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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Benchmarking
A study of organizations that are among the best in the world at performing a particular task.

Budget
A detailed plan for the future, usually expressed in formal quantitative terms.

Business process
A series of steps that are followed in order to carry out some task in a business.

Constraint
Anything that prevents an organization or individual from getting more of what it wants.

Control
The process of instituting procedures and then obtaining feedback to ensure that all parts of the organization are functioning effectively and moving toward overall company goals.

Controller
The manager in charge of the accounting department in an organization.

Controlling
Ensuring that the plan is actually carried out and is appropriately modified as circumstances change.

Cycle time
See Throughput time.

Decentralization
The delegation of decision-making authority throughout an organization by providing managers at various operating levels with the authority to make key decisions relating to their area of responsibility.

Directing and motivating
Mobilizing people to carry out plans and run routine operations.

Feedback
Accounting and other reports that help managers monitor performance and focus on problems and/or opportunities that might otherwise go unnoticed.

Financial accounting
The phase of accounting concerned with providing information to stockholders, creditors, and others outside the organization.

Finished goods
Units of product that have been completed but have not yet been sold to customers.

Just-in-time (JIT)
A production and inventory control system in which materials are purchased and units are produced only as needed to meet actual customer demand.

Line
A position in an organization that is directly related to the achievement of the organization's basic objectives.

Managerial accounting
The phase of accounting concerned with providing information to managers for use in planning and controlling operations and in decision making.

Non-value-added activity
An activity that consumes resources or takes time but that does not add value for which customers are willing to pay.

Organization chart
A visual diagram of a firm's organizational structure that depicts formal lines of reporting, communication, and responsibility between managers.

Performance report
A detailed report comparing budgeted data to actual data.

Plan-do-check-act (PDCA) cycle
A systematic approach to continuous improvement that applies the scientific method to problem solving.

Planning
Selecting a course of action and specifying how the action will be implemented.

Planning and control cycle
The flow of management activities through planning, directing and motivating, and controlling, and then back to planning again.

Process Reengineering
An approach to improvement that involves completely redesigning business processes in order to eliminate unnecessary steps, reduce errors, and reduce costs.

Raw materials
Materials that are used to make a product.

Segment
Any part of an organization that can be evaluated independently of other parts and about which the manager seeks financial data. Examples include a product line, a sales territory, a division, or a department.

Setup
Activities that must be performed whenever production is switched over from making one type of item to another.

Staff
A position in an organization that is only indirectly related to the achievement of the organization's basic objectives. Such positions are supportive in nature in that they provide service or assistance to line positions or to other staff positions.

Theory of constraints (TOC)
A management approach that emphasizes the importance of managing constraints.

Throughput time
The time required to make a completed unit of product starting with raw materials. Throughput time is also known as cycle time.

Total quality management (TQM)
An approach to continuous improvement that focuses on customers and using teams of front-line workers to systematically identify and solve problems.

Work in process
Units of product that are only partially complete and will require further work before they are ready for sale to a customer.

Process costing is used in situations where homogeneous products or services are produced on a continuous basis. Costs flow through the manufacturing accounts in basically the same way in both job-order and process costing systems. A process costing system differs from a job-order system primarily in that costs are accumulated by department (rather than by job) and the department production report replaces the job cost sheet.

To compute unit costs in a department, the department's output in terms of equivalent units must be determined. In the weighted-average method, the equivalent units for a period are the sum of the units transferred out of the department during the period and the equivalent units in ending work in process inventory at the end of the period.

The activity in a department is summarized on a production report. There are three separate (though highly interrelated) parts to a production report. The first part is a quantity schedule, which includes a computation of equivalent units and shows the flow of units through a department during a period. The second part consists of a computation of costs per equivalent unit, with unit costs being provided individually for materials, labor, and overhead as well as in total for the period. The third part consists of a cost reconciliation, which summarizes all cost flows through a department for a period.

Key Terms to learn in Process Costing

Conversion cost
direct labor cost plus manufacturing overhead cost.

Cost reconciliation
The part of a production report that shows what costs a department has to account for during a period and how those costs are accounted for.

Equivalent units
The product of the number of partially completed units and their percentage of completion with respect to a particular cost. Equivalent units are the number of complete whole units one could obtain from the materials and effort contained in partially completed units.

Equivalent units of production (weighted-average method)
The units transferred to the next department (or to finished goods) during the period plus the equivalent units in the department's ending work in process inventory.

FIFO method
A method of accounting for cost flows in a process costing system in which equivalent units and unit costs relate only to work done during the current period.

Operation costing
A hybrid costing system used when products are manufactured in batches and when the products have some common characteristics and some individual characteristics. This system handles materials the same as in job-order costing and labor and overhead the same as in process costing.

Process costing
A costing method used in situations where essentially homogeneous products are produced on a continuous basis.

Processing department
Any location in an organization where work is performed on a product and where materials, labor, or overhead costs are added to the product.

Production report
A report that summarizes all activity in a department's Work in Process account during a period and that contains three parts: a quantity schedule and a computation of equivalent units, a computation of total and unit costs, and a cost reconciliation.

Quantity schedule
The part of a production report that shows the flow of units through a department during a period and a computation of equivalent units.

Transferred-in cost
The cost attached to products that have been received from a prior processing department.

Weighted-average method
A method of process costing that blends together units and costs from both the current and prior periods.
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Job-order costing and process costing are widely used to track costs. Job-order costing is used in situations where the organization offers many different products or services, such as in furniture manufacturing, hospitals, and legal firms. Process costing is used where units of product are homogeneous, such as in flour milling or cement production.

Materials requisition forms and labor time tickets are used to assign direct materials and direct labor costs to jobs in a job-costing system. Manufacturing overhead costs are assigned to jobs through use of a predetermined overhead rate. The predetermined overhead rate is determined before the period begins by dividing the estimated total manufacturing cost for the period by the estimated total allocation base for the period. The most frequently used allocation bases are direct labor-hours and machine-hours. Overhead is applied to jobs by multiplying the predetermined overhead rate by the actual amount of the allocation base used by the job.

Since the predetermined overhead rate is based on estimates, the actual overhead cost incurred during a period may be more or less than the amount of overhead cost applied to production. Such a difference is referred to as under- or overapplied overhead. The under- or overapplied overhead for a period can be either (1) closed out to Cost of Goods Sold or (2) allocated between Work in Process, Finished Goods, and Cost of Goods Sold. When overhead is underapplied, manufacturing overhead costs have been understated and therefore inventories and/or expenses must be adjusted upwards. When overhead is overapplied, manufacturing overhead costs have been overstated and therefore inventories and/or expenses must be adjusted downwards

Key Terms to learn in Job Order Costing

Absorption costing
A costing method that includes all manufacturing costs - direct materials, direct labor, and both variable and fixed overhead - as part of the cost of a finished unit of product. This term is synonymous with full cost.

Allocation base
A measure of activity such as direct labor-hours or machine-hours that is used to assign costs to cost objects.

Bill of materials
A document that shows the type and quantity of each major item of materials required to make a product.

Cost driver
A factor, such as machine-hours, beds occupied, computer time, or flight-hours, that causes overhead costs.

Full cost
See Absorption costing.

Job cost sheet
A form prepared for each job that records the materials, labor, and overhead costs charged to the job.

Job-order costing system
A costing system used in situations where many different products, jobs, or services are produced each period.

Materials requisition form
A detailed source document that specifies the type and quantity of materials that are to be drawn from the storeroom and identifies the job to which the costs of materials are to be charged.

Multiple predetermined overhead rates
A costing system in which there are multiple overhead cost pools with a different predetermined rate for each cost pool, rather than a single predetermined overhead rate for the entire company. Frequently, each production department is treated as a separate overhead cost pool.

Normal cost system
A costing system in which overhead costs are applied to jobs by multiplying a predetermined overhead rate by the actual amount of the allocation base incurred by the job.

Overapplied overhead
A credit balance in the Manufacturing Overhead account that arises when the amount of overhead cost applied to Work in Process is greater than the amount of overhead cost actually incurred during a period.

Overhead application
The process of charging manufacturing overhead cost to job cost sheets and to the Work in Process account.

Plantwide overhead rate
A single predetermined overhead rate that is used throughout a plant.

Predetermined overhead rate
A rate used to charge overhead cost to jobs in production; the rate is established in advance for each period by use of estimates of total manufacturing overhead cost and of the total allocation base for the period.

Process costing system
A costing system used in those manufacturing situations where a single, homogeneous product (such as cement or flour) is produced for long periods of time.

Time ticket
A detailed source document that is used to record an employee's hour-by-hour activities during a day.

Underapplied overhead
A debit balance in the Manufacturing Overhead account that arises when the amount of overhead cost actually incurred is greater than the amount of overhead cost applied to Work in Process during a period.

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