A cost object, or cost driver, is anything you would like cost data on. This can include products, customers, job or subunits of the company. The costs are assigned to these cost objects for multiple purposes, including pricing, spending control and profitability studies.

Take a look at this video for a review of cost drivers and costs:

You can download the transcript for the video “What are Cost Drivers? (Cost Accounting Tutorial #2)” here.

When we assign these costs to a cost object, we need to differentiate between direct and indirect costs.

Direct costs can be easily traced to a specific cost object, such as a product or service. An example would be the person who runs the cutting machine in a print shop, or the paper for brochures that are printed.

Indirect costs cannot be easily traced to a specific cost object. An example here might be the oil for a piece of equipment or custodial wages for cleaning the manufacturing plant.

Costs can be direct or indirect, depending on the cost object. Let’s look at the wages paid to the plant manager who oversees the entire manufacturing process at a print shop. The manager’s wages are a direct expense of manufacturing, if we are using manufacturing as our cost object. If we are using a customer order of 1000 flyers as our cost object, then the manager’s wages are an indirect expense of that cost object.

The product costs includes:

• Direct materials: These costs can be directly and easily traced to a specified cost object. If you make running shoes, the materials that are in the shoes are direct materials. If you create printed flyers, the paper they are printed on are direct materials.
• Indirect materials: This includes items of materials that are not easily traceable to a specific cost object. The oil for a machine, needles for a sewing machine or glue for the running shoes may be too small to worry about tracking for each item. These materials may be lumped into manufacturing overhead.
• Direct labor: The labor cost that can be directly and easily traced to a specified cost object. The employees who run the presses in a printing company, or those who attach the soles to the shoes are considered direct labor.
• Indirect labor: This includes the wages for custodial work, security guards and supervisors. These wages can’t be directly linked to a particular product, but are needed for the overall operation of the company. These costs, like indirect materials, might be put into the manufacturing overhead calculation.
• Manufacturing overhead: This is a catch-all category and it includes any costs of manufacturing other than materials and labor. Incidental materials and labor, maintenance on machinery or custodial wages would be included here. Any expense incurred for the manufacture or acquisition of the product a company makes or sells, that is NOT direct labor or direct materials, will be put here, and then later allocated.

There are two final types of manufacturing costs that may be used in discussion.

1. Prime cost is the total of direct labor plus direct materials.
2. Conversion cost is the sum of direct labor plus manufacturing overhead costs. These are the costs required to turn (convert) a raw material into a finished product.

Let’s look at an example to better clarify the differences between the different manufacturing costs.

SunRize, an organic sports drink company has incurred the following costs:

We can categorize these costs in many ways including the following:

Product Cost

[latex]\begin{array}{lr}\text{Product cost}&=&\text{direct materials}&+&\text{direct labor}&+&\text{manufacturing overhead}&&\\&=& \$60,000&+&\$30,000&+&\$15,000&=&\$105,000\end{array}[/latex]

Period Cost

[latex]\begin{array}{llr}\text{Period cost}&=&\text{Selling expenses}&+&\text{Administrative expenses}&&\\&=&\$22,000&+&\$45,000&=&\$67,000\end{array}[/latex]

Conversion Costs

[latex]\begin{array}{llr}\text{Conversion costs}&=&\text{Direct labor}&+&\text{Manufacturing overhead}&&\\&=&\$30,000&+&\$15,000&=&\$45,000\end{array}[/latex]

Prime Costs

[latex]\begin{array}{llr}\text{Prime costs}&=&\text{Direct material}&+&\text{Direct labor}&&\\&=&\$60,000&+&\$30,000&=&\$90,000\end{array}[/latex]

These are the basic classifications of costs in businesses. Each serves a purpose in helping to make decisions as a manager. Knowing how these costs interact and respond with changing levels of activity is an important management task.