Cost Accounting — Cost Concepts and Classification: Traceability, Cost Behavior and Product Costs

Cost accounting calculates what it costs to make one product or deliver one service. Where financial accounting sets inventory and cost of sales for external reporting, cost accounting deals both with how those numbers are produced and with the information management needs to control costs. This first chapter sets out how costs are classified differently for different purposes. The same electricity bill can be an indirect cost, a mixed cost and a product cost, depending on the question.

1. Costs and cost objects

A cost is a resource sacrificed to achieve a specific objective, measured in money. Anything for which a separate measurement of cost is wanted is a cost object. Products, services, customers, departments and projects can all be cost objects. How costs are classified depends on the cost object and the question.

2. Traceability: direct and indirect costs

• Direct costs: costs that can be traced to the cost object in an economically feasible way — the wood used in a piece of furniture and the wages of the worker who assembled it.
• Indirect costs: costs that are hard to trace or too expensive to trace and so must be allocated — depreciation of the factory building, the plant manager’s salary, the factory’s electricity.

Manufacturers usually divide manufacturing costs into three elements: direct materials, direct labor and manufacturing overhead, which is every other manufacturing cost. Direct materials plus direct labor is prime cost; direct labor plus manufacturing overhead is conversion cost.

3. Cost behavior: how costs change with activity

Cost behavior is how a cost responds to changes in an activity level such as output.

Saying a fixed cost is constant holds only within the relevant range. If output exceeds plant capacity, capacity must be added and fixed costs rise too.

4. Splitting a mixed cost: the high-low method

Splitting a mixed cost into its variable and fixed parts lets you forecast costs and use them in CVP analysis (chapter 13). The simplest method is the high-low method.

A factory’s monthly output and power costs are as follows.

The cost function is $Y = 80 + 0.12X$ (₩10,000). Power cost at 2,500 units is forecast at $80 + 0.12 \times 2{,}500 = 380$, i.e. ₩3.8 million. Checking against January and April, the forecasts are ₩2.96 million and ₩3.44 million, a little off the actual figures. Because the high-low method uses only two points, abnormal extremes distort the cost function. Regression analysis, which uses all the data, is more accurate.

5. Product costs and period costs

• Product costs (inventoriable costs): costs of making the product. They first become inventory and then cost of sales when the product is sold. The three elements of manufacturing cost belong here.
• Period costs: costs that never become inventory and are expensed in the period incurred. Selling and administrative expenses belong here.

Even depreciation splits: the factory building’s share is a product cost and the head office building’s share is a period cost. Getting this wrong misstates both inventory and profit, because the cost of products made in the factory and still in the warehouse is not yet an expense.

Check your understanding

A call center’s monthly call volume and operating costs were 8,000 calls and ₩15.2 million in March, 12,000 calls and ₩18.8 million in July, 10,000 calls and ₩16.5 million in September, and 6,000 calls and ₩13.4 million in November. Find the cost function with the high-low method and forecast operating costs for 9,000 calls a month. How does a forecast based on total cost per call go wrong?

The high point is July (12,000 calls, ₩18.8 million) and the low point is November (6,000 calls, ₩13.4 million). Variable cost per call is $(1{,}880 - 1{,}340) / (12{,}000 - 6{,}000) = 0.09$ (₩900) and fixed cost is $1{,}880 - 0.09 \times 12{,}000 = 800$, i.e. ₩8 million. At 9,000 calls, $800 + 0.09 \times 9{,}000 = 1{,}610$, i.e. ₩16.1 million. Multiplying July’s total cost per call of about ₩1,567 by 9,000 gives about ₩14.1 million — a large underestimate from treating fixed cost as if it were variable.

References

• Charles Horngren, Srikant Datar and Madhav Rajan, Cost Accounting: A Managerial Emphasis, ch. 2, 10
• Ray Garrison, Eric Noreen and Peter Brewer, Managerial Accounting, ch. 1–2
• Robert Kaplan and Anthony Atkinson, Advanced Management Accounting, ch. 1