Chapter 2 – An introduction to cost terms and purposes
Costs and cost terminology
Accountants define cost as a resource sacrificed or forgone to achieve a specific objective. A cost is
usually measured as the monetary amount that must be paid to acquire goods or services. An actual
cost is the cost incurred, as distinguished from a budgeted cost, which is a predicted or forecasted
cost. When you think of cost, you invariably think of it in the context of finding the cost of a
particular thing. We call this thing a cost object.
How does a cost system determine the costs of various cost objects? Typically in two basic stages:
accumulation, followed by assignment. Cost accumulation is the collection of cost data in some
organized way by means of an accounting system. Managers and management accountants then
assign these accumulated costs to designated cost objects. This information can be used when
making decisions, and for implementing decisions.
Direct costs and indirect costs
- Direct costs of a cost object are related to the particular cost object and can be traced to it in
an economically feasible (cost-effective) way. The term cost tracing is used to describe the
assignment of direct costs to a particular cost object.
- Indirect costs of a cost object are related to the particular cost object but cannot be traced
to it in an economically feasible (cost-effective) way. The term cost allocation is used to
describe the assignment of indirect costs to a particular object. Cost assignment is a general
term that encompasses both (1) tracing direct costs to a cost object and (2) allocating
indirect costs to a cost object.
Factors affecting direct/indirect cost classifications
- The materiality of the cost in question. The smaller the amount of a cost – that is, the more
immaterial the cost is – the less likely that it is economically feasible to trace that cost to a
particular cost object.
- Available information-gathering technology. Improvements in information-gathering
technology make it possible to consider more and more costs as direct costs (e.g. bar codes).
- Design of operations. Classifying a cost as direct is easier if a company’s facility (or some part
of it) is used exclusively for a specific cost object, such as a specific product or a particular
customer.
Be aware that a specific cost may be both a direct cost of one cost object and an indirect cost of
another cost object. That is, the direct/indirect classification depends on the choice of the cost object.
A useful rule to remember is that the broader the definition of the cost object the higher the
proportion of total costs that are direct costs and the more confidence a manager has in the accuracy
of the resulting cost amounts.
Cost-behavior patterns: variable costs and fixed costs
Costing systems record the cost of resources acquired and track how those resources are used to
produce and sell products or services. Consider two basic types of cost-behavior patterns. A variable
cost changes in total in proportion to changes in the related level of total activity or volume. A fixed
cost remains unchanged in total for a given time period, despite wide changes in the related level of
total activity or volume. Costs are defined as variable or fixed with respect to a specific activity and
for a given time period.
1. Variable costs: the cost per unit of a variable cost is constant. Because the variable cost per
product is the same for each product the total variable cost changes proportionately with the
number of products produced. When considering how variable costs behave, always focus on
total costs.
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