Cost Accounting: Cost Concepts and The Cost Accounting Information System

Cost Accounting
Chapter 2
Cost Concepts and the Cost
Accounting Information System
Learning Objectives
1. Define the term cost object and give examples of cost
objects relevant to different types of decisions.
2. Describe several degrees of cost traceability implied by
the terms direct cost and indirect cost.
3. State the considerations involved in creating a cost
accounting information system.
4. Explain why increased attention is being given to
nonfinancial performance measures.
5. Name and describe the ways costs are classified.
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2-1 The Cost Concept
• Cost concepts have developed according to the needs of
accountants, economists, and engineers. Accountants
have defined cost as “an exchange price, a forgoing, a
sacrifice made to secure benefit. In financial
accounting, the forgoing or sacrifice at date of
acquisition is represented by a current or future
diminution in cash or other assets.”
• Cost Objects
– A cost object, or cost objective, is defined as any item or
activity for which costs are accumulated and measured.
– The concept of a cost object is one of the most pervasive

ideas in accounting. The selection of a cost object provides
the answer to the most fundamental question about cost: The
cost of what?
• Cost Objects
– Because of the multiple needs in cost finding, planning, and
control, cost accounting systems are multidimensional. For
example, it is necessary to assign costs to each product unit,
but also necessary to plan and control costs for which
individual managers are assigned responsibility, on a
departmental, geographical, or functional basis. The design of
cost accounting systems and their implementation must
address these multiple requirements.
• Traceability of Costs to Cost Objects
– The traceability of costs to a cost object varies by degree. A
common way of characterizing costs is to label them as either
direct or indirect costs of a particular cost object, as if there
were only two degrees of traceability. In fact, degrees of
traceability exist along a continuum.
• Cost Traceability in Service Industries
– The traceability of costs is as important for decision making
in service businesses as in manufacturing. For routine pricing
decisions, bidding on jobs, and dropping or adding a service,
knowing the costs of different services is of paramount
importance in any competitive environment, and the
traceability of costs is as fundamental in calculating the cost
of a service as it is in calculating the cost of a manufactured
good.
2-2 The Cost Accounting Information System
• The cost accounting information system must reflect
the division of authority so that individual managers
can be held accountable. The system should be
designed to promote the concept of management by
exception.
• Although the accounting records will not provide all the
necessary information for effective management, the
accountant who designs the system must know how
employees are paid, how inventories are controlled,
how equipment is costed, machine capacities, and other
operating information.
• The information system should focus management’s
attention.
• Some requirements for record keeping and reporting
are imposed on an organization by external forces.
• Sensitivity to Changing Methods
– Highly automated, robotics-oriented manufacturing may
employ little if any labor directly traceable to each unit of
output; this minimizes planning and controlling direct labor
and calls for methods of cost allocation that are not based on
labor. The just-in-time (JIT) philosophy seeks to reduce
dramatically the investment in inventories, which alters
accounting’s traditional focus on tracking large stocks of
work in process.
• Nonfinancial Performance Measures
– Many managers have found that the usefulness of
nonfinancial performance measures is not limited to
performance evaluation. The reasons for the increased
attention being given to nonfinancial measures include:
1. Dissatisfaction with financial measures.
2. Growing recognition that traditional financial measures are affected
by phenomena that are not necessarily relevant to the purpose at
hand.
3. Dissatisfaction with the slow pace at which a company’s accounting
and data processing.
4. Dissatisfaction with financial measures of plant utilization.
5. Dissatisfaction with financial measures of processing efficiency.
– Nonfinancial performance measures respond to these
problems by using simple physical data rather than allocated
accounting data, by being unconnected to the general
financial accounting system, by being selected to measure
only one specific aspect of performance rather than to be “all
things for all purposes,” or by a combination of these factors.
– Some nonfinancial performance measures are simple counts
or percentages of desirable or undesirable events and are
intended to measure the efficiency or effectiveness of a
production process.
– One popular measure of this type is manufacturing cycle
efficiency, which measures processing time as a fraction of
the total time a unit is in the factory. It is calculated as:
– A third type of nonfinancial performance measure indicates

success in simplifying a process.
2-3 Classifications of Costs
• Cost classifications are essential for meaningful
summarization of cost data. The most commonly used
classifications are based on the relationship of costs to
the following:
1. The product (a single lot, batch, or unit of a good or service)
2. The volume of production
3. The manufacturing departments, processes, cost centers, or
other subdivisions
4. The accounting period
5. A decision, action, or evaluation
• Costs in Relation to the Product
– Manufacturing cost—also called production cost or factory
cost—is usually defined as the sum of three cost elements:
direct materials, direct labor, and factory overhead.
– Direct materials
– Direct labor
– Factory overhead
– Indirect materials
– Indirect labor
FIGURE 2-1 Classifications of Costs in Relation
to the Product
16
• Commercial Expenses.
– Commercial expenses fall into two broad classifications:
marketing expenses and administrative expenses (also called
general and administrative expenses).
– Marketing expenses begin at the point at which the factory
costs end. That is, when manufacturing has been completed
and the product is in salable condition. They include the
expenses of promotion, selling, and delivery.
• Commercial Expenses.
– Administrative expenses include expenses incurred in
directing and controlling the organization. Not all such
expenses are allocated as administrative expenses. The salary
of a vice-president in charge of manufacturing can be treated
as a manufacturing cost, and the salary of a vice-president in
charge of marketing can be treated as a marketing expense.
• Costs in Relation to the Volume of Production
– The total amounts of variable costs change in proportion to
changes in activity within a relevant range
• Supplies
• Fuel
• Small tools
• Spoilage, salvage, and reclamation expenses
• Receiving costs
• Royalties
• Communication costs
• Overtime premium
• Materials handling
– Fixed Costs are constant in total amount within a relevant
range of activity.
• Salaries of production executives
• Depreciation
• Property tax
• Patent amortization
• Supervisory salaries
• Insurance—property and liability
• Wages of security guards and janitors
• Maintenance and repairs of buildings and grounds
• Rent
– Fixed costs may be thought of as the costs of being in
business, while variable costs are the costs of doing business.
– Some costs contain both fixed and variable elements; these
are called semivariable costs.
• Inspection
• Cost-department services
• Payroll-department services
• Personnel-department services
• Factory office services
– Some costs contain both fixed and variable elements; these
are called semivariable costs.
• Materials and inventory services
• Water and sewage
• Maintenance and repairs of plant machinery
• Payroll taxes
• Heat, light, and power
• Costs in Relation to Manufacturing Departments or
Other Segments
– In a producing department, manual and machine operations
such as forming and assembling are performed directly on the
product or its parts.
– In a producing department, forming and assembling are
performed directly on the product or its parts.
– The terms direct and indirect can also be used in connection
with charging overhead costs to departments of any
organization. If a cost is traceable to the department in which
it originates, it is referred to as a direct departmental cost;
the salary of the departmental supervisor is an example.
Other Segments
– If a cost is shared by several departments that benefit from its
incurrence, it is referred to as an indirect departmental cost;
building rent and building depreciation are examples of
indirect departmental costs. In this cost classification system,
the department is the cost object.
Other Segments
– Common costs are costs of facilities or services employed by
two or more operations.
– Joint costs occur when the production of one product makes
it inevitable that one or more other products are also
produced. The meat-packing, oil and gas, and liquor
industries are good examples of production that involves joint
costs. In such industries, joint costs can be allocated to joint
products only by arbitrary calculations.
• Costs in Relation to a Decision, Action, or
Evaluation
– Differential cost is one name for a cost that is relevant to a
choice among alternatives. Differential cost is sometimes
called marginal cost or incremental cost. If a differential cost
will be incurred only if one particular alternative is followed,
then that cost can also be called an out-of-pocket cost
associated with that alternative.
• Costs in Relation to a Decision, Action, or
Evaluation
– A cost that has already been incurred and is, therefore,
irrelevant to a decision is referred to as a sunk cost. In a
decision to discontinue a product or division, some of the
product’s or division’s costs may be unaffected by the
decision; these are called unavoidable costs. The avoidable
costs, in contrast, are relevant to the decision.

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Cost Accounting

– The concept of a cost object is one of the most pervasive

– A third type of nonfinancial performance measure indicates

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