cost assignment elements

Cost Accounting: What It Is And When To Use It

Updated: Jun 1, 2024, 2:12pm

Table of Contents

What is cost accounting, types of cost accounting, cost accounting vs. financial accounting, cost accounting software, frequently asked questions (faqs).

Knowing how much your business spends is a key component of accounting. After all, if you don’t have this information on hand, it will be difficult to determine whether you’re making a profit. That’s where cost accounting comes in. It revolves around the costs associated with running your business.

Cost accounting is a type of managerial accounting that focuses on the cost structure of a business. It assigns costs to products, services, processes, projects and related activities. Through cost accounting, you can home in on where your business is spending its money, how much it earns and where you might be losing money. Managers and employees may use cost accounting internally to improve your business’s profitability and efficiency.

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Elements of Cost Accounting

There are a few key elements of cost accounting, listed below.

Direct and Indirect Materials

Materials are usually divided into two groups: direct and indirect. Direct materials are directly integrated into a finished product. Cotton in clothing and wood in furniture are a few examples of direct materials. Meanwhile, indirect materials are used in the production process but can’t be tied to a specific product, such as glue, gloves and tape.

Direct Labor

Labor refers to any wages to employees which relate to a specific aspect of producing products or delivering services. Wages can include salaries, hourly rates, overtime, bonuses and employee benefits.

Overheads are costs that relate to ongoing business expenses that are not directly attributed to creating products or services. Office staff, utilities, the maintenance and repair of equipment, supplies, payroll taxes, depreciation of machinery, rent and mortgage payments and sales staff are all considered overhead costs.

There are several types of cost accounting. Find the breakdown of each type below.

Standard Cost Accounting

Standard cost accounting is a traditional method for analyzing business costs. It assigns an average cost to labor, materials and overhead evenly so that managers can plan budgets, control costs and evaluate the performance of cost management. Many small businesses prefer standard cost accounting due to its ease and simplicity.

Activity-based Cost Accounting

Activity-based accounting (ABC) assigns overhead costs to products and services to give you a better idea of what they cost. Compared to standard cost accounting, ABC dives deeper into the cost of manufacturing a product or providing a service. It can help explain which activities increase production costs.

Marginal Cost Accounting

Also known as marginal costing, marginal cost accounting reveals the incremental cost that comes with producing additional units of goods and services. With marginal cost accounting, you can identify the point where production is maximized and costs are minimized.

Lean Accounting

Lean accounting is designed to streamline accounting processes to maximize productivity and quality. It eliminates unnecessary transactions and systems, reducing time, costs and waste. You can use it to understand what creates the most value for your customers and how you can continuously improve.

Life Cycle Accounting

Life cycle accounting examines the cost of producing a product from start to finish so you know how much you’ll spend on it over its useful life. It can come in handy if you’d like to choose between two or more assets, understand the benefits of an asset and budget more accurately.

Cost accounting is specifically intended for managers and employees who are a part of your business and responsible for making important decisions. It can help them improve operations and increase profitability.

Financial accounting, on the other hand, is designed to help shareholders, lenders, regulators and other parties who don’t have access to your internal information. It takes a business’s financials and presents them in a way that showcases how it’s doing in terms of assets, liabilities and shareholders’ equity.

The reality is cost accounting is complex and tedious. By automating it with cost accounting software, you can save time and money. NetSuite is one example of software that offers cost accounting capabilities. It’s versatile, customizable and integrates easily with a variety of other tools your business may already be using. Learn more about it with our NetSuite review .

Bottom Line

No matter your industry, cost accounting is essential for your internal team. It will help you record and analyze the costs of products in services so that you can operate smoothly and grow your business. If you don’t have the time or expertise to handle your accounting manually, get the help you need with one of the best accounting platforms .

What is the purpose of cost accounting?

Cost accounting can give your business detailed insight into how your money is being spent. With this information, you can better budget for the future, reduce inefficiencies and increase profitability.

What is the main difference between cost accounting and financial accounting?

Financial accounting is governed by regulators and must comply with the generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS). Cost accounting, however, doesn’t have to abide by these regulations since it’s used internally.

Is QuickBooks the best accounting software?

QuickBooks is one of the most popular accounting software programs on the market and while it is one of the best options, it’s not necessarily the best for every business. For example, while QuickBooks is very robust, it may involve a steeper learning curve and come at a higher cost than competitors–especially for businesses that want to use its payroll features. For more information, check out our QuickBooks Online review .

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Anna Baluch is a freelance writer from Cleveland, Ohio. She enjoys writing about a variety of health and personal finance topics. When she's away from her laptop, she can be found working out, trying new restaurants, and spending time with her family. Connect to her on LinkedIn.

What is Cost Structure?

Fixed vs. variable costs, fixed costs, variable costs, direct vs. indirect costs, direct costs, indirect costs, cost allocation, example of cost allocation, the importance of cost structures and cost allocation, additional resources, cost structure.

The different types of cost structures incurred by a business

Cost structure refers to the various types of expenses a business incurs and is typically composed of  fixed and variable costs . Costs may also be divided into direct and indirect costs. Fixed costs are costs that remain unchanged regardless of the amount of output a company produces, while variable costs change with production volume.

Direct costs are costs that can be attributed to a specific product or service, and they do not need to be allocated to the specific cost object. Indirect costs are costs that cannot be easily associated with a specific product or activity because they are involved in multiple activities.

Operating a business must incur some kind of costs, whether it is a retail business or a service provider. Cost structures differ between retailers and service providers, thus the expense accounts appearing on a  financial statement  depend on the cost objects, such as a product, service, project, customer or business activity. Even within a company, cost structure may vary between product lines, divisions or business units, due to the distinct types of activities they perform.

Key Highlights

• Cost structure refers to the various types of expenses a business incurs and is typically composed of fixed and variable costs, or direct and indirect costs.
• Fixed costs are incurred regularly and are unlikely to fluctuate over time. Variable costs are expenses that vary with production output.
• Direct costs are costs that are directly related to the creation of a product and can be directly associated with that product. Direct costs are usually variable costs, with the possible exception of labor costs. Indirect costs are costs that are not directly related to a specific cost object. Indirect costs may be fixed or variable.
• Having a firm understanding of the difference between fixed and variable and direct and indirect costs is important because it shapes how a company prices the goods and services it offers.

Fixed costs are incurred regularly and are unlikely to fluctuate over time. Examples of fixed costs are overhead costs such as rent, interest expense, property taxes, and  depreciation  of fixed assets. One special example of a fixed cost is direct labor cost. While direct labor cost tends to vary according to the number of hours an employee works, it still tends to be relatively stable and, thus, may be counted as a fixed cost, although it is more commonly classified as a variable cost where hourly workers are concerned.

Variable costs are expenses that vary with production output. Examples of variable costs may include direct labor costs,  direct material cost , and bonuses and sales commissions. Variable costs tend to be more diverse than fixed costs. For businesses selling products, variable costs might include direct materials, commissions, and piece-rate wages. For service providers, variable expenses are composed of wages, bonuses, and travel costs. For project-based businesses, costs such as wages and other project expenses are dependent on the number of hours invested in each of the projects.

As alluded to earlier, direct costs are costs that are directly related to the creation of a product and can be directly associated with that product. Direct material is an example of a direct cost.

Direct costs are almost always variable because they are going to increase when more goods are produced. As discussed earlier, an exception to this is labor. Employee wages may be fixed and unlikely to change over the course of a year. However, if the employees are hourly and not on a fixed salary then the direct labor costs can increase if more products are manufactured.

Indirect costs are costs that are not directly related to a specific cost object like a function, product or department. They are costs that are needed for the sake of the company’s operations and health. Some other examples of indirect costs include overhead , security costs, administration costs, etc. The costs are first identified, pooled, and then allocated to specific cost objects within the organization.

Indirect costs may be either fixed or variable costs. An example of a fixed cost is the salary of a project supervisor assigned to a specific project. An example of a variable indirect cost would be utilities expense. This expense may fluctuate depending on production (for example, there would be an increase in utility expense if a manufacturing plant is running at a higher capacity utilization ).

Having a firm understanding of the difference between fixed and variable and direct and indirect costs is important because it shapes how a company prices the goods and services it offers. Knowing the actual costs of production enables the company to price its products efficiently and competitively.

Cost allocation is the process of identifying costs incurred, and then accumulating and assigning them to the right cost objects (e.g. product lines, service lines, projects, departments, business units, customers, etc.) on some measurable basis. Cost allocation is used to distribute costs among different cost objects in order to calculate the profitability of different product lines.

A cost pool is a grouping of individual costs, from which cost allocations are made later. Overhead cost, maintenance cost and other fixed costs are typical examples of cost pools. A company usually uses a single cost-allocation basis, such as labor hours or machine hours, to allocate costs from cost pools to designated cost objects.

A company with a cost pool of manufacturing overhead uses direct labor hours as its cost allocation basis. The company first accumulates its overhead expenses over a period of time (for example, a year) and then divides the total overhead cost by the total number of labor hours to find out the overhead cost “per labor hour” (the overhead allocation rate ). Finally, the company multiplies the hourly cost by the number of labor hours spent to manufacture a product to determine the overhead cost for that specific product line.

To maximize  profits , businesses must find every possible way to minimize costs. While some fixed costs are vital to keeping the business running, a  financial analyst  should always review the financial statements to identify possible excessive expenses that do not provide any additional value to core business activities.

When an analyst understands the overall cost structure of a company, they can identify feasible cost-reduction methods without affecting the quality of products sold or service provided to customers. The financial analyst should also keep a close eye on the cost trend to ensure stable cash flows and no sudden cost spikes occurring.

Cost allocation is an important process for a business because if costs are misallocated, then the business might make wrong decisions, such as over/underpricing a product, or invest unnecessary resources in non-profitable products. The role of a financial analyst is to make sure costs are correctly attributed to the designated cost objects and that appropriate cost allocation bases are chosen.

Cost allocation allows an analyst to calculate the per-unit costs for different product lines, business units, or departments, and, thus, to find out the per-unit profits. With this information, a financial analyst can provide insights on improving the profitability of certain products, replacing the least profitable products, or implementing various strategies to reduce costs.

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Classification of Cost

Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on March 07, 2023

Get Any Financial Question Answered

Table of contents.

The idea of cost accounting is to collect, classify, record, and suitably allocate expenditures to determine the costs of products or services.

After collecting costs, these are classified to ensure their identification with cost centers or cost units.

Costs have different features or characteristics, and they are grouped or classified based on their common characteristics.

The process of grouping costs based on their common characteristics is known as the classification of cost .

Different Classes of Cost

The groups that costs are classified into are known as classes .

Costs can be classified using different bases or characteristics, including element, nature, variability, controllability , normality, and function. The main classes of cost are shown in the image below.

Classification of Cost by Element

In this class, costs are categorized based on the factors they are incurred for. Based on their elements, costs may be grouped as:

• Material cost

Material cost refers to the cost of commodities supplied to an undertaking (e.g., in the case of a textile mill, the cost of cotton or yarn, the cost of cotton waste to clean the machinery, the cost of dyes, the cost of finishing material, and so on).

Labor cost refers to the cost of paying employees in an undertaking, which includes salary, wages, and commission.

Expenses refer to the cost of services provided to an undertaking and include the notional cost of owned assets (e.g., rent for a building, telephone expenses, depreciation of the owned factory building, depreciation of delivery van, and so on).

Classification of Cost by Nature

In this class, costs are classified based on their identifiability with cost centers or cost units. Costs can be grouped as follows based on their nature:

• Direct costs
• Indirect costs

Direct costs are costs that can be directly and easily traced to (or identified with) a product, process, or department.

Common examples of direct costs include the materials used and labor employed in manufacturing an article or in a production process.

Indirect costs , on the other hand, are costs that are not traceable to any particular product, process, or department, but which are common in a number of products, processes, or departments.

Examples of indirect costs are factory rent, factory insurance, and the salary of the factory manager.

Classification of Cost by Variability or Behavior

Costs (both direct and indirect) can also be classified into the following groups based on their behavior relative to changes in the volume of activity:

• Variable costs
• Fixed costs
• Semi-variable or semi-fixed costs

Variable costs are costs that vary in a directly proportional way to changes in the volume of output or sales.

These costs tend to increase or decrease with the rise and fall in production or sales. Variable costs vary in total but their per-unit cost stays the same.

Examples of variable costs are direct material cost, direct wages, direct expenses, consumable stores, and commission on sales.

Fixed costs are costs that generally remain unaffected by changes in sales volume/output. Fixed costs remain unchanged when output or sales increase or decrease.

These costs remain fixed in total but their per-unit cost changes with output or sales.

These costs depend mainly on the passage of time and do not vary directly with the changes in the volume of output or sales.

Typical examples of fixed costs include rent, rates, taxes, insurance charges, and salaries for managers.

It is worth remembering that fixed costs are not absolutely fixed for all of time. In fact, fixed costs are fixed only in relation to a particular level of production capacity.

Semi-variable costs are costs that tend to vary with changes in the volume of output or sales, but which do not vary in a directly proportional way relative to such changes. These costs have the characteristics of both fixed and variable costs.

One part of semi-variable costs remains constant irrespective of changes in the volume of output or sales. By contrast, the other part varies in proportion to changes in the volume of output or sales.

Typical examples of semi-variable costs include repairs and maintenance costs for plants, machinery, and buildings and supervisor salaries.

Cost Classification by Controllability

Under this category, costs are classified based on whether or not they are influenced by the action of a given member of an undertaking. The classes of costs are:

• Controllable costs
• Uncontrollable costs

Controllable costs are costs that an entity in an undertaking can influence through their action.

An undertaking is usually divided into several departments or cost centers that are placed under the direct control and supervision of specified persons.

The person in charge of a particular department or cost center can control only those costs that come directly under their control.

Uncontrollable costs , on the other hand, are costs that cannot be influenced by the action of a specified member of an undertaking.

Costs that are controllable for one person may be uncontrollable for another person.

Therefore, the issue of whether a cost is controllable or uncontrollable is determined by the individual or level of management in question.

Cost Classification by Normality

In this category, costs are classified based on whether they are normally incurred at a particular level of output under the conditions for which that level of output is normally attained.

Based on normality, costs may be classified as:

• Normal or unavoidable costs
• Abnormal or avoidable costs

Normal or unavoidable costs are normally incurred at a given level of output under the conditions for which that level of output is normally attained. Costs of this kind cannot be avoided at all.

The cost of normal spoilage of materials and the cost of normal idle time are typical examples of normal costs.

Abnormal or avoidable costs are costs that are not normally incurred at a given level of output under the conditions for which that level of output is attained.

It is possible to avoid such costs if proper care is taken. The cost of spoilage of material over and above the normal limit is an example of an abnormal cost.

Cost Classification by Function

Costs can also be classified based on their perceived function. The following types of cost exist by function:

• Production costs
• Administration costs
• Selling costs
• Distribution costs

Production costs refer to costs that arise in the course of acquiring, processing, and using raw materials.

Production costs include the cost of materials, cost of labor, other factory expenses, and the cost of primary packing.

Administration costs are the costs incurred in formulating business policies, directing the organization, and controlling the operations of an undertaking.

Administration costs are not related to research, development, production, distribution, or selling activities.

Selling costs are incurred to create and stimulate demand and secure orders. As such, these costs are incurred in connection with the marketing of products.

Distribution costs are associated with the sequence of operations. This sequence starts with dispatch preparations for the packed product and ends by facilitating the availability of the reconditioned, returned, and empty packages for re-use.

Classification by Time

From the view of time, costs can be classified as:

• Historical costs
• Predetermined costs

Historical costs are costs that are identified after they have been incurred. That is to say, they are determined after goods have been manufactured or services have been rendered.

Historical costs simply represent a post-mortem of past events, and they are useful in ascertaining profitability but not in exercising cost control.

Predetermined costs are computed in advance of production based on a specification of all the factors affecting them. Predetermined costs can be further divided into:

• Estimated costs
• Standard costs

Estimated costs are costs that, according to investigation and analysis, are most likely to be incurred.

They are estimated in advance based on the following assumptions: firstly, that costs are more or less free to move; and secondly, that what is made is the best estimate of the cost conditions that will apply when the cost is incurred.

Standard costs refer to a predetermined cost that is calculated from the management's standards of efficient operation and the relevant necessary expenditure.

Standard cost is established based on the assumption that costs will not be allowed to move freely but will be controlled as far as possible.

This ensures that the actual cost will be as close to the standard cost as possible, and that any disparity between actual and standard cost can be reasonably explained.

The basic difference between an estimated cost and a standard cost is that an estimated cost is a more or less reasonable assessment of what a cost will be when it is incurred.

A standard cost, on the other hand, is a specification of what a cost ought to be when it is incurred.

Cost Classification by Relevance to Decision-making and Control

In this category, costs are classified based on whether they are relevant to managerial decisions. These costs are as follows:

Marginal Cost: Marginal cost is defined as "the amount at any given volume of output by which aggregate costs are changed if the volume of output is increased or decreased by one unit."

Marginal cost refers to the increase in total cost that results from an increase in output by one unit.

Marginal cost is denoted by variable cost, and it consists of direct material cost, direct labor cost, direct expenses, and variable overheads.

Sunk Costs: Sunk costs refer to costs that have already been incurred and cannot be changed by a future decision. These costs become irrelevant costs for later decisions.

For example, if a manager decides to replace an existing machine with a new one, the amount of capital invested in the existing machine (less scrap value) will be irrecoverable and, as a result, is known as a 'sunk cost'.

Out-of-pocket Costs: These costs represent the present or future case expenditure regarding decisions, which vary based on the nature of the decision.

Management decisions are directly affected by such costs because they give rise to cash expenditure.

For example, consider a firm that has its own fleet for transporting raw materials and finished goods from one place to another.

It seeks to replace these vehicles by employing public carriers.

In making this decision, the depreciation of the vehicles is not to be considered but the management must take into account the present expenditure on fuel, maintenance, and driver salaries. Such costs are treated as out-of-pocket costs.

Opportunity Costs: The opportunity cost of a product or service is measured in terms of revenue that could have been earned by applying the resources to some other use. Opportunity cost can be defined as the cost of foregoing the best alternative.

Thus, the opportunity cost of yarn produced by a composite spinning and weaving mill, which is used in the weaving section, would be the price that could have been obtained by selling the yarn in the market.

Imputed Costs: Imputed costs are costs that are not included in costs but are considered for making management decisions. These costs are hypothetical in character.

For example, interest on capital, though not actually payable, must often be included to judge the relative profitability of two products involving unequal outlays of cash .

Differential Costs: Differential costs refer to the difference in total costs between two alternatives.

When choosing an alternative increases total costs, such increased costs are known as incremental costs .

On the other hand, if the choice results in a decrease in total costs, such decreased costs are called decremental costs .

Shut-down Costs: Shut-down costs are costs that will still be incurred when a plant is shut down temporarily.

Sometimes, the normal operations of a business must be suspended temporarily due to unfavorable market conditions, strikes, or other forces.

During the suspension of production or other activities, certain costs may still need to be incurred, and these are considered 'shut-down costs'.

Examples of shut-down costs include rent for factory premises, salaries of top management, and so on.

Postponable Costs: These are the costs that can be postponed or shifted to the future with little or no effect on the efficiency of current operations. These costs are postponable but not avoidable and must be incurred at a later stage.

The concept of a postponable cost is highly significant in the railway and transport business, where it’s possible to delay the cost of repairs and maintenance for a certain period.

In manufacturing, economic crises can also be averted by postponing certain costs. This strategy was used during the depression period.

Replacement Cost: Replacement cost is the cost of replacing an asset in the current market or at the current price.

Thus, the replacement cost of an asset is the cost that would be incurred if the asset were purchased at the current market price and not at the original purchase price.

Abandonment Costs: Abandonment refers to the complete retirement or withdrawal of a fixed asset from service or use. Fixed assets are abandoned when they are no longer serviceable.

Abandonment cost refers to the cost incurred in abandoning a fixed asset (i.e., the cost that cannot be recovered or salvaged from the abandoned asset). It is also known as abandonment loss.

Other Types of Cost

Research Cost: This refers to the cost of searching for new or improved products, new applications of materials, or new or improved methods of production.

Development Cost: This refers to the cost of the process that begins with making the decision to produce a new/improved product/method and ends with the commencement of formal production of that product/method.

Pre-production Cost: This refers to the part of the overall development cost that is incurred in making a trial production run before beginning formal production.

Conversion Cost: This refers to the costs incurred to convert raw materials into finished goods, and it consists of direct labor cost, direct expenses, and factory overhead .

Classification of Cost FAQs

What is classification of cost.

Classification of Cost is the process of organizing costs into categories for better understanding and analysis. It involves dividing costs into fixed, variable, direct, indirect, and semi-variable to help in better decision-making.

What are examples of costs that can be classified?

Examples of costs that can be classified include raw materials, labor costs, administrative expenses, marketing expenses, overhead costs, etc.

What are the advantages of classifying cost?

The advantages of classifying costs include obtaining an accurate assessment of cost performance; increased efficiency in managing costs; improved accuracy when estimating future costs; enhanced ability to identify areas for potential savings; and improved forecasting and budgeting capabilities.

How can costs be classified?

Costs can be classified based on several criteria such as nature of cost, elements of cost, controllability of cost, function or department from where the cost is incurred, etc.

What are the different categories of cost classification?

The different categories of cost classification include fixed costs, variable costs, direct costs, indirect costs, and semi-variable costs. Each category has its characteristics that help in understanding the cost structure and making more informed decisions.

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide , a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University , where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon , Nasdaq and Forbes .

Related Topics

• Account Analysis Method
• Committed vs Discretionary Fixed Cost
• Cost Center and Cost Unit
• Cost of Production Report (CPR) Questions and Answers
• Difference Between Controllable and Uncontrollable Costs
• Difference Between Direct Costs and Indirect Costs
• Difference Between Product Costs and Period Costs
• Dual-Rate Method
• Fixed Costs
• Period Expenses
• Process Costing
• Semi-Variable Costs
• Variable Cost

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• Comfortable Lifestyle: $3,500 - $5,500
• Affluent Living: $5,500 - $8,000
• Luxury Lifestyle: $8,000+

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What is Cost Assignment?

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Cost assignment.

Cost assignment is the process of associating costs with cost objects, such as products, services, departments, or projects. It encompasses the identification, measurement, and allocation of both direct and indirect costs to ensure a comprehensive understanding of the resources consumed by various cost objects within an organization. Cost assignment is a crucial aspect of cost accounting and management accounting, as it helps organizations make informed decisions about pricing, resource allocation, budgeting, and performance evaluation.

There are two main components of cost assignment:

• Direct cost assignment: Direct costs are those costs that can be specifically traced or identified with a particular cost object. Examples of direct costs include direct materials, such as raw materials used in manufacturing a product, and direct labor, such as the wages paid to workers directly involved in producing a product or providing a service. Direct cost assignment involves linking these costs directly to the relevant cost objects, typically through invoices, timesheets, or other documentation.
• Indirect cost assignment (Cost allocation): Indirect costs, also known as overhead or shared costs, are those costs that cannot be directly traced to a specific cost object or are not economically feasible to trace directly. Examples of indirect costs include rent, utilities, depreciation, insurance, and administrative expenses. Since indirect costs cannot be assigned directly to cost objects, organizations use various cost allocation methods to distribute these costs in a systematic and rational manner. Some common cost allocation methods include direct allocation, step-down allocation, reciprocal allocation, and activity-based costing (ABC).

In summary, cost assignment is the process of associating both direct and indirect costs with cost objects, such as products, services, departments, or projects. It plays a critical role in cost accounting and management accounting by providing organizations with the necessary information to make informed decisions about pricing, resource allocation, budgeting, and performance evaluation.

Example of Cost Assignment

Let’s consider an example of cost assignment at a bakery called “BreadHeaven” that produces two types of bread: white bread and whole wheat bread.

BreadHeaven incurs various direct and indirect costs to produce the bread. Here’s how the company would assign these costs to the two types of bread:

• Direct cost assignment:

Direct costs can be specifically traced to each type of bread. In this case, the direct costs include:

• Direct materials: BreadHeaven purchases flour, yeast, salt, and other ingredients required to make the bread. The cost of these ingredients can be directly traced to each type of bread.
• Direct labor: BreadHeaven employs bakers who are directly involved in making the bread. The wages paid to these bakers can be directly traced to each type of bread based on the time spent working on each bread type.

For example, if BreadHeaven spent $2,000 on direct materials and $1,500 on direct labor for white bread, and $3,000 on direct materials and $2,500 on direct labor for whole wheat bread, these costs would be directly assigned to each bread type.

• Indirect cost assignment (Cost allocation):

Indirect costs, such as rent, utilities, equipment maintenance, and administrative expenses, cannot be directly traced to each type of bread. BreadHeaven uses a cost allocation method to assign these costs to the two types of bread.

Suppose the total indirect costs for the month are $6,000. BreadHeaven decides to use the number of loaves produced as the allocation base , as it believes that indirect costs are driven by the production volume. During the month, the bakery produces 3,000 loaves of white bread and 2,000 loaves of whole wheat bread, totaling 5,000 loaves.

The allocation rate per loaf is:

Allocation Rate = Total Indirect Costs / Total Loaves Allocation Rate = $6,000 / 5,000 loaves = $1.20 per loaf

BreadHeaven allocates the indirect costs to each type of bread using the allocation rate and the number of loaves produced:

• White bread: 3,000 loaves × $1.20 per loaf = $3,600
• Whole wheat bread: 2,000 loaves × $1.20 per loaf = $2,400

After completing the cost assignment, BreadHeaven can determine the total costs for each type of bread:

• White bread: $2,000 (direct materials) + $1,500 (direct labor) + $3,600 (indirect costs) = $7,100
• Whole wheat bread: $3,000 (direct materials) + $2,500 (direct labor) + $2,400 (indirect costs) = $7,900

By assigning both direct and indirect costs to each type of bread, BreadHeaven gains a better understanding of the full cost of producing each bread type, which can inform pricing decisions, resource allocation, and performance evaluation.

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Module 5: Job Order Costing

Introduction to accumulating and assigning costs, what you will learn to do: assign costs to jobs.

Financial and managerial accountants record costs of production in an account called Work in Process. The total of these direct materials, direct labor, and factory overhead costs equal the cost of producing the item.

In order to understand the accounting process, here is a quick review of how financial accountants record transactions:

Let’s take as simple an example as possible. Jackie Ma has decided to make high-end custom skateboards. She starts her business on July 1 by filing the proper forms with the state and then opening a checking account in the name of her new business, MaBoards. She transfers $150,000 from her retirement account into the business account and records it in a journal as follows:

For purposes of this ongoing example, we’ll ignore pennies and dollar signs, and we’ll also ignore selling, general, and administrative costs.

After Jackie writes the journal entry, she posts it to a ledger that currently has only two accounts: Checking Account, and Owner’s Capital.

Debits are entries on the left side of the account, and credits are entries on the right side.

Here is a quick review of debits and credits:

You can view the transcript for “Colin Dodds – Debit Credit Theory (Accounting Rap Song)” here (opens in new window) .

Also, this system of debits and credits is based on the following accounting equation:

Assets = Liabilities + Equity.

• Assets are resources that the company owns
• Liabilities are debts
• Equity is the amount of assets left over after all debts are paid

Let’s look at one more initial transaction before we dive into recording and accumulating direct costs such as materials and labor.

Jackie finds the perfect building for her new business; an old woodworking shop that has most of the equipment she will need. She writes a check from her new business account in the amount of $2,500 for July rent. Because she took managerial accounting in college, she determines this to be an indirect product expense, so she records it as Factory Overhead following a three-step process:

• Analyze transaction

Because her entire facility is devoted to production, she determines that the rent expense is factory overhead.

2. Journalize transaction using debits and credits

If she is using QuickBooks ® or other accounting software, when she enters the transaction into the system, the software will create the journal entry. In any case, whether she does it by hand or computer, the entry will look much like this:

3. Post to the ledger

Again, her computer software will post the journal entry to the ledger, but we will follow this example using a visual system accountants call T-accounts. The T-account is an abbreviated ledger. Click here to view a more detailed example of a ledger .

Jackie posts her journal entry to the ledger (T-accounts here).

She now has three accounts: Checking Account, Owner’s Capital, and Factory Overhead, and the company ledger looks like this:

In a retail business, rent, salaries, insurance, and other operating costs are categorized into accounts classified as expenses. In a manufacturing business, some costs are classified as product costs while others are classified as period costs (selling, general, and administrative).

We’ll treat factory overhead as an expense for now, which is ultimately a sub-category of Owner’s Equity, so our accounting equation now looks like this:

Assets = Liabilities + Owner’s Equity

147,500 = 150,000 – 2,500

Notice that debits offset credits and vice versa. The balance in the checking account is the original deposit of $150,000, less the check written for $2,500. Once the check clears, if Jackie checks her account online, she’ll see that her ledger balance and the balance the bank reports will be the same.

Here is a summary of the rules of debits and credits:

Assets = increased by a debit, decreased by a credit

Liabilities = increased by a credit, decreased by a debit

Owner’s Equity = increased by a credit, decreased by a debit

Revenues increase owner’s equity, therefore an individual revenue account is increased by a credit, decreased by a debit

Expenses decrease owner’s equity, therefore an individual expense account is increased by a debit, decreased by a credit

Here’s Colin Dodds’s Accounting Rap Song again to help you remember the rules of debits and credits:

Let’s continue to explore job costing now by using this accounting system to assign and accumulate direct and indirect costs for each project.

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

• Record direct materials and direct labor for a job
• Record allocated manufacturing overhead
• Prepare a job cost record

Learning Activities

The learning activities for this section include the following:

• Reading: Direct Costs
• Self Check: Direct Costs
• Reading: Allocated Overhead
• Self Check: Allocated Overhead
• Reading: Subsidiary Ledgers and Records
• Self Check: Subsidiary Ledgers and Records
• Introduction to Accumulating and Assigning Costs. Authored by : Joseph Cooke. Provided by : Lumen Learning. License : CC BY: Attribution
• Colin Dodds - Debit Credit Theory (Accounting Rap Song). Authored by : Mr. Colin Dodds. Located at : https://youtu.be/j71Kmxv7smk . License : All Rights Reserved . License Terms : Standard YouTube License
• What the General Ledger Can Tell You About Your Business. Authored by : Mary Girsch-Bock. Located at : https://www.fool.com/the-blueprint/general-ledger/ . License : All Rights Reserved . License Terms : Standard YouTube License

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• What is Accounting?
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• Overview of Financial Controls
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• Cost Accounting
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• Calculate Customer Acquisition Costs
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Elements of Cost in Cost Accounting with Examples

In cost accounting , elements of cost refers to the components that make up the cost of manufacturing a product. The three main cost elements include material, labor, and expenses.

You can subdivide these elements into direct and indirect material, direct and indirect labor, and direct and indirect expenses. However, you can group the elements of costs into two categories: direct and indirect costs.

Direct costs include direct material, labor, and expense, which form the prime cost. Similarly, all the indirect costs, such as indirect material, labor, and expense, are also known as supplementary costs.

This article covers everything you need to know about the 4 elements of costs in cost accounting.

Let’s get started.

1. Material

Material refers to all the raw materials involved in creating a finished product, whether direct or indirect.

Types of Materials

1. direct materials.

Direct material cost includes all raw materials and goods a company requires to create its product. You can call them functional materials because, without these materials, there will be no production.

When considering direct material cost during production, remember that the overall cost depends on the company's output.

The most influential factor when considering the cost of direct materials is the output size. This direct cost comes in the form of process, stored, purchased primary packing, and production materials that’s integral to the success of every manufacturing process.

An example of a direct material is cotton in the production of clothing and textiles. Furniture-based organizations require direct materials like wood to execute production operations.

2. Indirect Materials

Indirect materials are resources or tools used in production that do not directly fluctuate with the output. In simple terms, indirect materials play a significant role in a company’s overall production process but are not integral to the furnished product.

A production company can function without these materials because the final product does not need them to be effective. Some examples of indirect materials include disposable gloves, personal protective equipment, tape, and nails.

Indirect material cost does not vary in direct proportion to the product. As a business owner, pay attention to the difference between these elements and their unique cost types to ensure you don't go overboard in costing and financial reporting.

Once you understand direct and indirect materials, you can seamlessly make informed decisions. For example, determining the total cost of production, setting selling prices, and analyzing the efficiency of the production process becomes easier and more accurate.

Your knowledge of direct and indirect materials is handy when making vital decisions like budgeting, cost control, and managerial decision-making regarding resource allocation.

Labor cost is vital in successfully executing an organization's production cycle. Human resources are among the most valuable resources that give a company an advantage regarding production. Without people, nothing happens in an organization.

The process of managing human resources requires proper cost allocation and informed decisions. In simple terms, labor cost refers to the amount an organization pays to workers involved in production. Labor in cost accounting includes direct and indirect labor.

Types of Labor

1. direct labor.

Direct labor cost is remuneration paid to the individuals or staff producing goods and services. The amount you pay employees is directly proportional to the product output.

Most companies calculate the input these workers offer based on the overall output to pay them the amount due.

Direct labor cost refers to direct wages you can trace to specific products or services. Any form of salary paid to trainees or apprentices does not come under direct labor.

For example, in a food packaging production line, the workers assembling the food carry out direct labor. You can consider their wages as direct costs associated with the production of each food package.

2. Indirect Labor

An indirect laborer is an individual who supports the production process through supervision or monitoring but is not directly involved in producing goods or services.

Indirect labor costs are wages paid to dispensable workers in producing goods. Their work does not vary directly with the product output, which means a higher increase in production does not mean a pay increase.

An example of this indirect cost is the amount you pay interns for a particular job in a beverage company.

Remember that every manufacturing firm has key players, like maintenance staff, supervisors, and quality control inspectors. These staff members are not part of the production team, which means they do not get their hands dirty with the production process.

As long as they are staff members in a manufacturing firm, they will receive a salary, which is indirect labor costs.

A clear understanding of the difference between direct and indirect labor costs is your one-way ticket to accurate figures in cost accounting and financial analysis.

This information will make the process seamless when making managerial decisions concerning workforce allocation, productivity improvement, and cost control.

3. Expenses

Expenses are a vital element of cost in cost accounting. This type of cost centers around the amount an organization pays or spends during production.

In simple terms, expenses refer to costs incurred during production to generate more revenue, such as production costs.

Examples of expenses include payments to suppliers, employee wages, factory leases, and equipment depreciation. The prices of these expenses largely depend on the production level, whether on a large or small scale.

Types of Expenses

1. direct expenses.

Direct expenses are known as chargeable expenses. They refer to expenses incurred during an organization's production process. Examples include the cost of goods sold (COGS) , administrative fees, office supplies, direct labor, and rent.

Such expenses vary directly with the output, meaning the more you produce, the more money you spend. These expenses are specifically incurred and vital to the success of their production process. Without this manufacturing expense, the production of goods will not occur.

You must ensure you properly manage your direct expenses to seamlessly maximize profit without incurring loss.

2. Indirect Expenses

Indirect expenses refer to various costs incurred by an organization necessary for production. The difference between this form of expense and the direct expense is that there is no specificity to the indirect expense.

In most cases, the expenses occur outside the company's day-to-day activities and may be hard to track without proper assessment.

Indirect expenses do not vary with the output and are not easily identifiable. An example of indirect expense is the cost incurred for electricity during cloth manufacture, interest charges, and other costs associated with borrowing money.

4. Overhead

Overhead are indirect costs incurred in the production of goods in an organization. These costs are necessary for daily business operations.

You can define it as the summation of indirect material, labor, and expenses. In most cases, the cost and management accountants are responsible for running these costs.

Types of Overheads

1. factory or manufacturing overhead.

Factory or manufacturing overhead refers to a particular cost unit or indirect manufacturing costs incurred within an owned factory building.

Examples include factory rent, equipment depreciation, maintenance, taxes, and rates.

2. Administration Overhead

Administration overhead is a cost related to the administration of a company or organization . This overhead cost includes insurance, audit fees, stationery, and office salaries. Office cost is the summation of factory cost and administration overhead.

3. Selling and Distribution Overheads

Selling overhead refers to expenses in connection with sales in manufacturing operations. Examples are sales commissions, advertising costs, travel expenses, marketing materials, and customer entertainment.

4. Distribution Overhead

Distribution overhead refers to expenses involved from the time of the finished product to the time of delivery to consumers.

Examples are costs incurred during transportation, warehousing, packaging, and marketing. They are useful in calculating individual cost units.

Explore Further

• Variable Cost vs. Fixed Cost
• What Is an Expenditure?
• Business Cycle
• Working Capital vs Investing Capital
• What is Financial Accounting?
• What is Managerial Accounting?

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Cost Element: How to Define and Use Your Cost Elements

1. what is a cost element and why is it important for accounting and budgeting, 2. how to classify your costs into different categories based on their nature and behavior, 3. how to link your cost elements to your cost objects such as products, projects, activities, or orders, 4. how to use your cost elements to track and monitor your costs and performance indicators, 5. how to generate and interpret reports based on your cost elements and what insights to derive from them.

Cost elements are the basic building blocks of any accounting and budgeting system. They represent the different types of costs that a business incurs or generates in its operations. Cost elements can be classified into various categories, such as direct or indirect, fixed or variable, product or period, and so on. Understanding the nature and behavior of cost elements is crucial for managers and accountants, as they help them to plan, control, and evaluate the performance of the business . In this section, we will explore the following aspects of cost elements:

1. The definition and characteristics of cost elements. A cost element is a unit of measurement that describes the amount of resources consumed or produced by a specific activity, process, or output. Cost elements have two main characteristics: they have a monetary value and they can be traced to a cost object. A cost object is anything for which costs are measured and assigned, such as a product, a service, a department, a project, or a customer.

2. The purpose and benefits of cost elements. Cost elements serve several purposes and provide various benefits for accounting and budgeting. Some of the main ones are:

- They enable the allocation and apportionment of costs to different cost objects , based on the cause-and-effect relationship or the benefit received principle. This helps to determine the profitability and efficiency of each cost object and to make informed decisions about pricing , outsourcing, product mix, and resource utilization.

- They facilitate the analysis and comparison of costs across different periods, activities, processes, and outputs. This helps to identify the trends, patterns, and variances in costs and to take corrective actions if needed.

- They support the preparation and presentation of financial statements , such as the income statement, the balance sheet, and the cash flow statement . This helps to communicate the financial performance and position of the business to the stakeholders, such as the owners, the investors, the creditors, and the regulators.

3. The challenges and limitations of cost elements. Cost elements are not without challenges and limitations. Some of the common ones are:

- They may not capture the full cost of a cost object, as some costs may be difficult to measure or allocate, such as opportunity costs, sunk costs, or intangible costs. These costs may have a significant impact on the value and profitability of the cost object, but they may not be reflected in the cost elements.

- They may not reflect the true cost behavior of a cost object, as some costs may change due to factors other than the level of activity, such as inflation, technology, or market conditions. These costs may not follow the assumptions or the models used to classify and estimate the cost elements.

- They may not provide sufficient information for decision making , as some decisions may require more than just the cost information, such as the quality, the customer satisfaction, the environmental impact, or the strategic alignment of the cost object. These factors may not be captured or quantified by the cost elements.

In the section "Types of cost elements: How to classify your costs into different categories based on their nature and behavior," we will explore the various ways to categorize costs based on their characteristics. Understanding the different types of cost elements is crucial for effective cost management and decision-making .

1. Fixed Costs: These are costs that remain constant regardless of the level of production or sales. Examples include rent, salaries, and insurance premiums. Fixed costs do not vary with changes in activity levels.

2. variable costs : Variable costs fluctuate in direct proportion to changes in production or sales volume. Raw materials, direct labor, and sales commissions are examples of variable costs. As production increases, variable costs increase , and vice versa.

3. semi-Variable costs : Also known as mixed costs, semi-variable costs have both fixed and variable components. They consist of a fixed portion that remains constant and a variable portion that changes with activity levels. Telephone bills with a fixed monthly fee and additional charges based on usage are an example of semi-variable costs.

4. direct costs : Direct costs are directly attributable to a specific product, service, or project. They can be easily traced to a particular cost object. For instance, the cost of raw materials used in manufacturing a product is a direct cost.

5. indirect costs : Indirect costs, also known as overhead costs, are not directly tied to a specific cost object. They support the overall operations of a business. Examples include rent for the entire facility, utilities, and administrative salaries.

6. Step Costs: Step costs exhibit a step-like pattern, where the cost remains constant within a certain range of activity levels and then jumps to a higher level when a threshold is crossed. For example, hiring additional staff when production reaches a certain level incurs a step cost.

7. opportunity costs : Opportunity costs represent the potential benefit or value that is foregone when choosing one alternative over another. It is the value of the next best alternative that is sacrificed. For instance, if a company decides to invest in Project A, the opportunity cost is the potential profit from Project B.

Remember, these are just a few examples of cost elements and their classifications. By understanding the nature and behavior of costs, businesses can make informed decisions , optimize resource allocation , and improve profitability.

How to classify your costs into different categories based on their nature and behavior - Cost Element: How to Define and Use Your Cost Elements

In the section "Cost element assignment: How to link your cost elements to your cost objects such as products, projects, activities, or orders?" we delve into the crucial aspect of connecting cost elements with various cost objects. This linkage plays a vital role in accurately allocating costs and understanding the financial impact of different activities within an organization.

From a managerial perspective, linking cost elements to cost objects enables better cost control and decision-making . By assigning cost elements to specific products, projects, activities, or orders, businesses can track and analyze the expenses associated with each entity. This information helps in evaluating profitability, identifying cost drivers , and optimizing resource allocation .

Now, let's explore some key insights on cost element assignment:

1. Understanding cost elements : Cost elements represent different categories of expenses incurred by an organization. Examples include direct materials, direct labor, overhead costs, marketing expenses, and administrative costs. Each cost element captures specific types of expenditures and contributes to the overall cost structure.

2. Mapping Cost Elements to Cost Objects: To link cost elements with cost objects, businesses need to establish a systematic framework. This involves identifying the relevant cost objects, such as products, projects, activities, or orders, and associating them with the appropriate cost elements. This mapping ensures that costs are allocated accurately and provides a clear picture of the cost distribution across different entities.

3. Cost Element Hierarchy: In some cases, cost elements can be organized hierarchically to reflect the underlying cost structure. This hierarchy helps in categorizing costs at different levels of granularity. For example, a cost element hierarchy may include high-level categories like "Direct Costs" and further break down into subcategories like "Direct Materials" and "Direct Labor." Such a hierarchy facilitates cost analysis and reporting.

4. Cost Element Assignment Methods: There are various methods to assign cost elements to cost objects. One common approach is direct assignment, where costs are directly attributed to specific objects based on a predetermined allocation basis. Another method is cost allocation , which involves distributing shared costs among multiple cost objects based on allocation keys or drivers. The choice of assignment method depends on the nature of costs and the desired level of accuracy.

5. Importance of Accurate Assignment: Accurate cost element assignment is crucial for reliable financial reporting , cost analysis, and decision-making. It ensures that costs are allocated in a fair and transparent manner, enabling businesses to assess the profitability of different products, projects, activities, or orders. Moreover, accurate assignment helps in identifying cost-saving opportunities , optimizing resource allocation, and improving overall cost management .

By following these insights and implementing effective cost element assignment practices, organizations can gain valuable insights into their cost structure, enhance cost control, and make informed business decisions .

How to link your cost elements to your cost objects such as products, projects, activities, or orders - Cost Element: How to Define and Use Your Cost Elements

cost element analysis is a process of identifying, categorizing, and evaluating the different types of costs that are involved in a project, a product, a service, or a business activity. By using cost elements, you can track and monitor how your costs are distributed, allocated, and controlled. You can also use cost elements to measure your performance indicators, such as profitability, efficiency, and return on investment. Cost element analysis can help you to:

- Understand the structure and composition of your costs

- Identify the sources and drivers of your costs

- Compare your costs with your budget, forecast, or benchmark

- optimize your costs and improve your margins

- Make informed decisions and plan for the future

To perform a cost element analysis, you need to follow these steps:

1. Define your cost elements. Cost elements are the basic units of cost that can be assigned to a cost object, such as a project, a product, a service, or a business activity. Cost elements can be classified into different categories, such as direct or indirect, fixed or variable, material or labor, etc. For example, the cost elements of a manufacturing project could include raw materials, labor, utilities, depreciation, etc.

2. Collect and organize your cost data . You need to gather and record the relevant cost data for each cost element. You can use various sources of data, such as invoices, receipts, timesheets, reports, etc. You also need to organize your cost data in a systematic and consistent way, such as by using a cost accounting system , a spreadsheet, or a database.

3. Analyze your cost elements. You need to calculate and evaluate the amount, proportion, and trend of each cost element. You can use various methods and tools, such as ratios, percentages, graphs, charts, etc. You also need to compare your cost elements with your budget, forecast, or benchmark, and identify any variances, deviations, or anomalies.

4. report and communicate your cost element analysis. You need to present and explain your cost element analysis to your stakeholders, such as managers, investors, customers, etc. You can use various formats and media, such as reports, dashboards, presentations, etc. You also need to provide recommendations and suggestions for improving your cost performance and achieving your goals.

Here is an example of a cost element analysis for a software development project:

| Cost Element | Amount | Percentage | Trend | Variance |

| Labor | $50,000 | 50% | ↑ | +$10,000 |

| Software | $20,000 | 20% | ↔ | -$5,000 |

| Hardware | $15,000 | 15% | ↓ | -$2,000 |

| Travel | $10,000 | 10% | ↑ | +$3,000 |

| Other | $5,000 | 5% | ↔ | -$1,000 |

The cost element analysis shows that the total cost of the project is $100,000, which is $5,000 higher than the budget of $95,000. The main cost drivers are labor and travel, which have increased by $10,000 and $3,000, respectively. The main cost savings are software and hardware, which have decreased by $5,000 and $2,000, respectively. The cost element analysis also shows that the labor cost is the largest and the most variable cost element, accounting for 50% of the total cost and increasing by 25% from the previous period. The software cost is the second largest and the most stable cost element, accounting for 20% of the total cost and remaining unchanged from the previous period. The hardware cost is the third largest and the most decreasing cost element, accounting for 15% of the total cost and decreasing by 12% from the previous period. The travel cost is the fourth largest and the most increasing cost element, accounting for 10% of the total cost and increasing by 43% from the previous period. The other cost is the smallest and the least significant cost element, accounting for 5% of the total cost and decreasing by 17% from the previous period.

The cost element analysis suggests that the project manager should:

- Monitor and control the labor and travel costs, which are the main sources of cost overrun and variability

- Negotiate and optimize the software and hardware costs, which are the main sources of cost saving and stability

- Review and justify the other costs, which are the least relevant and impactful

- Communicate and explain the cost element analysis to the stakeholders, and seek their feedback and approval

How to use your cost elements to track and monitor your costs and performance indicators - Cost Element: How to Define and Use Your Cost Elements

One of the most important aspects of cost element accounting is reporting. Reporting allows you to monitor and analyze your cost elements and their impact on your business performance. By generating and interpreting reports based on your cost elements, you can gain valuable insights into your cost structure, profitability, efficiency, and budgeting. In this section, we will discuss how to generate and interpret reports based on your cost elements and what insights to derive from them. We will also provide some examples of common reports and how to use them for decision making .

To generate and interpret reports based on your cost elements, you need to follow these steps:

1. Define your reporting objectives and requirements. Before you generate any report, you need to have a clear idea of what you want to achieve and what information you need. For example, do you want to compare your actual costs with your planned costs? Do you want to analyze your cost drivers and variances? Do you want to identify your most profitable or costly products, services, or customers? Do you want to evaluate your cost efficiency and effectiveness? Depending on your objectives and requirements, you will need to select the appropriate cost elements, time periods, dimensions, and measures for your report.

2. Select the appropriate report type and format. There are different types of reports that you can use to display and analyze your cost elements, such as tables, charts, dashboards, or scorecards. Each type has its own advantages and disadvantages, depending on the complexity and purpose of your report. For example, tables are good for showing detailed and numerical data, but they can be hard to read and interpret. Charts are good for showing trends and patterns, but they can be misleading or inaccurate if not designed properly. Dashboards are good for showing key performance indicators (KPIs) and alerts, but they can be overwhelming or distracting if not customized. Scorecards are good for showing strategic goals and targets, but they can be irrelevant or unrealistic if not aligned with your business strategy. You need to choose the report type and format that best suits your reporting objectives and requirements, as well as your audience and preferences.

3. generate the report using your cost element data. Once you have defined your reporting objectives and requirements and selected the report type and format, you can generate the report using your cost element data. You can use various tools and methods to generate your report, such as spreadsheets, databases, software applications, or online platforms. You need to ensure that your data is accurate, complete, consistent, and reliable, and that your report is clear, concise, and comprehensive. You also need to apply the appropriate filters, calculations, aggregations, and transformations to your data, as well as the appropriate visualizations, labels, and annotations to your report.

4. Interpret the report and derive insights from your cost elements. After you have generated the report, you need to interpret the report and derive insights from your cost elements. You need to examine the data and the report carefully and critically, and look for any patterns, trends, anomalies, or outliers. You need to ask yourself questions such as: What does the report tell me about my cost elements? How do my cost elements compare with my expectations, benchmarks, or standards? What are the main drivers and variances of my cost elements? What are the implications and consequences of my cost elements? What are the strengths and weaknesses of my cost elements? What are the opportunities and threats of my cost elements? What are the recommendations and actions based on my cost elements? You need to answer these questions using evidence, logic, and reasoning, and communicate your findings, conclusions, and recommendations clearly and effectively.

Here are some examples of common reports and how to use them for cost element reporting:

- Cost element overview report. This report shows the summary and breakdown of your cost elements by different dimensions, such as cost type, cost center, cost category, or cost object. You can use this report to get a quick and comprehensive overview of your cost structure and distribution, and to identify your major cost elements and their proportions. For example, you can use this report to see how much you spend on direct costs, indirect costs, fixed costs, variable costs, or overhead costs, and how they are allocated to different cost centers, cost categories, or cost objects.

- Cost element variance report. This report shows the difference between your actual costs and your planned costs, or between your current costs and your previous costs, by different dimensions, such as cost type, cost center, cost category, or cost object. You can use this report to monitor and analyze your cost performance and deviations, and to identify the causes and effects of your cost variances. For example, you can use this report to see how much you over- or under-spend on your budget, or how much your costs increase or decrease over time, and why.

- Cost element profitability report. This report shows the relationship between your cost elements and your revenue elements, by different dimensions, such as cost type, cost center, cost category, or cost object. You can use this report to measure and evaluate your cost profitability and efficiency, and to identify your most profitable or costly products, services, or customers. For example, you can use this report to see how much revenue you generate from each cost element, or how much profit or loss you make from each product, service, or customer, and how to improve them.

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Cost objects and cost assignment in accounting

In this article, we will define cost objects and discuss how the choice of a cost object affects the cost assignment process and hence outcome.

• 1. Cost object definition

A cost object is anything we want to determine the cost of.

Examples of cost objects are: a product, a product line, a brand category, a service, a project, an activity or task, a process, a department, a business segment, a channel, a customer, a supplier, a geographic area, etc.

For reporting purposes, organizations usually have to determine the cost of their products or services. But, internally the organizations can create additional reports where they try to measure costs of various cost objects (e.g., departments, product lines, segments, suppliers) in order to get more insights into operations, performance, risks, and opportunities.

• 2. Cost object choice and cost assignment

The choice of the cost object impacts whether a specific cost can be directly traced to it or not. For example, raw materials that are part of a product usually can be traced to specific products via materials requisition forms. But, it might be more challenging to trace the same information (about raw materials used) to product lines when different products use the same raw materials. The ability to trace specific costs to cost objects in an economically feasible (i.e., cost effective) way determines whether a specific cost is a “direct cost” or “indirect cost”.

Direct costs of a cost object can be traced to that cost object in an economically feasible (cost-effective) way.

Indirect costs of a cost object cannot be traced to that cost object in an economically feasible (cost-effective) way. As the result, indirect costs are allocated to cost objects using some kind of allocation rule.

The ability to (directly) trace costs to cost objects usually depends on:

• The design of operations
• The availability of technology for information gathering and processing
• The materiality of the cost

Complex operations make it more challenging to trace costs to cost objects. The lack of information gathering and processing technology or poorly organized information systems (e.g., accounting, operations) also make it more difficult to trace costs to cost objects. Finally, immaterial costs (e.g., relatively small costs) are often not directly traced to cost objects because the benefit from tracing immaterial costs is lower than the cost associated with tracing that information. We have to remember that in a reporting process the benefits from reporting should outweigh the costs associated with preparing those reports.

Ideally, we want to be able to directly trace costs to the cost objects. But in practice, often available data does not allow cost tracing, and the result, organizations need to allocate costs to cost objects. The issue with cost allocation is that it is less accurate and can be subjective depending on the allocation process and rules.

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What Is Activity-Based Costing (ABC)?

How activity-based costing (abc) works, requirements for activity-based costing (abc), benefits of activity-based costing (abc).

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Activity-Based Costing (ABC): Method and Advantages Defined with Example

Activity-based costing (ABC) is a costing method that assigns overhead and indirect costs to related products and services. This accounting method of costing recognizes the relationship between costs, overhead activities, and manufactured products, assigning indirect costs to products less arbitrarily than traditional costing methods. However, some indirect costs, such as management and office staff salaries, are difficult to assign to a product.

Key Takeaways

• Activity-based costing (ABC) is a method of assigning overhead and indirect costs—such as salaries and utilities—to products and services. 
• The ABC system of cost accounting is based on activities, which are considered any event, unit of work, or task with a specific goal.
• An activity is a cost driver , such as purchase orders or machine setups. 
• The cost driver rate, which is the cost pool total divided by cost driver, is used to calculate the amount of overhead and indirect costs related to a particular activity. 

ABC is used to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy. 

Investopedia / Theresa Chiechi

Activity-based costing (ABC) is mostly used in the manufacturing industry since it enhances the reliability of cost data, hence producing nearly true costs and better classifying the costs incurred by the company during its production process.

This costing system is used in target costing, product costing, product line profitability analysis, customer profitability analysis, and service pricing. Activity-based costing is used to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy. 

The formula for activity-based costing is the cost pool total divided by cost driver, which yields the cost driver rate. The cost driver rate is used in activity-based costing to calculate the amount of overhead and indirect costs related to a particular activity. 

The ABC calculation is as follows:  

• Identify all the activities required to create the product. 
• Divide the activities into cost pools, which includes all the individual costs related to an activity—such as manufacturing. Calculate the total overhead of each cost pool.
• Assign each cost pool activity cost drivers, such as hours or units. 
• Calculate the cost driver rate by dividing the total overhead in each cost pool by the total cost drivers. 
• Divide the total overhead of each cost pool by the total cost drivers to get the cost driver rate. 
• Multiply the cost driver rate by the number of cost drivers. 

As an activity-based costing example, consider Company ABC that has a $50,000 per year electricity bill. The number of labor hours has a direct impact on the electric bill. For the year, there were 2,500 labor hours worked, which in this example is the cost driver. Calculating the cost driver rate is done by dividing the $50,000 a year electric bill by the 2,500 hours, yielding a cost driver rate of $20. For Product XYZ, the company uses electricity for 10 hours. The overhead costs for the product are $200, or $20 times 10.

Activity-based costing benefits the costing process by expanding the number of cost pools that can be used to analyze overhead costs and by making indirect costs traceable to certain activities. 

The ABC system of cost accounting is based on activities, which are any events, units of work, or tasks with a specific goal, such as setting up machines for production, designing products, distributing finished goods, or operating machines. Activities consume overhead resources and are considered cost objects.

Under the ABC system, an activity can also be considered as any transaction or event that is a cost driver. A cost driver, also known as an activity driver, is used to refer to an allocation base. Examples of cost drivers include machine setups, maintenance requests, consumed power, purchase orders, quality inspections, or production orders.

There are two categories of activity measures: transaction drivers, which involve counting how many times an activity occurs, and duration drivers, which measure how long an activity takes to complete.

Unlike traditional cost measurement systems that depend on volume count, such as machine hours and/or direct labor hours, to allocate indirect or overhead costs to products, the ABC system classifies five broad levels of activity that are, to a certain extent, unrelated to how many units are produced. These levels include batch-level activity , unit-level activity, customer-level activity, organization-sustaining activity, and product-level activity.

Activity-based costing (ABC) enhances the costing process in three ways. First, it expands the number of cost pools that can be used to assemble overhead costs. Instead of accumulating all costs in one company-wide pool, it pools costs by activity. 

Second, it creates new bases for assigning overhead costs to items such that costs are allocated based on the activities that generate costs instead of on volume measures, such as machine hours or direct labor costs. 

Finally, ABC alters the nature of several indirect costs, making costs previously considered indirect—such as depreciation , utilities, or salaries—traceable to certain activities. Alternatively, ABC transfers overhead costs from high-volume products to low-volume products, raising the unit cost of low-volume products.

Chartered Global Management Accountant. " Activity-Based Costing (ABC) ."

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Cost Accumulation: Meaning, Types, and More

Cost accumulation: meaning.

Cost Accumulation is the process of collecting all costs information about the business with the help of the cost accounting system . It is a process of collection of all relevant data regarding the various costs incurred by the company at various stages of production. This calculation is the result or outcome of the cost accounting system prevalent or practices in the company.

Cost Accumulation calculates all manufacturing costs in a sequential pattern. It considers all costs in the production process, starting from inventory to the finished goods. The focus and the objective are to come up with the cost of a particular product or service by identifying various cost objects and their respective cost drivers . Here there exists a cause-effect relationship between cost object and their cost drivers. Thus Cost Accumulation becomes a very connected and integral part of the Cost Accounting System.

Whether Cost Accumulation a part of Managerial accounting too?

Job costing system, assumptions of process costing system, hybrid costing system, difference between job costing and process costing, cost accumulation vs cost assignment vs cost tracing.

The management of the company, after collecting and analyzing the cost data, makes calculative decisions regarding the day-to-day working of the company. The costing data helps the management at all stages of operations, including planning, monitoring, controlling, and decision making. The management also decides when and how the assignment of cost to a particular job or process will happen. And thus, Cost Accumulation becomes a part of both Cost Accounting and Managerial Accounting.

Types of Cost Accumulation

There are majorly three types of Cost Accumulation methods, as follows:-

Job Costing System is most useful when the total production quantity is small or there exist small batches of production. It is also relevant and important when each job is unique. It is a process of accumulating cost information about a particular project or a specific production or product. Under this system, linking and recording the accumulation of direct labor, direct materials, and manufacturing overhead costs happens with respect to the particular job or batch.

Also Read: Types of Costing

This system is widely useful in the delivery of a special or customized product. It also helps while asking for cost- reimbursements or stage-wise advances from the customer. Once the job completion happens, all the costs of the respective job are accumulated. And after that, that particular job sheet and costing exercise on that job also close. It is necessary to consider both direct and indirect costs under this system. At times calculation of indirect costs for a particular job may become difficult.

Thus under the Job Costing System, accumulation takes place according to the respective job order.

Process Costing System

Accumulation of cost through the Process Costing System occurs when the production of a huge amount of identical goods occurs. In this system, the accumulation of costs for a large batch of products takes place. And afterward, further allocation of all such accumulated costs takes place for an individual unit.

Process Costing System accumulates costs on the basis of departments or divisions. In this system, identification and booking of costs to respective cost centers take place. Cost centers are the places of origination of the costs. Accumulation of costs takes place according to the cost centers they belong to.

This method is best suitable when the production is very large in quantity. The production process is also generally continuous in nature without any customization.

Also Read: Cost Accounting Systems – Meaning, Importance And More

• The first assumption is that all products are identical in nature.
• The second assumption of this system is that the costs of all units of production are the same.

At the end of this process, the creation of a ‘Cost of Production Report’ takes place. This report shows the total cost for a particular cost center and the state of both opening and closing inventory. 

Manufacturing units where some production is large while some are small, this is best suitable. Under Hybrid Costing System, process costing is used where the production quantities are large. While if the product is in small batches, the Job System is used. Thus this hybrid system is widely used and now well accepted in such circumstances.

The key differences between both this system of cost accumulation and accounting are:

Sometimes, both Cost Assignment and Cost Accumulation are loosely called and referred to as the same. But it is not so, and they both are different. Cost Assignment is the identification and attachment of costs to the respective costs driver. It is a process of linking costs to their place of origin. Cost Assignment is mainly useful for an activity-based costing method, where linking of overhead expenses occurs where incurrence takes place of these overheads. Cost Allocation is the other name of Cost Assignment.

On the other hand, Cost Accumulation is a completely different concept. And here, the focus and objective are to collect all costs/total costs of that product or service. It is to know the overall cost of production and stages of the cost incurred and analyze this information about the costs for further management decisions. In this system, the process begins with recognizing cost objects and their respective cost drivers.

Cost Tracking is the third term here, which is useful in assigning costs to the departments. Cost Assignment and Cost Tracking helps in the Allocation of costs to the respective department. Thus the main focus of Cost Tracking is to trace back the origin of indirect costs and also establish a causal relationship with the cost driver.  

In simple words, Cost Assignment and Cost Tracking helps in the allocation of costs, and Cost accumulation helps in the collection of costs.

Cost Accumulation is an important step in the cost accounting process. Moreover, accumulating the costs according to the cost object and its drivers is the base of all other cost accounting processes. And the decision is with the management whether to adopt a Job, Process, or Hybrid Costing System. Moreover, it is of vital importance to accumulate costs without any error. Because all further processes are dependent on the accuracy of these figures. Thus Cost Accumulation is one of the important tools for the management of the company to guide and help them in making correct decisions.

Refer to Costing Terms for various other basic cost concepts.

RELATED POSTS

• Cost Accounting and Management Accounting
• Types of Costs and their Classification
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• Cost Object – Meaning, Advantages, Types and More
• Job Costing – Meaning, Benefits, Process and More
• Types of Cost Accounting

Sanjay Bulaki Borad

MBA-Finance, CMA, CS, Insolvency Professional, B'Com

Sanjay Borad, Founder of eFinanceManagement, is a Management Consultant with 7 years of MNC experience and 11 years in Consultancy. He caters to clients with turnovers from 200 Million to 12,000 Million, including listed entities, and has vast industry experience in over 20 sectors. Additionally, he serves as a visiting faculty for Finance and Costing in MBA Colleges and CA, CMA Coaching Classes.

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• Cost optimisation

Creating value and maximising profitability should be key elements of banks’ cost reduction programmes

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An increasing focus on costs is a global theme for the banking sector according to a recent report from KPMG, which found that banks have clearly defined ambitious cost saving targets, with some aiming for 10% cost efficiencies over the next 12 months and up to 20% to 30% over the next three years 1 .

Banks have benefitted from a higher interest rate environment recently, but with anticipated reductions in rates and continued increase in costs, the challenge for managing costs and creating headroom for continued investment has become an imperative.

To achieve their ambition, leading organisations are focused on consolidating common capabilities, the elimination of non-value add activities, digitising key functions, reducing labour costs, and critically linking process metrics to customer outcomes.

Leading organisations are looking beyond more traditional cost reduction approaches to optimise their cost base. This requires the careful balance of creating value and reducing cost by making better strategic decisions on business models, products and services, and maximising profitability through front-to-back operating models.

Traditionally, Cost Income Ratio and Return on Equity metrics have been used to measure a bank’s financial performance. Removing the income variable and applying a customer lens to understand both Cost to Serve (CTS) and FTE per customer, means that the focus can evolve to address productivity and efficiency as well as profitability.  Since Covid, the requirement to serve customers digitally has increased the CTS, yet, our research indicates, customer experience (measured by net promoter score) has declined.

Executing a cost optimisation programme begins with a strong understanding of where the cost base sits and the value that it is delivering.  In our research, 86% of banks indicated that they have a strong understanding of this. More progressive organisations are adopting horizontal and vertical cost structures, aligned to value streams, to ensure that there is a connection between the needs of the business and the spend, and investments in the business are prioritised to deliver the best outcome.

Measuring the real costs that exist across the entire value chains and the options available for cost reduction will move the value equation in the right direction. Just focusing on cutting costs runs the risk of leaving functional elements underinvested and finding that costs begin to creep back into the business over time.

In this regard, banks have indicated that their biggest challenge in effecting change is the deep cultural challenge to achieving sustainable cost reductions. To overcome this, having a clearly defined strategy and mechanisms to drive commitment and actions with tangible metrics is required. This will ensure the impact expected is delivered, embedding a cost culture mindset across the whole organisation, from leadership buy-in to day-to-day operations.

The adoption of emerging technologies, such as GenAI, will be critical to unlock costs that have been difficult to access in the past. Banks expect AI to make servicing customers’ needs more efficient and effective. Despite their value, the size of financial investment required to implement new technologies is a concern and holding a number of organisations back. However, a lack of focus on innovation and investing in new capabilities could be a mistake from a cost reduction point value.

Beyond the front line, the next wave of cost transformation will extend to functions including risk, compliance, finance and marketing. Within the risk function, for example, new risks continue to emerge and evolve including cyber, ESG and geopolitical risks, requiring very different resources compared to more traditional risks. To maintain efficiency and effectiveness, the use of GenAI has become a top priority for these teams to help manage these risks. Use of outsourcing and offshore capabilities are being adopted for mature and standardised elements of the risk framework.

Increasingly, we observe more focus on controlling and optimising third party spend as a faster way to savings than what has sometimes been achievable with internal functions. Outsourcing has become another important lever in the effort to reduce costs, by becoming more central to operating models, following examples from other industries.

Cost and value management is a strategic capability that is required to help drive shareholder value. It is a core discipline that provides transparency of costs and investments benefits across the value chain. It needs to be fully embedded in the culture of the organisation, to support the daily operations and create value through better investment and transformation decisions, over the longer term.

[1] Beyond Savings: Cost optimization for the modern bank: https://kpmg.com/xx/en/home/insights/2024/04/beyond-savings-cost-optimization-for-the-modern-bank.html

Mark Longworth

Global head of insurance advisory, hong kong kpmg china.

Fergal Power

Partner, financial services, hong kong kpmg china, financial results.

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