Basic Cost Accouting Terms and Cost Behavior

These lectures cover basic cost accounting terms such direct labor, direct material, indirect cost, cost behavior, variable cost, and fixed cost.

Basic Cost Accounting Terms

Cost Behavior

Direct and Indirect Materials Costs
Direct materials cost includes the cost of materials in the product or other cost object (less purchase discounts but including freight and related charges) and usually a reasonable allow- ance for scrap and defective units (e.g., if a part is stamped from strip steel, the material lost in the stamping is ordinarily included as part of the product’s direct materials).
On the other hand, the cost of materials used in manufacturing that are not part of the finished product is indirect materials cost. Examples include supplies used by manufacturing employees, such as rags and small tools, or materials required by the machines, such as lubricant. For convenience and economic feasibility (cost vs. benefit), direct materials that are a very small part of materials cost, such as glue and nails, are often not traced to each product but are included instead in indirect materials.

Direct and Indirect Labor Costs

Direct labor cost includes the labor used to manufacture the product or to provide the service plus some portion of non-value-added time that is normal and unavoidable, such as cof- fee breaks and personal time. Other types of nonproductive labor that are discretionary and planned, such as downtime, payroll taxes, fringe benefits (vacation, etc.), and training might be treated as indirect labor. Indirect labor costs include supervision, quality control, inspection, purchasing and receiving, materials handling, janitorial labor, downtime, training, and cleanup. Note that an element of labor can sometimes be both direct and indirect, depending on the cost object; for example, labor for the maintenance and repair of equipment might be direct to the manufacturing department where the equipment is located but indirect to each specific product manufactured in that department. Although these examples of direct and indirect costs are from a manufacturing setting, the concepts also apply to service companies. For example, in a restaurant where the cost object is each meal served, the food and food preparation costs are direct costs for each meal served, but the costs of purchasing, handling, and storing food items are indirect costs. Similarly, in professional services firms such as law firms or accounting firms, the professional labor and materials costs for providing client services are direct costs, but the costs of research materials, nonprofessional support staff, and training are indirect costs.

Other Indirect Costs

In addition to labor and materials, other types of indirect costs are necessary to manufacture the product or provide the service. They include the costs of facilities, the equipment used to manufacture the product or provide the service, and any other support equipment, such as that used for materials handling. All indirect costs—for indirect materials, indirect labor, and other indirect items—are commonly combined into a single cost pool called overhead. In a manufacturing firm, it is called factory overhead. The three types of costs—direct materials, direct labor, and factory overhead—are sometimes combined for simplicity and convenience. Direct materials and direct labor are sometimes considered together and called prime costs. Similarly, direct labor and overhead are often combined into a single amount called conversion cost. The labor component of total manufacturing costs for many firms that have highly automated operations is relatively low, and these firms often choose to place their strategic focus on materials and facilities/overhead costs by combining labor costs with overhead.

Cost Drivers and Cost Behavior

Cost drivers provide two important roles for the management accountant: (1) enabling the assignment of costs to cost objects, as we saw in the earlier discussion and in Exhibits 3.1 and 3.2, and (2) explaining cost behavior: how total costs change as the cost driver changes. Generally, an increase in a cost driver will cause an increase in total cost. Occasionally, the relationship is inverse; for example, assume the cost driver is degree of temperature, then in the colder times of the year, increases in this cost driver will decrease total heating cost. Cost drivers can be used to provide both the cost assignment and cost behavior roles at the same time. In the remainder of this section, we focus on the cost behavior role of cost drivers. Most firms, especially those following the cost leadership strategy, use cost management to maintain or improve their competitive position.

Cost management requires a good understanding of how the total cost of a cost object changes as the cost drivers change. The four types of cost drivers are activity-based, volume-based, structural, and executional. Activity-based cost drivers are developed at a detailed level of operations and are associated with a given manufacturing activity (or activity in providing a service), such as machine setup, product inspection, materials handling, or packaging. In contrast, volume-based cost drivers are developed at an aggregate level, such as an output level for the number of units produced. Structural and executional cost drivers involve strategic and operational decisions that affect the relationship between these cost drivers and total cost.

Fixed and Variable Costs

Total cost is made up of variable costs and fixed costs. A variable cost is a cost that changes in total in response to changes in one or more cost drivers. The cost driver can be activity-based or volume-based, though typically management accountants in practice use the term variable costs in connection with volume-based cost drivers. Common examples of variable costs are costs of direct materials and direct labor. In contrast, a fixed cost is that portion of the total cost that does not change with the volume of a designated cost driver within the relevant range. Total fixed costs and unit variable costs are expected to remain approximately constant within the relevant range.