in the stores department. The
cost of materials used to repair machinery cannot be identified with a specific product and can
therefore be classified as indirect material costs. Examples of indirect expenses in manufacturing,
service or a departmental store where products, the provision of a service or departments are the
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cost objectives, include lighting and heating expenses and property taxes. These costs cannot be
specifically identified with a particular product, service or department.
The term ‘overheads ’ is widely used instead of indirect costs. In a manufacturing organization
overhead costs are categorized as either manufacturing, administration and marketing (or selling)
overheads. Manufacturing overheads include all the costs of manufacturing apart from direct labour
and material costs. Administrative overheads consist of all costs associated with the general
administration of the organization that cannot be assigned to either manufacturing, marketing and
distribution overheads. Examples of administrative overheads include top-executive salaries, general
accounting, secretarial and research and development costs. Those costs that are necessary to
market and distribute a product or service are categorized as marketing (selling) costs, also known as
order-getting and order-filling costs. Examples of marketing costs include advertising, sales personnel
salaries/commissions, warehousing and delivery transportation costs.
Figure 2.1 illustrates the various classifications of manufacturing and non-manufacturing costs. You
will see from this figure that two further classifications of manufacturing costs are sometimes used.
Prime cost consists of all direct manufacturing costs (i.e. it is the sum of direct material and direct
labour costs). Conversion cost is the sum of direct labour and manufacturing overhead costs. It
represents the cost of converting raw materials into finished products.
FIGURE 2.1 Manufacturing and non-manufacturing costs
Distinguishing between direct and indirect costs
Sometimes, direct costs are treated as indirect because it is not cost effective to trace costs directly
to the cost object. For example, the nails used to manufacture a particular desk can be identified
specifically with the desk, but, because the cost is likely to be insignificant, the expense of tracing
such items does not justify the possible benefits from calculating more accurate product costs.
The distinction between direct and indirect costs also depends on the cost object. A cost can be
treated as direct for one cost object but indirect in respect of another. For example, if the cost object
is the cost of using different distribution channels, then the rental of warehouses and the salaries of
storekeepers will be regarded as direct for each distribution channel. If, on the other hand, the cost
object is the product, both the warehouse rental and the salaries of the storekeepers will be an
indirect cost because these costs cannot be specifically identified with the product.
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