Cost Accounting serves 2 purposes:

1) Provides information to evaluate the performance of an organizational unit or its managers.

2) Means for estimating costs of units of product or services that the organization manufacturers or provides.

Performance Measurement

By comparing actual costs to standard/budgeted costs. Variance is the deviation of the actual cost from the
standard cost. Costs are assigned to parts of an organization that are identified as cost centres. When managers
are held accountable for the costs incurred in a cost centre, they are sometimes called responsibility centres.

Product Costs and the Cost of Services

Inventory cost

Total manufacturing cost including indirect costs

Profitability Analysis

Product cost information allows managers to evaluate contribution margin—the difference between price and
variable costs—and gross margin—the difference between price and total product costs.

Product mix

Finding the most and least profitable products in a company

Pricing

A change in the cost of a critical material or component may signal the need to reconsider the prices asked for
products

Cost of service

Unless the cost of service is measured, there is no way to know if providing the service is profitable or not and
whether changes in pricing or marketing strategy are needed.

Cost Behaviour:

The level of cost can be a function of either or both the volume of activity or time when the cost is incurred.

Relation of costs to Volume

Variable Costs

Strict proportionality to volume

Non-variable costs

Does not vary with volume

Semi-variable costs

Combination of variable and non-variable components, varies in the same direction as volume but not
proportional.

Chunky costs

Step function costs, fixed for a range of volume of production but changes in a chunk when the volume
increases or decreases beyond the relevant range of volume

Accounting for costs

Classifying costs
Direct costs

Direct costs can be specifically traced to or are caused by a product

Indirect costs

Indirect costs cannot be specifically traced to or are caused by a single product

Accounting for direct costs

Businesses tend to incur certain direct costs regardless of the industry in which they operate, such as sales
commissions and credit card fees. These costs are only considered direct if they can be tied to a cost object.
However, companies’ direct costs usually depend on the industry in which they operate.

Here are some industries and examples of direct costs they incur:

 manufacturing

 direct labour

 raw materials

 manufacturing supplies tied to the product

 fuel or power consumption tied to a facility

 retail

 product purchased for resale

 duties and freight paid to acquire a product for resale

 display and packaging materials

 fees for online ordering platform if directly tied to a product

 services and construction

 direct labour to provide a service

 materials used to provide a service

 rental equipment used to provide a service

 technology and software

 solution implementation support

 customer support—when charged based on usage

 labour for customization of solutions

 trucking and logistics

 fuel

 driver wages

Accounting for indirect costs

1. Fixed cost classification

Fixed cost classification is the simplest way to assign a cost object. This method works for all indirect fixed
expenses.

How to allocate costs using fixed-cost classification

Fixed costs are allocated as a fixed charge to a specific asset or department within the business.

 Example A: the depreciation expense associated with a widget machine may be allocated to that
machine and to a product based on the number of machine hours required to produce that product.

 Example B: office supply expenses are allocated to the department ordering the supplies.

2. Proportional allocation

Proportional allocation assigns a percentage of an indirect cost to all or several departments within the
business.

 Example A: for a company offering a service, the electricity bill may be allocated to each department
based on the square footage each one occupies in the building.

 Example B: for a manufacturing company, the electricity bill may be allocated to the production facility
first, and then to each widget machine based on the number of hours of operation.

3. Activity-based cost allocation

Activity-based cost allocation (ABC) is a method of assigning overhead and indirect costs such as salaries and
utilities to products and services. This system of cost accounting is based on activities, which are considered an
event, unit of work or task.

It is used mainly by manufacturing companies that produce several product lines or work with a number of
businesses.

 The individual business activity is the cost driver. For example, the maintenance of a widget machine
would be considered an activity.

 The cost driver rate, that is, the cost pool total divided by cost driver, is then used to calculate the
amount of overhead and indirect costs related to a particular activity.

 Cost pools are cost categories, such as marketing or manufacturing.

 Cost drivers are quantifiable units, such as machine or employee hours.

While ABC costing is the most complex and time-consuming allocation method, it helps a business understand
its cost structure.