Cost Objects and Cost Pools

Next, we will discuss cost objects and cost pools.

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 would say it is anything for which a manager desires a cost, or someone with the power to get the cost, desires a cost.

Let's review some specific examples:

Products

Products, such as a car. A product is a common example that anyone would have thought of immediately. Some additional examples will show cost is not just a narrow concept that's applied to a product at a manufacturing company.

Product Lines

Product lines, such as digital single lens reflex cameras. This example is included because it is a common practice among the Japanese. An American company that makes four different cameras would likely try to determine the profitability of each camera. A Japanese company will look at the profitability of the overall camera line. Assume Nikon has four cameras in its single lens reflex camera line. Nikon might sell the entry level camera near breakeven, the next level up might sell at a 30% profit, the third level at a 50% profit, and top level at an 80% profit. The company might take the position that it is willing to have very little profit on its entry level camera to get someone to buy Nikon. 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, Nikon is happy.

The advantage this provides the Japanese is that when they treat the entire product line as the 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'd 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 way to look at the world.

Services

Services. If you're going to open a Jiffy Lube, you need to know what it costs you to change the oil in a car.

Jobs

Jobs. If you're opening an accounting firm, each client is billed for the particular services he or she desires. To determine whether your work for Exxon is profitable, you need to know what it cost you to do the Exxon audit or the Exxon tax return. Note that you might charge based on time or based on particular services within a 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."

Projects

Projects, such as research and development to create a new drug to lower cholesterol.

Organizational Units

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.

Activities or Processes

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, say, 25 cents to do a credit card authorization, do you really want to do one on a 25 cent or $1 sale, or do you want to have some minimum level?

Distribution Channels

Distribution channels. What does it cost to do an Internet sale versus a retail outlet sale? 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 outlet sales and quit doing retail outlet sales. Although Dell has re-entered the retail outlet market, it has not eliminated use of the Internet.

Customers

Customers, such as Wal-Mart. What does it cost 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 cost 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 are quick with your math, you are 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 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

Cost pools. Accountants pool the costs 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. Three examples are reviewed here:

Manufacturing Overhead

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.

On the other hand, some companies may accumulate overhead in separate pools for different factory departments, such as assembly and finishing.

Departments

Departments, such as accounting, human resources and shipping, are a common way that companies accumulate their costs and pool them together.

Geographical Regions

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.

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