Cost and Cost Terminology:
Cost is a resource sacrificed or forgone to achieve a specific objective. It is usually measured as the monetary amount that must be paid to acquire goods and services. A cost must not be confused with an expense, that is that part of costs of the goods or services that has been used up in the process of generating revenues. Actual Cost is the cost incurred (a historical cost) as distinguished nom budgeted costs.
Cost Object is any activity, product, service or other item for which we can make a separate cost measurement. Examples would include a product, sales area, TV advertising campaign, employee, delivery van etc.
Costs Classification
Costs may be analysed into: Manufacturing costs (factory/ production) - Direct: labour, materials and variable overhead Indirect: manufacturing support Non-manufacturing costs - Selling and Marketing, Distribution, Research and Development Finance, General & Administrative
Handout: Cost classification
There are two basic stages of accounting for costs:
1) Cost Accumulation: the collection of cost data in some organised way based on some natural classification such as materials or labour, using an accounting system.
2) Cost Assignment: involves
(a) tracing accumulated costs to one or more cost objects; and
(b) allocating/apportioning accumulated costs to one or more cost objects such as activities, departments, products, customers etc.
Handout: Basic cost concepts:
Cost Assignment Methods
Traceability is the ability to assign a cost directly to a cost object in an economically feasible way using a causal relationship. Tracing is the assignment of costs to cost objects using either an observable measure of the cost object s resource consumption or factors that allegedly capture the causal relationship. “ Drivers are factors that cause changes in resource usage, activity usage, costs and revenues. Resource drivers measure the demands placed on resources by activities and are used to assign the cost of resources to activities by allocation and apportionment.
For example, factory rates apportioned by floor space or supervisor time allocated to different production departments.
Resource drivers also allocate/apportion service activities to production activities. Activity drivers measure the demands placed on activities by cost objects and are used to assign the cost of activities to cost objects. For example, the number of inspection hours used to assign the cost of inspection to individual products, or machine hours as a basis for absorbing departmental indirect costs.
Direct tracing is the process of assigning costs to cost objects based on physically observable causal relationships (direct materials and labour).
Driver tracing is assigning costs using drivers, which are causal factors. Often this means that costs are first traced to activities using resource drivers and then to cost objects using activity drivers. The driver approach relies on identification of factors that allegedly capture the causal relationship.
Handout: Functional cost classification
All costs can broadly be classified into manufacturing and non-manufacturing costs. Manufacturing costs include all costs of converting raw materials into completed products and non-manufacturing costs are all costs other than manufacturing costs. Manufacturing costs can further be divided into direct costs and indirect costs.
• direct costs of a cost object are those that are related to a given cost object (product, department. etc.) and that calibe traced to it in an economically feasible way. Direct costs can be divided into direct materials and direct labour (and possibly direct expenses).
• indirect costs are related to the particular cost object but cannot be traced to it in an economicallyfeasible way instead the costs are allocated to cost objects.
Identifying product costs for a manufacturing firm
There are typically two major cost elements:
• Direct costs
• Indirect overhead Cost
The direct costs include direct materials, labour and expenses.
The overhead costs include indirect material, labour and expenses split between:
• Establishment costs (expenses incurred in providing the product or service environment [factory overheads]
• Selling and Distribution costs (all costs of marketing and distributing the product); Administration costs (all costs of directors, managers and administrators and their associated expenses in terms of office overheads)
• Finance costs (all costs of borrowed capital including interest and expenses incurred in raising funds) For product costs we are concerned with direct costs and establishment costs.
Direct vs. indirect materials
The cost of those materials and components that can be directly and conveniently traced to a unit of product are called direct materials (e.g. steel, windscreen-wipers or gearbox In a car). _Materials not directly traceable, and those extremely small in monetary value, are typically called indirect materials (e.g. dishwasher detergent in a fast-food restaurant, oil for production equipment, rags for cleaning or screws in a furniture factory)
Direct VS. indirect labour
The costs of production labour that can be directly and conveniently traced to a unit of product are called direct labour (e.g. workers on an assembly line, or chef in a restaurant) is direct labour, while labour costs that are not directly traceable, or those extremely small in monetary value, are typically called indirect labour (e.g. storekeepers, foremen, or secretaries)
Production/factory/manufacturing overheads
All costs related to the manufacturing operations, except for direct materials and direct labour, are called production/factory/ manufacturing overhead. Examples of such costs include, factory rent, factory rates, factory heating and lighting, depreciation of plant and equipment, insurance of the factory, and store costs.
