Nature of Costs
The term cost is used in a wide variety of ways. As a result, the term can become quite confusing.In ordinary speech, we often equate costs with effort, regardless of whether there is a dollar
component. For instance, we say that it costs a lot to run a marathon, meaning that it takes a lot
of energy measured in gallons of sweat and sore, aching muscles afterwards.
Economists like to equate the term with opportunity costs. In this approach, costs are defined by
alternative actions. By choosing action A one has chosen not to take action B. The cost of
choosing A, economists say, is the value of the benefit that one could have enjoyed from
choosing B.
Example: By electing to come to school, one has chosen not to be a full-time employee. The
opportunity cost of being in school is the salary you could have been earning.
Accountants focus their attention on the dollar cash costs of an activity. Using the previous
example, they would ignore the personal costs associated with the pain of learning, staying up late
before an examination, and the like. They would ignore the salary that a full-time student
foregoes. The only costs that the accountant tracks are the tuition and fees that one pays.
Instead of making alternative B, the road not taken, a cost of alternative A, accountants tend to
list the two alternatives side by side and to see which dollar costs change as one considers one
alternative and then the other. Those costs that change are called differential costs. Those costs
that increase are called incremental costs.
In financial accounting, the costs that the accountant tracks are recognized when incurred. An
elaborate system of accruing revenues and expenses is set up to do this. In managerial accounting,
for reasons that are not entirely clear, there is a tendency to focus on cash costs only i.e., on
receipts and disbursements. This makes things a little easier but, as we shall see later, is not
necessary. Even though it is unusual, one can handle accrued costs in managerial accounting just
like cash costs.
Financial accounting is oriented more towards the past than is managerial accounting. For
instance, the depreciation expense on a machine acquired years ago is included in the calculation
of net income. Managerial accountants tend to exclude past costs on grounds that they are sunk
costs, meaning that they are done and gone and have no effect on a decision. All decisions should
be based upon future costs, not past costs. Sunk costs are irrelevant.
Example: A meal plan, once paid for, is a sunk cost. Its cost should have no effect on one’s
decision to eat a hamburger in the school cafeteria rather than a pizza. The cost of the meal plan
should have no bearing on whether one chooses to eat a hamburger or a pizza off campus either.
In fact, since the decision to eat on or off campus will have absolutely no effect on the cost of the
meal plan already paid for, that decision too is independent of the initial cost. The meal plan is in
every way a sunk cost.
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It is often convenient in accounting to distinguish between direct costs and indirect costs. Direct
costs are those that can be traced directly to a product, a service, a person, a business department,
and activity or more generally a cost object, which is an accounting term for the “object” that one
is trying to cost. The ingredients that go into a meal are a direct cost of that meal as is the labor of
the chef. Indirect costs are costs that are associated with a product or service but only indirectly.
The maitre d’ at a restaurant is an important part of the ambience of a meal, but his or her salary
is not a direct cost of any particular meal. Indirect costs are often called overhead.
Whether a particular cost is direct or indirect depends upon the object that one is costing. Our
Dean is a direct cost of the School, but an indirect cost of the accounting department. The
President is a direct cost of the University, but an indirect cost of the School. All costs that are
direct costs of a lower level object, such as a department, remain direct costs of higher level
objects, such as the School. Costs that are indirect to a higher level object, such as the School,
remain indirect to a lower level object, such as a department in the School.
For financial accounting reasons, more than managerial accounting reasons, accountants
distinguish between product costs and period costs. Essentially, product costs are those that are
associated with making a product or preparing a service; period costs are those that are associated
with administering the business or selling the product or service. Advertising is a classic period
cost; the raw material that goes into a product is a classic product cost.
The terms product and period as well as direct and indirect derive from the world of
manufacturing. The goal is to produce an income statement that has a cost of goods sold,
consisting of all product costs, segregated from selling, administrative and financial expenses,
making up all the period costs. This is the origin of the terms – we argue by analogy when using
these terms in a service business such as a hospital.
As a general rule, all manufacturing costs are product costs i.e., all costs incurred inside the factory
are product costs. This includes the labor of all factory employees, including the Vice-President of
Manufacturing; all the materials and supplies that are used; the cost of trucking materials to the
factory; insurance, light, rent and so on for the factory. It also includes things like cafeteria costs
in the factory and the salaries of managerial accountants employed in the factory. All costs that
are incurred in the business but outside the walls of the factory are period costs. The salaries of
financial accountants, for instance, are period costs and part of administrative expenses.
The result of these classifications is a 2 x 2 of product versus period costs and direct versus indirect
costs. The material used in making a product is a direct, product cost as is the labor of the worker
who actually shapes the product. The salary of a factory foreman is an indirect, product cost. Most
period costs are by definition indirect costs although the advertizing associated with a specific
product is a direct cost as is the commission paid to a sales person for selling a specific product. In
the parlance of textbook accounting:
Direct material = Cost of material used in making a product
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Direct labor = Cost of labor of a person making a product
Indirect labor = Cost of labor of a person supervising the making of products
Indirect material = Cost of supplies used making products e.g., cleaning rags
Overhead = All indirect costs, typically referring just to manufacturing costs
Direct material and direct labor are called prime costs. Direct labor and manufacturing overhead,
that is all the costs incurred in turning raw material into finished goods, are called conversion costs.
Direct materials, direct labor and manufacturing overhead constitute what accountants call the
full cost of a product and are all charged to inventory. They are, therefore, also called inventoriable
costs. Inventoriable costs make their way into the income statement at the time a product is sold
in the form of cost of goods sold.
Task: Classify the following costs as product or period costs.
1. Secretarial support to sales department.
2. Magazine subscriptions for factory lunch room.
3. Depreciation on delivery vans.
4. Insurance on finished goods.
5. Fringe benefits of factory workers.
Task: Classify the following costs as direct or indirect costs. In each case, state to what cost object
the cost is direct or indirect.
1. Rent on factory building.
2. Syrup used in soft-drinks.
3. Janitorial supplies in a factory.
4. Office supplies for the Vice-President of Finance.
5. Cost of workers installing a picture tube in a TV set.
