Main Content
Lesson 1a: Cost Concepts
Lesson 1a: Cost Concepts—Defining Cost Terms | Video
Throughout the lessons in this course, you will often encounter video and text. Unless you are told otherwise, the video will cover the same material as the text. You have the option to use whichever format works best for you. If you choose to watch the video, you may skip the text in lesson 1a and continue to lesson 1b.
Video 1.1: Cost Concepts: Defining Cost Terms.
Cost Concepts: Defining Cost Terms
THOMAS BUTTROSS: There are a few lessons on basic cost concepts. This lesson is on defining cost terms and is material that is simple enough for you to master using this presentation. The learning objective is to understand and be able to use cost terms that underlie managerial and cost accounting.
Note that these cost terms apply to all kinds of organizations. Manufacturing, merchandising-- whether wholesale or retail-- service, not for profit, and governmental. In short, these terms apply to any organization that incurs costs. Note also that this cost terminology is used throughout most cost or managerial accounting courses.
The terms we're going to talk about are "cost," "cost objects," "cost pools," "unit or average cost," "marginal and variable cost," "cost assignment," "cost tracing," "cost allocation," "cost drivers," and "cost allocation basis." Later, after you've covered this material, you will see the same list at the end. That allows you, if there is a particular term, you're unclear on, to go back directly to the discussion of that term.
Cost. Now there's some very technical definitions of accounting terms. For example, when you start talking about assets, what makes something an asset in accounting has to do with its future utility. And automobile gives you future transportation. That's what makes it an asset.
It's not listed as an asset simply because you own 2,000 pounds of steel. You could get 2,000 pounds of steel much more cheaply. But it's OK in accounting for day-to-day speaking to say an asset is something of value that you own or in some cases control.
We're doing the same thing here. What is cost? A cost is what you give in return for something else. That's actually my favorite definition of a cost, what you give in return for something else.
Another definition of cost is a sacrifice made for a specific purpose. Let's review some specific examples. You give $1,000 for equipment. What is your cost of that equipment? $1,000, the amount of cash you paid.
Number two, you sign a $100,000 mortgage note for land. What is the cost of the land? The $100,000 you gave a written promise to pay.
Number three, you pay factory workers $10,000 for last week's production. Your cost is $10,000.
Number four, you pay sales staff $2,000 commission from last month's sales. Your cost is $2,000.
Number five, you pay office workers $5,000 salary for last month. Your cost is $5,000
Number six, on Saturday you spent six hours to help a friend move. What is your cost? Your cost is six hours of your life.
Now there are two things you need to note from this. First, you want to note that cost does not mean expense. Only the fourth and fifth items, the sales staff commissions, which go into commissions expense, and the office worker salary, which goes into office salaries expense, are expenses at the time of payment.
For the first item you've got equipment, a property, plant, and equipment asset. For the second item, you've got the land, a property, plant, and equipment asset. The third item you've got work in process, which is an inventory account among the current assets.
And for the last item where you helped your friend move, you've got an account receivable from your friend. However, if you do not have an account receivable from your friend, you could have an expense in that particular instance.
The second thing you should know from the above examples is that cost does not mean cash outlay. Take number two. There's no cash being paid in number two. There's a written promise to pay later, yet we still have a cost.
And take number six, where you gave up six hours of your life to help your friend move. There's a cost there, but there's no cash outlay. In the case of number six, there never will be a cash outlay.
Cost objects. A cost object is any item for which someone desires a cost. Now to say any item for which someone desires a cost may be an overstatement. For example, the janitor at IBM could say, I'd like to know what it costs to do something at the company. However, it is very unlikely that the janitor would have the power or the authority to go to accounting and demand that they compute and provide the cost.
So some people will say it is anything for which a manager desires a cost or anything for which someone with the power to get the cost desires a cost. Let's review some specific examples.
Products, such as a car. A product is a common example that anyone would have thought of off the top of their head. Some additional examples will show cost is not just a narrow thing that's applied to a product at a manufacturing company.
Product line, such as digital single-lens reflex cameras. This one's pointed out because it is common practice among the Japanese. An American company would make four different cameras and we would actually try to determine the profitability of each of those four cameras.
What a Japanese company would do is look at the profitability of the overall camera line. They will say, OK, here at Canon we have four cameras in our single-lens reflex camera line. We will sell the entry-level camera near break even. The next level up might sell at a 30% profit, the third level at a 50% profit, and top level at an 80% profit.
Canon might take the position that it is willing to have very little profit on its entry-level camera to get someone to buy a Canon. The profit margin goes up, because as people move up the line they start buying for features, not cost. As long as the overall camera line is making a healthy profit, Canon is happy.
The advantage this provides the Japanese is that when they treat the entire product line as a cost object instead of individual cameras, they have a lot less cost allocation to do.
For example, assume that all four cameras are made at the same plant. In an American computation by product, you would have to allocate the plant depreciation among the four cameras. In the Japanese company, you simply charge the plant depreciation to the camera line.
This discussion is not advocating that the Japanese practice of doing product lines in some cases as opposed to individual products is superior to the common American way of costing individual products. It is just presenting an alternative view, an alternative way to look at the world.
Number three, services such as changing the oil in a car. If you're going to open a Jiffy Lube, you need to know what it costs you to change the oil in a car.
Number four, jobs. If you're opening an accounting firm, each client is billed for the particular services he or she desires. To work for Exxon, you need to know what it would cost you to do the Exxon audit or the Exxon tax return.
Note that you might charge for particular services within the job. For example, an accountant might say, I charge $100 per hour for tax return preparation. Or I charge $100 to prepare a Schedule D.
Number five, projects such as research and development on a new drug to lower cholesterol.
Number six, organizational units. What does it cost to run the purchasing department or the human resources department? That would be especially important if an organization is considering outsourcing.
Number seven, activities or processes such as credit card authorization or order entry. What does it cost to do a credit card authorization? If it costs you $0.25 to do a credit card authorization, do you really want to do one on a $0.25 sale or a $1 sale? Or do you want to have some minimum level?
Number eight, distribution channels such as internet sales versus retail outlet sales. This particular example comes from Dell, which years ago did an activity-based costing study and decided that internet sales were more profitable than retail outlets sales and quit doing retail outlet sales. While Dell has re-entered the retail outlet market, it has not eliminated use of the internet.
Number nine, customers such as Wal-Mart. What does it cost me to service Wal-Mart? Is Wal-Mart a profitable customer? It is easy to know the sales revenue from Wal-Mart. If the organization can come up with the full cost of servicing Wal-Mart, the cost of goods sold, the shipping, the cost of calling on the customer, the costs of handling its orders and everything else, the organization can decide how profitable Wal-Mart or Sears or some other company is as a customer.
This customer profitability analysis, which requires you to know customer cost, is actually a very interesting area, because studies show that for a lot of companies 20% of customers provide 80% of the company's profit, and another 60% of customers provide another 40% of the company's profit.
If you're quick with your math, you're thinking, wait a minute, if I've got 80% and then 40%, that's 120%. You can't have more than 100%. And you're all right. The remaining 20% of customers will actually eat away 20% of the company's profit. That is, the company is losing money on them.
So doing customer profitability analysis can be a good way to increase your profitability by making sure you treat your good customers well and either make your unprofitable customers profitable or let them go elsewhere.
Cost pools. Accountants pool the cost together for various cost computations. So a cost pool is simply a related group of costs that is meaningful to a particular entity. There are many ways to pool costs. We will only look at three examples here.
Manufacturing overhead is a good example. All of the costs of running a factory, other than direct materials and direct labor, are collectively called manufacturing overhead. All of the manufacturing overhead for the entire factory could be added into one pool and allocated together using direct labor hours for the allocation.
On the other hand, some companies, because they have very different overhead used for assembly versus finishing-- let's say the assembly is very machine intensive and finishing is very labor intensive-- may actually accumulate overhead separately for assembly and finishing and allocate it separately.
In assembly they might allocate the overhead using machine hours since it is machine intensive. And finishing them they would allocate the overhead using direct labor hours, since it is very direct labor intensive.
Departments such as accounting, human resources, and shipping are a common way that companies accumulate their costs and pool them together.
Third, geographical regions such as the cost of North American operations versus Asian operations. In order for companies to know their profitability by geographic region, they have to have costs broken down that way.
Unit or average cost. In general, the unit cost equals the average cost. That is, you take the total cost for batch of units of product and divide it by number of units produced, which gives you the average cost.
So if a company spent $1 million and made 100,000 units, $1 million divided by 100,000 units is $10 per unit. That is the unit or average cost. You can also compute the average cost for service units produced such as the average cost of a cable installation at Comcast.
Marginal and variable cost. Marginal cost is not an average. It is a cost or providing one more unit of a good or service. We know that the marginal cost is not actually constant. That is, in economics we know the marginal cost is curvilinear, simply meaning a curved line.
And as the next slide shows, it actually looks like a backward S. The next slide will also show how accountants convert the curvilinear marginal cost to a linear cost called "variable cost."
We will cover the diagrams from the left to the right. In the left-most column, at very low levels of volume cost is increasing, but at a decreasing rate. Now that sounds odd, but here's an example of what is being said.
You're buying automobile tires for your car dealership from a tire manufacturer. Initially you order 100 tires a month at $100 per tire. As you order more tires, you get a price break. So when you increase your order above 100 tires a month, you start paying $98 per tire. Your total cost is increasing, but at a decreasing rate. At some point, the cost may level off. From 2,500 to 10,000 tires per month, the price is $92 per tire.
Above that level, you start getting dis-economies of scale instead of economies of scale, meaning that the cost per unit starts going up at an accelerating rate. So for example, once you need over 10,000 tires per month, the manufacturer has to work overtime and offers additional tires at $102 each. Now costs are increasing at an increasing rate again. This discussion explains why marginal cost is not constant.
In managerial accounting we simplify things by assuming we will be on the part of the marginal cost curve that is relatively straight, as shown in the middle diagram. This results in a linear cost, a straight line replacing the marginal cost as shown in the third diagram at the right. Assuming your tire needs are expected to be between 3,000 and 4,000 tires per month, your car costs will be $92 per unit, which is constant.
To distinguish the accounting simplification from economics marginal costs, accountants refer to this linear representation of cost as "variable cost."
Cost assignment. Cost assignment is a general term indicating the process of putting costs incurred into cost objects. How do we assign costs? In general there are two ways to do it. We either trace a cost we allocate the cost.
Cost tracing is the placement of a cost that belongs to only one cost object into that cost object. To the extent that you can trace cost, determining cost is easy. The costs that can be traced are called "direct costs," and they are covered in another presentation.
Cost allocation. Cost allocation is the placement of a cost that belongs to two or more cost objects into those cost objects. When a cost cannot be traced and therefore has to be allocated, it is called an "indirect cost." Indirect costs are also covered in another presentation, along with direct costs.
Here's an extremely important point about cost allocations that people do not always realize. Numbers are very precise-looking, so someone says that the product cost for making a particular part is $17.33. People tend to think of that as gospel. But a lot of cost allocations went into that $17.33. If you change the way the cost allocations are done, it might be $16.05 or $18.10, and these other amounts might be just as correct, that is, just as defensible.
So what is the point? The point is there is more than one logically defensible way to allocate the same costs to the cost objects. And if there is more than one logically defensible way to allocate the cost, then there's more than one right answer.
From the standpoint of an independent observer, the choice between multiple right answers is arbitrary. So accountants say that all cost allocations are arbitrary.
A simple example is depreciation methods. One company might allocate depreciation of its machinery based on a 10-year life with no salvage value. Another might allocate depreciation on the same equipment based on 1 million units of output. A third organization might allocate it based on a 9-year life with a 10% salvage value.
Each time you change the way you calculate depreciation or change any of the depreciation assumptions, you will get a different amount of depreciation allocated to each unit of product produced. Which cost per unit is correct? Well, they're all correct as long as your assumptions are reasonable.
Notice that your assumptions need to be reasonable. You cannot simply say, oh well, if they're all right, I'm just going to use a 10,000-your life for my equipment. Of course that's not reasonable.
All cost allocations are arbitrary. You want to remember that no matter how precise your costs look when you hand them to people, the number is not the right answer. In fact, if someone says the true cost is, he or she is misspeaking, because there is no one true cost. At best, all you can reasonably say is that some cost calculation is more accurate than others for the particular decision to be made.
Cost drivers. A cost driver is a cause of cost. If you do more of it, it drives your cost up. If you do less of it, it drives your costs down. Let's review a couple of examples here just to solidify the concept.
Set up machines, example one. First a little background. Some companies have crews that go out and set up the machines to make the next batch of product. It can be something as simple as cleaning the paint tank to switch from painting red to painting green. It can be an auto company that is stamping bumpers, changing the dye in the machine so they can start stamping doors.
What causes the cost? You've got a cost pool called set up machines, and there's $1 million in it. Where did that $1 million in cost come from? Part of it is from the number of production runs scheduled. Assuming that each production run requires a setup, then every time you schedule another production run the setup crew has to go out and change your machine and that's costly.
The length of time it takes to do a setup is another part. A four-hour setup is more costly than a one-hour setup. The scheduling of the setups is another factor. If you have your setup crew doing the setup while the factory's in full operation and they have to make production workers stand and wait, that's going to be a more costly setup than if you have the setup crew do the setup while the factory is closed or do the setup on an extra machine that is idle.
The size and pay rate of the setup crew affects the cost. If you give your setup crew a 5% raise, everything else held equal, your setups are going to be more expensive than they were before the raise.
The equipment available for setups and its condition affects the cost. If you're using old forklifts that break down, it's going to impact the time and cost of doing a setup.
Shipping is another example. Shipping cost is caused by a number of factors. The number of shipments. More shipments cost more money. The method of shipment. Shipping overnight is most of the shipping for five-day delivery. The size of the shipment. If you have 2 boxes that are each 10 pounds and 1 is a square foot while the other is 5 square feet, the bigger one is more expensive to ship.
The weight of the shipment. If you have 2 boxes that are each 2 square feet and one weighs 10 pounds while the other weighs 40 pounds, the heavier one is more expensive to ship.
The fragileness of the shipment. Assuming you're either paying extra insurance for the fragileness or you are replacing items a break in shipment, more fragile items are more expensive to ship.
The size and pay rate of the shipping department staff.
So there are a lot of things that drive costs. Now why are we covering this? If you're going to manage cost in an organization, the first thing you need to do is figure out what is driving cost. Let's take this shipping cost. I can look at this list and say, wow, we've got all the shipping costs and there are many things listed on the slide that are causing it. What should I attack first?
Well, what if you found out that your organization so behind on customer orders that it is shipping overnight 40% of the time? Then perhaps you should attack the method of shipment first and try to fix the system so that you don't need to use overnight shipping frequently.
Then you look again and ask what is now the biggest contributor to shipping costs? If you have a lot of breakage in shipment which you have to replace, you could review how you pack your shipments.
Cost allocation basis. This is an extremely important concept. I'll go as far as to say that you can't do well in cost or managerial accounting if you don't understand cost allocation basis.
Cost allocation basis is an extremely important subject that any student of managerial or cost accounting must master early in the course. Because there's no single correct way allocate a particular cost, there's no single right answer when doing allocation. Still estimates of cost are needed, making cost allocation necessary.
You should know from your high school math that the top of a fraction is called the numerator and the bottom is called the denominator. The cost allocation base is the denominator of the cost allocation fraction.
For example, $200,000 of manufacturing overhead divided by 10,000 machine hours equals $20 of manufacturing overhead per machine hour. In this case, machine hours are the allocation base.
Notice that whenever you do a fraction you're always suppressing the denominator to one and saying how much numerator you have for every one of the denominator. Let's just say that in your hometown there are 1,000 dogs and 100 cats. Well 1,000 dogs divided by 100 cats is 10 dogs per cat. If you flip it and put the 100 cats over the 1,000, it is 0.1 cats per dog.
You're always ended up with one of the denominator and saying how much of the numerator there is for that one of the denominator. If you keep that in mind, any fraction you learn is a pretty simple thing.
If you get into financing, you learn the debt-to-equity ratio, which is debt divided by equity. What does it tell you? It tells you the amount of debt for every $1 of equity. Note that you have to know how debt is defined. Is it just long-term liabilities or all liabilities? What do you mean by equity? Is it just stockholders' equity or is it creditor and stockholders' equity? But the point is that the fraction, debt-to-equity, is simply the amount of debt for every $1 of equity.
We have the unit level allocation basis. What do we mean by unit level? The allocation base changes proportionally with changes in production. If production goes up 10%, the base goes up 10%, and if production goes down 4%, the base goes down 4%. It's called unit level, because it changes along with the units.
Let's look at three unit level allocation bases. Direct labor hours, if you're going to increase production 10%, then you should need 10% more direct labor hours. Direct labor dollars. If you're using 10% more direct labor hours, you're going to pay 10% more direct labor dollars. Machine hours. If you increase production 10%, you're going to need to run the machines 10% longer.
So these are called unit level, because they vary with the number of units produced. You could also have unit level allocation bases that vary with the number of units sold. Sales commissions vary with the number of dollars sold, so commissions are unit level with respect to sales revenue.
Some costs are unit level. For example, factory machinery or electricity is unit level. If you make 10% more units, you run the machines 10% longer, and your electric bill is going to go up about 10%.
Allocating it based on a unit level allocation base such as machine hours is logical. However, a unit level allocation base is often used to allocate costs that do not vary with the number of units produced.
Factory building depreciation is not unit level. Allocating it with the unit level allocation base can lead to misleading cost calculations. For example, your building depreciation is $1 million a year and you make 200,000 units, so you say it is $5 a unit. Well, it is $5 a unit if you make 200,000 units. If you make 100,000 units, it would be $10 per unit. If you make 500,000 units, it would be $2 per unit.
When you start using the unit level allocation base to allocate something that is not unit level, people can start thinking it is unit level and make some very bad business decisions. That's something you need to watch out for.
For any cost delegation it's preferable to use a cost driver as the denominator. That is, use a factor that actually causes the particular cost in the numerator to change. When using a cost driver, focus on the one cost driver considered best suited for allocation.
You might allocate setup machines cost using the number of setups or the number of setup hours. You might allocate shipping costs using the number of shipments or the weight of shipments if weight is the most important factor.
Something to remember is that the best cost driver for allocating the cost might not be the most important cost driver for managing the cost. You shouldn't forget that other cost drivers exist.
For example, you might allocate setup machines cost based on the number of setups. However, you might decide that decreasing the time they needed to do a setup, decreasing setup hours, is the most important cost driver for managing the cost.
Sometimes you cannot use a cost driver to allocate a cost because there is no cost driver. An example is straight-line depreciation of a factory building, which is based on the passage of time.
You cannot logically allocate using direct labor hours or number of setups or any other denominator that drives the cost, because it is strictly a function of time. We might allocate it based on square footage used by different product, which is logical, but changing the square footage used by any product does not change the depreciation.
Where a cost driver is not available, there are other criteria for selecting an allocation base that are covered in another presentation.
You are now familiar with a variety of cost accounting terms. Think about your understanding of each one as we review the list. "Cost," "cost objects," "cost pools," "unit average costs," "marginal and variable cost," "cost assignment," "cost tracing," "cost allocation," "cost drivers," "cost allocation bases."
If you're not comfortable with any of these terms, review it again. These terms are fundamental to any study of cost or managerial accounting and any lack of understanding can cause you problems later. This is the end of defining cost terms.