Cost Accounting Concepts and Definition









1. Direct and Indirect Cost

2. Period and Product Cost

3. Cost Behavior in relation to volume of activity

4. Relevant and Irrelevant Cost

5. Avoidable Cost and Unavoidable Cost

6. Sunk Cost

7. Opportunity Cost

8. Incremental Cost and Marginal Cost

Definition and Explanation of Direct Cost
A direct cost is a cost that can be easily and conveniently traced to the particular cost object under consideration. A cost object is anything for which cost data is required including products, customer’s jobs and organizational subunits. For example, if a company is assigning costs to its various regional and national sales offices, then the salary of the sales manager in its Tokyo office would be a direct cost of that office.

Definition and Explanation of Indirect cost
An indirect cost is a cost that cannot be easily and conveniently traced to the particular cost object under consideration. For example a soup factory may produce dozens of verities of canned soups. The factory manager's salary would be an indirect cost of a particular verity such as chicken noodle soup. The reason is that the factory manager's salary is not caused by any one variety of soup. To be traced to a cost object such as a particular product, the cost must be caused by the cost object. This salary of manger is called common cost of producing the various products of the factory. A common cost is a cost that is incurred to support a number of costing objects but cannot be traced to them individually. A common cost is a particular type of indirect cost.

A particular cost may be direct or indirect, depending on the cost object. While, in the above example, the soup factory manager's salary is an indirect cost of manufacturing chicken noodle soup, it is a direct cost of the manufacturing division. In the first case, the cost object is the chicken noodle soup product. In the second case, the cost object is the entire manufacturing division.

Definition and Explanation of Period Costs Period costs are all the costs that are not included in product costs. These costs are expensed on the income statement in the period in which they are incurred, using the usual rules of accrual accounting that we learn in financial accounting. Period costs are not included as part of the cost of either purchased or manufactured goods. Sales commissions and office rent are good examples of period costs. Both items are expensed on the income statement in the period in which they are incurred. Thus they are said to be period costs. Other examples of period costs are selling and administrative expenses.

Definition and Explanation of Product Cost
For financial accounting purposes, product costs include all the costs that are involved in acquiring or making product. In the case of manufactured goods, these costs consist of direct materials, direct labor, and manufacturing overhead. Product costs are viewed as "attaching" to units of product as the goods are purchased or manufactured, and they remain attached as the goods go into inventory awaiting sale. So initially, product costs are assigned to an inventory account on the balance sheet. When the goods are sold, the costs are released from inventory as expense (typically called Cost of Goods Sold) and matched against sales revenue. Since product costs are initially assigned to inventories, they are also known as inventorial costs. The purpose is to emphasize that product costs are not necessarily treated as expense in the period in which they are incurred. Rather, as explained above, they are treated as expenses in the period in which the related products are sold. This means that a product cost such as direct materials or direct labor might be incurred during one period but not treated as an expense until a following period when the completed product is sold.

Definition of Cost Behavior Cost behavior refers to how a cost will react or respond to changes in the level of business activity. As the level of activity rises and falls, a particular cost may rise and fall as well--or it may remain constant. Quite frequently, it is necessary to predict how a certain cost will behave in response to a change in activity for planning.

What are the Relevant and Irrelevant Costs?
Two partners who own Progressive Business Solutions, which currently operates out of an office in a small town near Boston, just discovered a vacancy in an office building in downtown Boston. One of the partners favors moving downtown because she believes the additional business gained by moving downtown will exceed the higher rent at the downtown location plus the cost of making the move. The other partner at PBS opposes moving downtown. He argues, "We have already paid for the office stationery, business cards, and a large sign that cannot be moved or sold. We have spent so much on our current office that we can't afford to waste this money by moving now." Evaluate the second partner's advice not to move downtown. Illustrate and fully explain using an example of

relevant cost (a cost whose value does affect the optimal decision) and an example of irrelevant cost (a cost whose value does not affect the optimal decision) to the business regarding this decision.

Avoidable and Unavoidable Cost
I think that avoidable cost is the cost that can be avoided if certain decision is taken or not taken. It is more or less cost which is varied according to the decision taken by management. That is all variable cost can be said to be avoidable.On the other hand unavoidable cost is that cost which cannot be avoidable at least for the short term. This means that unavoidable cost can be said to be more or less a fixed cost in the short term which cannot be changed.

Sunk Cost
Sunk costs are sometimes contrasted with prospective costs, which are future costs that may be incurred or changed if an action is taken. Both retrospective and prospective costs may be either fixed (that is, they are not dependent on the volume of economic activity, however measured) or variable (dependent on volume).

In traditional microeconomic theory, only prospective (future) costs are relevant to an investment decision. Traditional economics proposes that an economic actor not let sunk costs influence one's decisions, because doing so would not be rationally assessing a decision exclusively on its own merits. The decision-maker may make rational decisions according to their own incentives; these incentives may dictate different decisions than would be dictated by efficiency or profitability, and this is considered an incentive problem and distinct from a sunk cost problem. Evidence from behavioral economics suggests this theory fails to predict real-world behavior. Sunk costs greatly affect actors' decisions, because many humans are loss-averse and thus normally act irrationally when making economic decisions.

Opportunity Cost Definition
The cost of passing up the next best choice when making a decision. For example, if an asset such as capital is used for one purpose, the opportunity cost is the value of the next best purpose the asset could have been used for. Opportunity cost analysis is an important part of a company's decision-making processes, but is not treated as an actual cost in any financial statement.

Opportunity costs in production Opportunity costs may be assessed in decision-making process of production. If the workers on a farm can produce either 1 million pounds of wheat or 2 million pounds of barley, then the opportunity cost of producing 1 pound of wheat is the 2 pounds of barley forgone. Firms would make rational decisions by weighing the sacrifices involved.

Marginal and Incremental Costs Definition
Incremental cost is closely related to the economist's marginal cost. Marginal cost may be defined as the addition to the total cost resulting from producing one more unit. Incremental cost may be defined as the addition to total cost resulting from a particular decision. Both are concerned with changes in total cost, say increase or decrease in total costs that result from producing and distributing additional or fewer units of a product, or from a change in the method of production or distribution such as the use of improved machinery, addition of a product or territory, or selection of an additional sales channel. They are anticipated costs and refer to future operations. The term incremental cost is more widely used in business for reasons that are clear. First of all, businesses are concerned with more than increasing or decreasing the level of output. For example, in purchasing a new labor-saving machine, what is wanted is a

measurement of the prospective savings in cost (reduction in total cost) resulting from that machine. Secondly, even if the issue is one of increasing or decreasing output, businessmen normally think in terms of increases or decreases of a substantial percentage rather then by a single unit. The incremental cost concept is a more flexible tool, though in some respects a cruder one than marginal costs.

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