Nature and Classification of Costs

As practiced today, cost accounting may be defined as the process of measuring, analyzing, computing and reporting the cost, profitability and performance of operations. This can be contrasted to earlier definitions which limited cost accounting to "obtaining a figure representing the cost of a manufactured product."

The nature of modern business is such that all enterprises-whether large or small, manufacturing or nonmanufacturing, public or private, profit or nonprofit-require a wide variety of cost data in making day-to-day operating decisions. Thus, for the modern cost accountant, the positive emphasis on analysis and interpretation (managerial cost accounting) requires involvement in the dynamic phase of business-the current period and the future. The dynamic phase is concerned primarily with planning (i.e., selecting objectives and the means for their attainment) and controlling (i.e., achieving conformity to established plans).

Cost Accounting Concepts

A concept is a basic principle or assumption, as opposed to a procedure, for carrying out the concept. Cost accounting concepts may be separated into two groups: (1) planning and (2) controlling.

1.  Planning: There are two key types of planning, as described below. Project Planning. The process whereby management, confronted by a specific problem, evaluates each alternative in order to arrive at a decision as to the course of future action. Since planning requires a comparison of the costs of various alternative solutions, the cost of each alternative must be determined.

Period Planning: The process whereby management systematically develops an acceptable set of plans for the total future activities of the enterprise, or some functional subdivision thereof, for a specified period of time. This type of planning, covering a period of one year or more, usually refers to an overall budget.

2. Controlling: This involves the systematic monitoring of performance to determine the degree of adherence to established objectives. Actual results are continuously measured against yardsticks such as budgets, standard costs, time study standards, etc. previously established for manufacturing, marketing, finance and all other activities of the company. Any significant deviation from such yardsticks can be detected quickly and management action taken promptly for correction.

The concepts of cost, expense, and loss are often used interchangeably.

The AICP A, in Accounting Terminology Bulletin No.4, defines these terms as follows:

Cost is “the amount, measured in money, of cash expended or other property transferred, capital stock issued, services performed, or a liability incurred, in consideration of goods or services received or to be received.”

Expense is “all expired costs which are deductible from revenues.” In a narrower sense "the term 'expense' refers to operating, selling, or administrative expenses, interest, and taxes." Items included in cost of manufacturing, such as materials, labor, and overhead, should be described as costs, not expenses.

Loss is “(1) the excess of all expenses, in the broad sense of that word, over revenues for a period, or (2) the excess of all or the appropriate portion of the cost of assets over related proceeds, if any, when the items are sold, abandoned, or either wholly or partially destroyed by casualty or otherwise written off. When losses such as those described' in (2) are deducted from revenues, they are expenses in the broad sense of that term.”

Activities of the Cost Department

The principal activities or tasks of cost accounting include:

1. Providing data to aid management in making a choice among two or more alternatives.

2. Preparing data to aid in the reduction or improvement of costs.

3. Aiding in the creation and execution of budgets.

4. Computing costs and profit for an accounting period.

S. Developing inventory costs for inventory control and pricing.

Classification of Costs

Classification of costs is necessary in order to determine the most suitable method of accumulating and allocating cost data. The principal methods of accumulating costs are described below.

Function

Manufacturing: Costs applied to producing a product.

Marketing: Costs incurred in selling a product or service. Administrative: Costs incurred in policy-making activities.

Financial: Costs related to financial activities.

Elements

Direct material: Material which is an integral part of the finished product.

Direct labor: Labor applied directly to components of the finished product.

Factory overhead: Indirect materials, indirect labor, and the manufacturing expenses that cannot logically be charged directly to specific units, jobs, or products.

Product

Direct: Costs which are charged to the product and require no further allocation.

Indirect: Costs which are allocated.

Department

Production: A unit in which operations are performed on the part or    product and whose costs are not further allocated.

Service: A unit not directly engaged in production and whose costs are ultimately allocated to a production unit.

When Charged to Income

Product: Costs included when product costs, as defined above, are computed. Product costs are included in inventory and in cost of sales when the product is sold.

Period: Costs associated with the passage of time rather than with the product. These are closed out to the income summary each period since no future benefits are expected.

Relation to Volume

Variable: Costs which change in total in direct proportion to changes in related activity.

The unit cost remains the same regardless of volume. Fixed. Costs which do not change in total over wide ranges of volume. The unit costs decrease as volume increases.

Period Covered

Capital. Costs which are expected to benefit future periods and are classed as assets.

Revenue. Costs which benefit only the current period and are thus expenses.

Degree of Averaging

Total. The cumulative cost for the established category.

Unit. The total cost divided by the number of units of activity or volume.

Cost Systems

The cost classifications do not provide all required cost data. Most cost planning and control data can only be provided by an adequate cost system, designed so that individual supervisors, department heads, and executives can be held accountable for all costs which are their responsibility. The concepts of authority and responsibility are closely related to accountability and are carefully considered in evaluating personal performance.

The cost system must be closely tailored to the organizational structure of the company, the manufacturing process, and the type of information desired and required by executives. There are numerous kinds of cost systems, each with its own advantages and disadvantages. The principal types of cost systems, classified according to their particular attribute, are described below.

Nature of Manufacturing

Job order: The cost unit is the job and costs are accumulated by job. It is most suitable where each job or order is different than others, such as in a printing shop.

Process. The cost unit is the average cost for the units produced in a specified period of time, such as a week. The method is most suitable where high-volume similar products are produced, such as those of flour mills, steel mills, paper mills, etc.

Time When Computed

Actual Costs are collected as they occur, but determination of unit costs must wait for completion of manufacturing operations for the period.

Standard. Costs are. predetermined some time ahead of production. Standards may be used for both quantity and dollar value. Differences between actual and standard costs are shown in variance accounts which are then analyzed to determine the cause of the difference. Application of Overhead

Direct costing. This method, sometimes called variable costing, assigns only direct product costs to inventory. The fixed overhead costs are charged against revenue in the period incurred.

Full absorption. All costs, including fixed overhead costs, are applied to the product and are included in inventory.

Unit Costs

The total cost figure is usually unsatisfactory from a control standpoint since the quantity of production varies greatly from period to period. Therefore, . some common denominator, such as unit costs, must be available for

comparison of varying volumes and amounts. The unit cost figure can be readily computed by dividing total costs by the number of units produced. Unit costs may be stated in terms of tons, gallons, pounds, feet, individual units, etc.