Introduction to Cost Terms and Purposes
Acost is the value of economic resources (e.g., money) sacrificed or used up to achieve a particular objective
(e.g., produce a product or perform a service). Following are some examples of costs that may be incurred by a
o On Jan. 1, 2007 ABC Co. purchased a machine for $100,000 to be used in producing a certain product “X”.
The cost of acquiring the machine is the amount paid or to be paid in future so as to acquire the machine for the
purpose of using it in production activities.
o During 2007, ABC consumed 20% of the value of the machine in production. Part of the cost of producing
product “X” is the amount of resources consumed from the machine during 2007, which is called depreciation
$20,000 (100,000 * 20%).
A cost object is anything for which a separate measurement of cost is desired or needed (e.g., cost of a
product, a machine, a service, or a process).
Cost objects can vary in size from an entire company, to a division or program within the company, or down
to a single product or service.
A cost driver is any activity (e.g., production volume) or factor (e.g., time) that causes the total amount spent
on a particular cost object to change. For example, the total cost of renting a car is driven by all or some of the
following factors: number of miles driven, number of days the car is rented, the type and/size of the car,…etc.
Each of these factors is a cost driver for cost of renting a car.
Change in the cost driver result in a changes in the total costs incurred.
As a manager, you should attempt to continuously reduce costs by efficiently managing the use of cost
drivers. Thus, identifying the cost drivers is the first step to control costs.
Drive the costs up or down.
1. seen in the final product
2. economic/visible to trace
Direct: related to production
Indirect: unrelated to the production, such as security guards.
Variable Overhead cost
Rent/Insurance/Telephone charges -> Anything that’s not direct material/labour.
Fixed Overhead cost
- Constant such as insurance.
Cost Behavior For the purposes of planning, control, and decision making, managers need to understand how the TOTAL amount
spent on a particular cost object reacts to changes in a cost driver as measured, for example, by production or sales
- Unit variable cost is fixed or constant.
- Total variable cost change
Rent is $500
- Total fixed cost is fixed or constant
- Unit fixed cost is variable
o If 1 student comes then $500 rent/student, 2 students: 250/student, 5 students: $100/student etc.
Ex: Lecture hall teaching
Cost estimation is defined as the development of a well-defined relationship between a cost object and its cost
drivers, for the purpose of identifying cost behavior and predicting future costs. 2 CostAssignment
Cost assignment is the process of measuring the amount of costs consumed by a particular cost object from the
costs incurred. There are two stages in which an accounting system accounts for costs:
1. Cost accumulation (traced): collection of cost data in some organized means in an accounting system.
2. Cost assignment (untraced): is a general term that describes the process of assigning (charging) costs
incurred to a cost object. The method of assigning costs to cost objects depends on whether the relationship
between the costs incurred and the cost objects is direct or indirect. Direct costs are traced to their particular
cost objects while the indirect costs are allocated to cost objects.
-> best cost driver such as # of students in faculty, man power etc.
When something cannot be traced to a specific activity then you use cost drivers.
Glue, nails, paint may trace these costs to the product at the sole instruction of managers: True
Direct material are ALWAYS variable.
Sometimes its not viable economically to trace a direct material to an object so you may treat it as indirect:
Such as paint coat on a small table which is very small.
1. Direct costs of a cost object are those costs that can be traced easily to a cost object in an accurate and
economically feasible (cost-effective) way. Examples of direct costs in a manufacturing setting include:
Direct materials costs — the costs of all materials and parts that become an integral part of the finished
product and can be easily traced into it.
Direct labor costs — wages and fringe benefits paid to production line workers involved directly in
manufacturing a product.
2. Indirect costs of a cost object are related to the particular cost object but cannot be traced to that cost object
in an economically feasible (cost-effective) way. Indirect costs, therefore, should be allocated to the cost
objects using an allocation BASE factor. Examples of indirect costs in a manufacturing setting include all
production facilities required to transforming raw materials into finished goods such as depreciation of
machines, maintenance cost, rent of the factory, and salary of supervisors.
Note the following:
1. The classification of costs into direct and indirect are defined with reference to a specific cost object. A
particular cost can be classified as direct with respect to a certain cost object and indirect with respect to
another cost object.
2. A cost would be considered indirect for one of two reasons: either it is impractical or it is impossible to trace
the cost to the cost object. For example, it could be possible to measure the precise amount of nails or the
amount of glue used on each table produced at a furniture plant, but it wouldn’t be worth the effort. Instead,
cost of nails and glue would typically be considered an indirect material and would be included in overhead.
3 Raw Materials (R.M.) ***Know terminology very well !!! ***
BB R.M used
+ purchase R.M.
Direct materials indirect materials
Purchased (D.M.) purchased (I.M.)
Work in Progress or process (WIP)
BB cost of goods manufactured (C.O.G.M)
+ DM used
+ Direct Labor (D.L)
+ Manufacturing overhead (MOH)
DM + DL used = Prime Costs
D.L. + MOH = Conversion costs
DM + DL + MOH = Total Manufacturing costs (TMC)
Conversion costs may be assigned to a product rather than accumulated to a product. -> False
Prime costs may be allocated to a product rather -> False
Direct costs are not allocated! Finished Goods (F.G.)
BB ? = Cost of goods sold (COGS)
From W.I.P Cost of goods available for sale (COGAS)
manufacturer of machinery currently produces equipment for a single client. The job is expected to take the entire
month of April to complete. The client supplies all required raw material on a no-cost basis. The manufacturer
contracts to complete the desired units from this raw material. The total production costs incurred by the
manufacturer are correctly identified as:
A) Direct Lbor.
B) Factory overhead. DL + MOH