To study cost accounting and operational control systems, it is necessary to understand the meaning of cost and to become familiar with the cost terminology associated with the two systems. One must also understand the process used to assign costs. Cost assignment is one of the key processes of the cost accounting system. Improving the cost assignment process has been one of the major developments in the cost management field in recent years. Before discussing the cost assignment process, we first need to define what we mean by cost. Cost is the cash or cash equivalent value sacrificed for goods and services that are expected to bring a current or future benefit to the organization. We say cash equivalent because noncash assets can be exchanged for the desired goods or services. For example, it may be possible to exchange equipment for materials used in production.
Costs are incurred to produce future benefits. In a profit making firm, future benefits usually mean revenues. As costs are used up in the production of revenues, they are said to expire. Expired costs are called expenses. In each period, expenses are deducted from revenues on the income statement to determine the period’s profit. A loss is a cost that expires without producing any revenue benefit. For example, the cost of uninsured inventory destroyed by a flood would be classified as a loss on the income statement. Many costs do not expire in a given period. These unexpired costs are classified as assets and appear on the balance sheet. Computers and factory buildings are examples of assets lasting more than one period. Note that the main difference between a cost being classified as an expense or as an asset is timing. This distinction is important and will be referred to in the development of other cost concepts later in the text.
Costs are incurred to produce future benefits. In a profit making firm, future benefits usually mean revenues. As costs are used up in the production of revenues, they are said to expire. Expired costs are called expenses. In each period, expenses are deducted from revenues on the income statement to determine the period’s profit. A loss is a cost that expires without producing any revenue benefit. For example, the cost of uninsured inventory destroyed by a flood would be classified as a loss on the income statement. Many costs do not expire in a given period. These unexpired costs are classified as assets and appear on the balance sheet. Computers and factory buildings are examples of assets lasting more than one period. Note that the main difference between a cost being classified as an expense or as an asset is timing. This distinction is important and will be referred to in the development of other cost concepts later in the text.
Cost Objects
Management accounting systems are structured to measure and assign costs to cost objects. A cost object is any item, such as products, customers, departments, projects, activities, and so on, for which costs are measured and assigned. For example, if we want to determine what it costs to produce a bicycle, then the cost object is the bicycle. If we want to determine the cost of operating a maintenance department within a plant, then the cost object is the maintenance department. If we want to determine the cost of developing a new toy, then the cost object is the new toy development project. As a final example, activities should be mentioned. An activity is a basic unit of work performed within an organization. An activity can also be defined as an aggregation of actions within an organization useful to managers for purposes of planning, controlling, and decision making. In recent years, activities have emerged as important cost objects.Activities play a prominent role in assigning costs to other cost objects and are essentialelements of an activity-based management accounting system. Examples of activities includesetting up equipment for production, moving materials and goods, purchasingparts, billing customers, paying bills, maintaining equipment, expediting orders, designing products, and inspecting products. Notice that an activity is described by an action verb (e.g., paying and designing) and an object (e.g., bills and products) that receives the action. Notice also that the action verb and the object reveal very specific goals.
Accuracy of Assignments
Assigning costs accurately to cost objects is crucial. Our notion of accuracy is not evaluated based on knowledge of some underlying “true” cost. Rather, it is a relative concept and has to do with the reasonableness and logic of the cost assignment methods that are being used. The objective is to measure and assign as accurately as possible the cost of the resources used by a cost object. Some cost assignment methods are clearly more accurate than others. For example, suppose you want to determine the cost of lunch for Elaine Day, a student who frequents Hideaway, an off-campus pizza parlor. One cost assignment approach is to count the number of customers Hideaway has between 12:00 P.M. and 1:00 P.M. and then divide the total receipts earned by Hideaway during this period. Suppose that this divides out to $4.50 per lunchtime customer. Thus, based on this approach we would conclude that Elaine spends $4.50 per day for lunch.
Management accounting systems are structured to measure and assign costs to cost objects. A cost object is any item, such as products, customers, departments, projects, activities, and so on, for which costs are measured and assigned. For example, if we want to determine what it costs to produce a bicycle, then the cost object is the bicycle. If we want to determine the cost of operating a maintenance department within a plant, then the cost object is the maintenance department. If we want to determine the cost of developing a new toy, then the cost object is the new toy development project. As a final example, activities should be mentioned. An activity is a basic unit of work performed within an organization. An activity can also be defined as an aggregation of actions within an organization useful to managers for purposes of planning, controlling, and decision making. In recent years, activities have emerged as important cost objects.Activities play a prominent role in assigning costs to other cost objects and are essentialelements of an activity-based management accounting system. Examples of activities includesetting up equipment for production, moving materials and goods, purchasingparts, billing customers, paying bills, maintaining equipment, expediting orders, designing products, and inspecting products. Notice that an activity is described by an action verb (e.g., paying and designing) and an object (e.g., bills and products) that receives the action. Notice also that the action verb and the object reveal very specific goals.
Accuracy of Assignments
Assigning costs accurately to cost objects is crucial. Our notion of accuracy is not evaluated based on knowledge of some underlying “true” cost. Rather, it is a relative concept and has to do with the reasonableness and logic of the cost assignment methods that are being used. The objective is to measure and assign as accurately as possible the cost of the resources used by a cost object. Some cost assignment methods are clearly more accurate than others. For example, suppose you want to determine the cost of lunch for Elaine Day, a student who frequents Hideaway, an off-campus pizza parlor. One cost assignment approach is to count the number of customers Hideaway has between 12:00 P.M. and 1:00 P.M. and then divide the total receipts earned by Hideaway during this period. Suppose that this divides out to $4.50 per lunchtime customer. Thus, based on this approach we would conclude that Elaine spends $4.50 per day for lunch.
Another approach
is to go with Elaine and observe how much she spends. Suppose that she has a slice of pizza and a medium drink each day, costing $2.50. It is not difficult to see which cost assignment is more accurate. The $4.50 cost assignment is distorted by the consumption patterns of other customers (cost objects). As it turns out, most lunchtime clients order the luncheon special for $4.99 (a mini-pizza, salad, and medium drink). Distorted cost assignments can produce erroneous decisions and poor evaluations. For example, if a plant manager is trying to decide whether to continue producing power internally or to buy it from a local utility company, then an accurate assessment of how much it is costing to produce the power internally is fundamental to the analysis. If the cost of internal power production is overstated, the manager might decide to shut down the internal power department in favor of buying power from an outside company, whereas a more accurate cost assignment might suggest the opposite. It is easy to see that poor cost assignments can prove to be costly.
Traceability
The relationship of costs to cost objects can be exploited to help increase the accuracy of cost assignments. Costs are directly or indirectly associated with cost objects. Indirect costs are costs that cannot be traced easily and accurately to a cost object. Direct costs are those costs that can be traced easily and accurately to a cost object. For costs to be traced easily means that the costs can be assigned in an economically feasible way. For costs to be traced accurately means that the costs are assigned using a causal relationship. Thus, traceability is simply the ability to assign a cost directly to a cost object in an economically feasible way by means of a causal relationship. The more costs that can be traced to the object, the greater the accuracy of the cost assignments. Establishing traceability is a key element in building accurate cost assignments. One additional point needs to be emphasized. Cost management systems typically deal with many cost objects. Thus, it is possible for a particular cost item to be classified as both a direct cost and an indirect cost. It all depends on which cost object is the point of reference. For example, if the plant is the cost object, then the cost of heating and cooling the plant is a direct cost; however, if the cost objects are products produced in the plant, then this utility cost is an indirect cost.
Methods of Tracing
Traceability means that costs can be assigned easily and accurately, using a causal relationship. Tracing costs to cost objects can occur in one of two ways: (1) direct tracing and (2) driver tracing. Direct tracing is the process of identifying and assigning costs to a cost object that are specifically or physically associated with the cost object. Identifying costs that are specifically associated with a cost object is most often accomplished by physical observation. For example, assume that the power department is the cost object. The salary of the power department’s supervisor and the fuel used to produce power are examples of costs that can be specifically identified (by physical observation) with the cost object (the power department). As a second example, consider a pair of blue jeans. The materials (denim, zipper, buttons, and thread) and labor (to cut the denim according to the pattern and sew the pieces together) are physically observable; therefore, the costs of materials and labor can be directly charged to a pair of jeans. Ideally, all costs should be charged to cost objects using direct tracing.
Unfortunately, it is often not possible to physically observe the exact amount of resources being consumed by a cost object. The next best approach is to use cause-andeffect reasoning to identify factors called drivers that can be observed and which measure a cost object’s resource consumption. Drivers are factors that cause changes in resource usage, activity usage, costs, and revenues. Driver tracing is the use of drivers to assign costs to cost objects. Although less precise than direct tracing, driver tracing is very accurate if the cause-and-effect relationship is sound. Consider the cost of electricity for the jeans manufacturing plant. The factory manager might want to know how much electricity is used to run the sewing machines. Physically observing how much electricity is used would require a meter to measure the power consumption of the sewing machines, which may not be practical. Thus, a driver such as “machine hours” could be used to assign the cost of electricity.
Assigning Indirect Costs
Indirect costs cannot be traced to cost objects. This means that there is no causal relationship between the cost and the cost object, or that tracing is not economically feasible. Assignment of indirect costs to cost objects is called allocation. Since no causal relationship exists, allocating indirect costs is based on convenience or some assumed linkage. For example, consider the cost of heating and lighting a plant that manufactures five products. Suppose that this utility cost is to be assigned to the five products. Clearly, it is difficult to see any causal relationship. A convenient way to allocate this cost is simply to assign it in proportion to the direct labor hours used by each product. Arbitrarily allocating indirect costs to cost objects reduces the overall accuracy of the cost assignments. Accordingly, the best costing policy may be that of assigning only traceable direct costs to cost objects. However, it must be admitted that allocations of indirect costs may serve other purposes besides accuracy. For example, allocating indirect costs to products may be required for external reporting. Nonetheless, most managerial uses of cost assignments are better served by accuracy. At the very least, directand indirect cost assignments should be reported separately.
Cost Assignment Summarized
The foregoing discussion reveals three methods of assigning costs to cost objects: direct tracing, driver tracing, and allocation. These methods are illustrated in Exhibit 2-5. Of the three methods, direct tracing is the most precise since it relies on physically observable causal relationships. Direct tracing is followed by driver tracing in terms of cost assignment accuracy. Driver tracing relies on causal factors called drivers to assign costs to cost objects. The precision of driver tracing depends on the strength of the causal relationship described by the driver. Identifying drivers and assessing the quality of the causal relationship is much more costly than either direct tracing or allocation. In fact, one advantage of allocation is that it is simple and inexpensive to implement. However, allocation is the least accurate cost assignment method, and its use should be avoided where possible. In many cases, the benefits of increased accuracy by driver tracing outweigh its additional measurement cost. This cost-benefit issue is discussed more fully later in the chapter. What the process really entails is choosing among competing cost management systems.
is to go with Elaine and observe how much she spends. Suppose that she has a slice of pizza and a medium drink each day, costing $2.50. It is not difficult to see which cost assignment is more accurate. The $4.50 cost assignment is distorted by the consumption patterns of other customers (cost objects). As it turns out, most lunchtime clients order the luncheon special for $4.99 (a mini-pizza, salad, and medium drink). Distorted cost assignments can produce erroneous decisions and poor evaluations. For example, if a plant manager is trying to decide whether to continue producing power internally or to buy it from a local utility company, then an accurate assessment of how much it is costing to produce the power internally is fundamental to the analysis. If the cost of internal power production is overstated, the manager might decide to shut down the internal power department in favor of buying power from an outside company, whereas a more accurate cost assignment might suggest the opposite. It is easy to see that poor cost assignments can prove to be costly.
Traceability
The relationship of costs to cost objects can be exploited to help increase the accuracy of cost assignments. Costs are directly or indirectly associated with cost objects. Indirect costs are costs that cannot be traced easily and accurately to a cost object. Direct costs are those costs that can be traced easily and accurately to a cost object. For costs to be traced easily means that the costs can be assigned in an economically feasible way. For costs to be traced accurately means that the costs are assigned using a causal relationship. Thus, traceability is simply the ability to assign a cost directly to a cost object in an economically feasible way by means of a causal relationship. The more costs that can be traced to the object, the greater the accuracy of the cost assignments. Establishing traceability is a key element in building accurate cost assignments. One additional point needs to be emphasized. Cost management systems typically deal with many cost objects. Thus, it is possible for a particular cost item to be classified as both a direct cost and an indirect cost. It all depends on which cost object is the point of reference. For example, if the plant is the cost object, then the cost of heating and cooling the plant is a direct cost; however, if the cost objects are products produced in the plant, then this utility cost is an indirect cost.
Methods of Tracing
Traceability means that costs can be assigned easily and accurately, using a causal relationship. Tracing costs to cost objects can occur in one of two ways: (1) direct tracing and (2) driver tracing. Direct tracing is the process of identifying and assigning costs to a cost object that are specifically or physically associated with the cost object. Identifying costs that are specifically associated with a cost object is most often accomplished by physical observation. For example, assume that the power department is the cost object. The salary of the power department’s supervisor and the fuel used to produce power are examples of costs that can be specifically identified (by physical observation) with the cost object (the power department). As a second example, consider a pair of blue jeans. The materials (denim, zipper, buttons, and thread) and labor (to cut the denim according to the pattern and sew the pieces together) are physically observable; therefore, the costs of materials and labor can be directly charged to a pair of jeans. Ideally, all costs should be charged to cost objects using direct tracing.
Unfortunately, it is often not possible to physically observe the exact amount of resources being consumed by a cost object. The next best approach is to use cause-andeffect reasoning to identify factors called drivers that can be observed and which measure a cost object’s resource consumption. Drivers are factors that cause changes in resource usage, activity usage, costs, and revenues. Driver tracing is the use of drivers to assign costs to cost objects. Although less precise than direct tracing, driver tracing is very accurate if the cause-and-effect relationship is sound. Consider the cost of electricity for the jeans manufacturing plant. The factory manager might want to know how much electricity is used to run the sewing machines. Physically observing how much electricity is used would require a meter to measure the power consumption of the sewing machines, which may not be practical. Thus, a driver such as “machine hours” could be used to assign the cost of electricity.
Assigning Indirect Costs
Indirect costs cannot be traced to cost objects. This means that there is no causal relationship between the cost and the cost object, or that tracing is not economically feasible. Assignment of indirect costs to cost objects is called allocation. Since no causal relationship exists, allocating indirect costs is based on convenience or some assumed linkage. For example, consider the cost of heating and lighting a plant that manufactures five products. Suppose that this utility cost is to be assigned to the five products. Clearly, it is difficult to see any causal relationship. A convenient way to allocate this cost is simply to assign it in proportion to the direct labor hours used by each product. Arbitrarily allocating indirect costs to cost objects reduces the overall accuracy of the cost assignments. Accordingly, the best costing policy may be that of assigning only traceable direct costs to cost objects. However, it must be admitted that allocations of indirect costs may serve other purposes besides accuracy. For example, allocating indirect costs to products may be required for external reporting. Nonetheless, most managerial uses of cost assignments are better served by accuracy. At the very least, directand indirect cost assignments should be reported separately.
Cost Assignment Summarized
The foregoing discussion reveals three methods of assigning costs to cost objects: direct tracing, driver tracing, and allocation. These methods are illustrated in Exhibit 2-5. Of the three methods, direct tracing is the most precise since it relies on physically observable causal relationships. Direct tracing is followed by driver tracing in terms of cost assignment accuracy. Driver tracing relies on causal factors called drivers to assign costs to cost objects. The precision of driver tracing depends on the strength of the causal relationship described by the driver. Identifying drivers and assessing the quality of the causal relationship is much more costly than either direct tracing or allocation. In fact, one advantage of allocation is that it is simple and inexpensive to implement. However, allocation is the least accurate cost assignment method, and its use should be avoided where possible. In many cases, the benefits of increased accuracy by driver tracing outweigh its additional measurement cost. This cost-benefit issue is discussed more fully later in the chapter. What the process really entails is choosing among competing cost management systems.
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