Cost Concepts: An Overview

One of the key objectives of managerial accounting is to assign costs to products, services and other entities of interest to management. Cost refers to the cash or cash-equivalent value sacrificed for goods or services that are expected to provide future benefits to an organization.

Businesses can be classified into merchandising, manufacturing and service organizations. All three types of organizations incur costs to produce and sell products/services. Management accounting systems should help in developing reasonably accurate product/service costs. These systems should be designed in a way that helps management trace costs to products and services. These costs are used to make a variety of decisions such as determining the profitability of a product/service and establishing prices for products/services

This section introduces basic cost concepts used by management accountants to measure and assign costs to products or services provided by an organization.


Variable Costs and Fixed Costs

Variable Costs are costs that vary in total in direct proportion to changes in activity. For example, the raw materials used in maufacturing a product is proportional to the number of units produced.

Fixed Costs are costs that remain constant in total over a specified range of activity. Examples include depreciation on the factory building, and supervisors' salaries. These costs do not change as the level of production changes.


Direct and Indirect Costs

Costs are classified as direct or indirect so that cost objects are evaluated only on the basis of those costs that are directly traceable to that object. A direct cost is one that can be physically traced to the particular cost object under consideration without undue cost or inconvenience. Cost objects include products, activities or departments for which costs are measured and assigned.

Indirect cost is one that cannot be accurately traced to the particular cost object under consideration without undue cost or inconvenience. For example, the cost of utilities cannot be easily traced to specific products. Such costs are allocated to cost objects.

For example, the cost of the raw materials used to produce a product can be traced to the product (direct cost). However, it may not be possible to trace rent on the factory building to a particular product (indirect cost).


Product and Period Costs

Product costs are assigned to the products that are manufactured rather than being expensed in the time periods in which these costs are incurred. Product costs are inventoried and are expensed when the related products are sold. Product costs are also known as inventoriable costs. In a manufacturing firm, product costs are the costs required to create finished goods such as costs of raw materials, wages of factory workers, salaries of factory managers, and depreciation on factory. In a merchandising firm, product costs are the costs of acquiring merchandise and getting them ready for sale. For service organizations, costs directly related to providing services to customers are called costs of services.

Period Costs are costs that cannot be assigned to products or services. Period costs are expensed in the time period in which they are incurred. Selling and administrative costs are considered to be period costs. Period costs are also called non-inventoriable costs.


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