Introduction to Classifying Costs

What you will learn to do: assign costs to common cost categories

Building under constructionThe term “cost accounting” is sometimes used interchangeably with the term “managerial accounting,” but cost accounting is actually a subset of managerial accounting.

Managerial accounting deals with a wide variety of issues, including revenue forecasts, budgeting, capital decision making, and other non-cost issues, as you will see in this course. As you might expect, cost accounting specifically focuses on costs.

Costs are the result of paying cash or committing to pay cash in the future in order to earn revenue. Costs may be accumulated for a product, sales territory, department, or activity. It is critical to analyze costs because controlling them directly impacts profitability. Costs are also used to determine the selling prices of products, and they are monitored over time to evaluate progress and discover irregularities.

Note: usually, in accounting, the term “cost” means the amount paid for an item, and “price” means the sales price. For example, an item that a firm buys to resell costs $100. The firm lists it for sale at a price of $150. The “markup” is $50.

Cost accounting covers four broad categories: accumulating costs, analyzing costs, evaluating performance, and comparing alternatives.

Accumulating costs

Costs must be determined and recorded accurately, systematically, and on a timely basis. Unless cost information is correct and reliable, it is not very useful to managers who depend on it to make effective plans and informed decisions. Job order costing and process costing are two methods of systematically accumulating costs on manufactured products. Activity-based costing is a system that is combined with the other two methods to identify and measure costs more specifically.

Analyzing costs

Not all costs are created equal. Some are unavoidable; others are somewhat controllable. Separating them allows managers to focus on controllable costs that should be monitored in order to contain or lower them. Costs may also be used to mathematically determine sales requirements to achieve desired levels of volume and profitability. Break-even analysis and other cost relationships, as well as variable costing, will address these issues.

Evaluating performance

Planning involves looking into the future and estimating what a business’s financial activities will look like. This process is called budgeting, and it projects what sales, costs, production, cash flows, etc. will be at a future point in time. Controlling methods such as variance analysis compare expected outcomes to actual results and analyze overall progress in meeting goals.

Comparing alternatives

Managerial decision-making includes choosing one option over others, such as whether to make or buy a component part or whether to continue manufacturing a product. For instance, capital investment analysis involves evaluating proposed investments in property, plant, or equipment that a company will use in its operations.

Cost is a financial measure of the resources used or given up to achieve a stated purpose. Product costs are the costs of making a product, such as an automobile; the cost of making and serving a meal in a restaurant; or the cost of teaching a class in a university. A company assigns product costs to units produced. Often, the object to which costs are being assigned is called the cost object.

Manufacturing companies use the most complex product costing methods. To ensure that you understand how and why product costing is done in manufacturing companies, we use many manufacturing company examples. However, since many of you could have careers in service or merchandising companies, we also use non-manufacturing examples.

In this section, we’ll look at four different ways to classify costs that will help us with the four categories above:

  • Product and Period
  • Direct and Indirect
  • Prime and Conversion
  • Fixed and Variable

You’ll find even more ways to classify costs as you learn to plan, direct, and control operations. For instance, some costs are controllable and some are non-controllable. Rent, in the short term, is non-controllable. Advertising is controllable, but reducing the marketing budget could have long-term negative ramifications. You’ll also run into terms such as discretionary and non-discretionary, differential costs, opportunity costs, and more. For now, however, we’ll focus on the classifications listed above.

When you are done with this section, you will be able to:

  • Differentiate between period and product costs
  • Differentiate between direct and indirect costs
  • Differentiate between prime and conversion costs
  • Differentiate between fixed and variable costs

Learning Activities

The learning activities for this section include the following:

  • Reading: Period and Product Costs
  • Self Check: Period and Product Costs
  • Reading: Direct and Indirect Costs
  • Self Check: Direct and Indirect Costs
  • Reading: Prime and Conversion Costs
  • Self Check: Prime and Conversion Costs
  • Reading: Fixed and Variable Costs
  • Self Check: Fixed and Variable Costs