cost assignment definition and examples

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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COST ASSIGNMENT Definition

COST ASSIGNMENT involves assigning costs of an account to the accounts that are responsible or accountable for incurring the cost. For example, the cost of issuing purchase orders is allocated to the various objects procured. The cost assignment is done through assignment paths and cost drivers. The assignment path identifies the source account (the account whose cost is being assigned "Issue Purchase Orders" in the above example) and destination accounts (the accounts to which the costs are being allocated the various cost objects procured by issuing purchase orders in the above example). The cost driver identifies the measure or rationale on the basis of which the assignment needs to be done, that is, whether the costs of issuing purchase orders need to be assigned to various cost objects evenly, based on some defined percentage values, or based on some criterion, like the number of purchase orders of each cost object issued. Defining the cost drivers and assignment paths (i.e., source and destination accounts) enable proper assignment and accounting of the various costs incurred in the organization.

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Chapter 3: Process Costing

Introduction to accumulating and assigning costs, what you will learn to do: assign costs to various stages of production.

Here is an overview of what you will learn in detail in this section:

You can view the transcript for “Process Costing” here (opens in new window) .

There are two methods for using process costs: Weighted Average and FIFO (First In, First Out). Each method uses equivalent units and cost per equivalent units but calculates them just a little differently.

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

• Prepare a production cost report for the first stage of a multi-step process using the weighted-average method
• Prepare a production cost report for a second or subsequent stage of a multi-step process using the weighted-average method
• Prepare a production cost report using the FIFO method

Learning Activities

The learning activities for this section include the following:

• Reading: First-stage production report
• Self Check: First-stage production report
• Reading: Subsequent-stage production report
• Self Check: Subsequent-stage production report
• Reading: Production report using FIFO
• Self Check: Production report using FIFO
• Introduction to Accumulating and Assigning Costs. Authored by : Joseph Cooke. Provided by : Lumen Learning. License : CC BY: Attribution
• Process Costing. Authored by : Edspira. Located at : https://youtu.be/guZc84c5HNI. . License : All Rights Reserved . License Terms : Standard YouTube License

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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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Classification of Cost

Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on March 07, 2023

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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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• Cost Classifications
• Relevant Cost of Material
• Manufacturing Overhead Costs
• Conversion Costs
• Quality Costs
• Revenue Expenditure
• Product Cost vs Period Cost
• Direct Costs and Indirect Costs
• Prime Costs and Conversion Costs
• Relevant vs Irrelevant Costs
• Avoidable and Unavoidable Costs
• Cost Allocation
• Joint Products
• Accounting for Joint Costs
• Service Department Cost Allocation
• Repeated Distribution Method
• Simultaneous Equation Method
• Specific Order of Closing Method
• Direct Allocation Method

Cost allocation is the process by which the indirect costs are distributed among different cost objects such as a project, a department, a branch, a customer, etc. It involves identifying the cost object, identifying and accumulating the costs that are incurred and assigning them to the cost object on some reasonable basis.

Cost allocation is important for both pricing and planning and control decisions. If costs are not accurately calculated, a business might never know which products are making money and which ones are losing money. If cost are mis-allocated, a business may be charging wrong price to its customers and/or it might be wasting resources on products that are wrongly categorized as profitable.

Cost allocation is a sub-process of cost assignment , which is the overall process of finding total cost of a cost object. Cost assignment involves both cost tracing and cost allocation. Cost tracing encompasses finding direct costs of a cost object while the cost allocation is concerned with indirect cost charge.

Steps in cost allocation process

Typical cost allocation mechanism involves:

• Identifying the object to which the costs have to be assigned,
• Accumulating the costs in different pools,
• Identifying the most appropriate basis/method for allocating the cost.

Cost object

A cost object is an item for which a business need to separately estimate cost.

Examples of cost object include a branch, a product line, a service line, a customer, a department, a brand, a project, etc.

A cost pool is the account head in which costs are accumulated for further assignment to cost objects.

Examples of cost pools include factory rent, insurance, machine maintenance cost, factory fuel, etc. Selection of cost pool depends on the cost allocation base used. For example if a company uses just one allocation base say direct labor hours, it might use a broad cost pool such as fixed manufacturing overheads. However, if it uses more specific cost allocation bases, for example labor hours, machine hours, etc. it might define narrower cost pools.

Cost driver

A cost driver is any variable that ‘drives’ some cost. If increase or decrease in a variable causes an increase or decrease is a cost that variable is a cost driver for that cost.

Examples of cost driver include:

• Number of payments processed can be a good cost driver for salaries of Accounts Payable section of accounting department,
• Number of purchase orders can be a good cost driver for cost of purchasing department,
• Number of invoices sent can be a good cost driver for cost of billing department,
• Number of units shipped can be a good cost driver for cost of distribution department, etc.

While direct costs are easily traced to cost objects, indirect costs are allocated using some systematic approach.

Cost allocation base

Cost allocation base is the variable that is used for allocating/assigning costs in different cost pools to different cost objects. A good cost allocation base is something which is an appropriate cost driver for a particular cost pool.

T2F is a university café owned an operated by a student. While it has plans for expansion it currently offers two products: (a) tea & coffee and (b) shakes. It employs 2 people: Mr. A, who looks after tea & coffee and Mr. B who prepares and serves shakes & desserts.

Its costs for the first quarter are as follows:

Total tea and coffee sales and shakes sales were $50,000 & $60,000 respectively. Number of customers who ordered tea or coffee were 10,000 while those ordering shakes were 8,000.

The owner is interested in finding out which product performed better.

Salaries of Mr. A & B and direct materials consumed are direct costs which do not need any allocation. They are traced directly to the products. The rest of the costs are indirect costs and need some basis for allocation.

Cost objects in this situation are the products: hot beverages (i.e. tea & coffee) & shakes. Cost pools include rent, electricity, music, internet and wi-fi subscription and magazines.

Appropriate cost drivers for the indirect costs are as follows:

Since number of customers is a good cost driver for almost all the costs, the costs can be accumulated together to form one cost pool called manufacturing overheads. This would simply the cost allocation.

Total manufacturing overheads for the first quarter are $19,700. Total number of customers who ordered either product are 18,000. This gives us a cost allocation base of $1.1 per customer ($19,700/18,000).

A detailed cost assignment is as follows:

Manufacturing overheads allocated to Tea & Cofee = $1.1×10,000

Manufacturing overheads allocated to Shakes = $1.1×8,000

by Irfanullah Jan, ACCA and last modified on Jul 22, 2020

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10.19: Assignment- Production and Costs

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In this module you learned that cost functions are derived from production functions and that the marginal cost curve is the inverse of the marginal product curve. Work through this problem to demonstrate those findings.

Production Function:

1. Using the production function, compute the figures for marginal product using the definition given earlier in this module.  Draw a graph of the marginal product curve using the numbers you computed.

Suppose this firm can hire workers at a wage rate of $10 per hour to work in its factory which has a rental cost of $100. Use the production function to derive the cost function.

2. First compute the variable cost for Q = 0 through Q = 5.

3. Next compute the fixed cost for Q = 0 through Q = 5.

4. Then compute the total cost for Q = 0 through Q = 5.  This is the cost function.

5. Finally compute the marginal cost for Q = 0 through Q = 5.  Draw the marginal cost curve and compare it to the marginal product curve above.  Explain what you see.

• Assignment: Production and Costs. Authored by : Steven Greenlaw and Lumen Learning. License : CC BY: Attribution

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Direct Costs

Indirect costs, fixed costs, variable costs, operating costs, opportunity costs, controllable costs, the bottom line.

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What Are the Types of Costs in Cost Accounting?

Charlene Rhinehart is a CPA , CFE, chair of an Illinois CPA Society committee, and has a degree in accounting and finance from DePaul University.

Ariel Courage is an experienced editor, researcher, and former fact-checker. She has performed editing and fact-checking work for several leading finance publications, including The Motley Fool and Passport to Wall Street.

Cost accounting is an accounting process that measures all of the costs associated with production, including both fixed and variable costs. The purpose of cost accounting is to assist management in decision-making processes that optimize operations based on efficient cost management. The costs included in cost accounting are discussed in detail below.

Key Takeaways

• Cost accounting is an accounting method that takes into consideration a company's total cost of production by evaluating both fixed and variable costs.
• Managers use cost accounting to help make business decisions based on efficient cost management.
• The types of costs evaluated in cost accounting include variable costs, fixed costs, direct costs, indirect costs, operating costs, opportunity costs, sunk costs, and controllable costs.
• Cost accounting is not generally accepted accounting principles (GAAP) compliant and can only be used for internal decision-making.

Direct costs are related to producing a good or service. A direct cost includes raw materials, labor, and expense or distribution costs associated with producing a product. The cost can easily be traced to a product, department, or project.

For example, Ford Motor Company ( F ) manufactures cars and trucks. A plant worker spends eight hours building a car. The direct costs associated with the car are the wages paid to the worker and the cost of the parts used to build the car.

Indirect costs, on the other hand, are expenses unrelated to producing a good or service. An indirect cost cannot be easily traced to a product, department, activity, or project. For example, with Ford, the direct costs associated with each vehicle include tires and steel.

However, the electricity used to power the plant is considered an indirect cost because the electricity is used for all the products made in the plant. No one product can be traced back to the electric bill.

Fixed costs do   not vary with the number of goods or services a company produces over the short term. For example, suppose a company leases a machine for production for two years. The company has to pay $2,000 per month to cover the cost of the lease , no matter how many products that machine is used to make. The lease payment is considered a fixed cost as it remains unchanged.

Variable costs fluctuate as the level of production output changes, contrary to a fixed cost. This type of cost varies depending on the number of products a company produces. A variable cost increases as the production volume increases, and it falls as the production volume decreases. Businesses can also decide to forego an activity or production to avoid the associated expenses—called the avoidable costs .

For example, a toy manufacturer must package its toys before shipping products out to stores. This is considered a type of variable cost because, as the manufacturer produces more toys, its packaging costs increase, however, if the toy manufacturer's production level is decreasing, the variable cost associated with the packaging decreases.

Operating costs   are expenses associated with day-to-day business activities but are not traced back to one product. Operating costs can be variable or fixed. Examples of operating costs, which are more commonly called operating expenses , include rent and utilities for a manufacturing plant.

Operating costs are day-to-day expenses, but are classified separately from indirect costs – i.e., costs tied to actual production. Investors can calculate a company's operating expense ratio, which shows how efficient a company is in using its costs to generate sales.

Opportunity cost  is the benefits of an alternative given up when one decision is made over another. This cost is, therefore, most relevant for two mutually exclusive events. In investing, it's the difference in return between a chosen investment and one that is passed up. For companies, opportunity costs do not show up in the financial statements but are useful in planning by management. 

For example, a company decides to buy a new piece of manufacturing equipment rather than lease it. The opportunity cost would be the difference between the cost of the cash outlay for the equipment and the improved productivity versus how much money could have been saved in interest expense had the money been used to pay down debt.

Sunk costs are historical costs that have already been incurred and will not make any difference in the current decisions by management. Sunk costs are those costs that a company has committed to and are unavoidable or unrecoverable costs. Sunk costs are excluded from future business decisions.

Controllable costs are expenses managers have control over and have the power to increase or decrease. Controllable costs are considered when the decision of taking on the cost is made by one individual. Common examples of controllable costs are office supplies, advertising expenses, employee bonuses, and charitable donations. Controllable costs are categorized as short-term costs as they can be adjusted quickly.

What Are the Types of Cost Accounting?

The different types of cost accounting include standard costing, activity-based costing, lean accounting, and marginal costing. Standard costing uses standard costs rather than actual costs for cost of goods sold (COGS) and inventory. Activity-based costing takes overhead costs from different departments and pairs them with certain cost objects. Lean accounting replaces traditional costing methods with value-based pricing. Marginal costing evaluates the impact on cost by adding one additional unit into production.

What Is the Main Purpose of Cost Accounting?

The main purpose of cost accounting is to evaluate the costs of a business and based on the data, make better decisions, improve efficiency, determine the best selling price, reduce costs, and determine the profit of each activity involved in the operational process.

What Is the Difference Between Cost Accounting and Financial Accounting?

Cost accounting focuses on a business's costs and uses the data on costs to make better business decisions, with the goal of reducing costs and improving profitability at every stage of the operational process. Financial accounting is focused on reporting the financial results and financial condition of the entire business entity.

Cost accounting looks to assess the different costs of a business and how they impact operations, costs, efficiency, and profits. Individually assessing a company's cost structure allows management to improve the way it runs its business and therefore improve the value of the firm.

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Indirect Cost: Definition and Example

To facilitate preparation of an indirect cost proposal, shown below are (1) some definitions of the term "indirect costs," (2) a brief discussion of indirect cost rate structures and (3) a simple example of an indirect cost rate computation.

Indirect Costs (definition extracted from FAR Part 31.2)

An indirect cost is any cost not directly identified with a single, final cost objective, but identified with two or more final cost objectives or an intermediate cost objective. It is not subject to treatment as a direct cost. After direct costs have been determined and charged directly to the contract or other work, indirect costs are those remaining to be allocated to the several cost objectives. An indirect cost shall not be allocated to a final cost objective if other costs incurred for the same purpose in like circumstances have been included as a direct cost of that or any other final cost objective.

In simpler terms, indirect costs are those costs not readily identified with a specific project or organizational activity but incurred for the joint benefit of both projects and other activities. Indirect costs are usually grouped into common pools and charged to benefiting objectives through an allocation process/indirect cost rate.

An indirect cost rate is simply a device for determining fairly and expeditiously the proportion of general (non-direct) expenses that each project will bear. It is the ratio between the total indirect costs of an applicant and some equitable direct cost base.

Indirect costs include costs which are frequently referred to as overhead expenses (for example, rent and utilities) and general and administrative expenses (for example, officers' salaries, accounting department costs and personnel department costs).

Commercial (for-profit) organizations usually treat "fringe benefits" as indirect costs. These fringe benefits are applied to direct salaries charged to projects either through a fringe benefit rate or as part of an overhead/indirect cost rate. Therefore, fringe benefits treated as indirect costs should not be included as a direct cost in the "Personnel" category of the budget form of the grant application or on a contract proposal.

The indirect cost base or bases (that is, the denominator(s) of the fraction producing a rate) should be selected so as to permit an equitable distribution of indirect costs to the benefiting cost objectives.

Generally, indirect cost rate structures for commercial organizations follow a single, two-rate (for example, fringe and overhead rates), or three-rate (for example, fringe, overhead, and General and Administrative expense rates) system. A single rate structure is illustrated below.

* Includes costs associated with independent (self-sponsored) research and development (IR&D) activities.

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The theory of opportunity cost

Basic principles behind opportunity cost, types of opportunity cost, how to calculate opportunity cost, how opportunity cost influences decision-making.

• Why opportunity cost matters for investors

Opportunity cost FAQs

Understanding opportunity cost.

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• Opportunity cost represents the benefits forgone by choosing one option over another.
• Recognizing opportunity costs can help you make better decisions in all aspects of your life.
• It can be difficult to identify opportunity costs when the benefits of the alternative choice aren't easily quantifiable.

Opportunity cost is a term that refers to the potential reward that you forgo when choosing one option over the next-best alternative. It's an economic concept that can be applied to many different situations, from a business determining what projects to pursue, to an employee deciding to work overtime or spend that time with their family, to an investor choosing an index fund over a self-managed portfolio.

Opportunity costs can be easily overlooked because sometimes the benefits are unrealized, and therefore, hidden from view. 

Societal resources are limited. As a result, individuals inevitably face trade-offs when making decisions. For example, if an investor decides to put $100 into ABC stock, that is $100 he cannot put into XYZ stock, or alternatively, some other kind of asset, for example a bond. Alternatively, if an individual spends $20,000 on a sedan, he cannot put that same amount toward a minivan. 

Other examples appear in personal decision-making. If a man marries someone, he cannot choose another person to be his spouse. If an individual chooses to go to one university full-time, that will require many spent either in class or studying that cannot be used for other purposes. 

Any time an individual makes a purchase now, he is doing so at the expense of future consumption or savings. In other words, any time someone buys an item in the present, he is giving something up in the future. For example, if someone spends $20 on lunch every day at work instead of packing their own lunch using $5 worth of groceries, they are losing $15 every day through this decision-making. 

Over the course of a year, $15 every week day would add up to thousands of dollars, money that could potentially pay for a nice vacation. 

When looking at opportunity costs, economists consider two types: explicit and implicit.

Explicit opportunity cost

"Explicit costs are those that are incurred when taking a specific course of action," says Bob Castaneda, program director of Walden University's College of Management of Technology. 

The explicit opportunity costs associated with a decision could include wages, materials, stock purchases, rent, utilities, and other tangible expenses. Any dollar amount required to move forward with a choice will fall under the explicit costs. 

Implicit opportunity cost

On the other hand, "implicit costs may or may not have been incurred by forgoing a specific action," says Castaneda.

Implicit costs are indirect and can be difficult to identify. They represent the income or other benefits that could possibly have been generated had you made the alternative choice.

The formula to calculate opportunity cost is straightforward. 

Here's a very simple way to put this formula into practice. 

Let's say you are deciding to invest in either Company A or Company B. You choose to invest in company A, which provides a return of 6% in one year. On the other hand, Company B had a return of 10% in the same year. 

The opportunity cost of choosing to invest in Company A versus Company B is 10% minus 6%. With that choice, the opportunity cost is 4%, meaning you would forgo the opportunity to earn an additional 4% per year on your funds. 

Here are some more examples:

• A business owner wants to add a new product to the lineup. It requires an upfront investment of $1,000 to build and market. The opportunity cost is the potential value of that money being spent elsewhere or saved for the future. 
• A worker with a full-time job earning $50,000 per year decides to return to school to complete a master's degree that will enable her to increase her salary. The opportunity cost of this choice is the income she won't earn while focusing her time and energy on school in the meantime. 
• A book lover spends $150 per month feeding her habit. If she switched from buying books to borrowing them from the library, and earned 4% interest on the money she saved, she would have $9,926.85 at the end of five years. Those savings would be the opportunity cost of continuing to buy books.

Now, take a minute to consider the decisions on the horizon in your life. Understanding the opportunity costs associated with your choices could illuminate the best path forward.

In personal finance 

Opportunity costs influence personal finance decision-making by providing individuals with tradeoffs on individual purchases they make. For example, a person who spends $300 on leasing a sedan every month cannot put those funds toward a car payment that might help them build equity over the long-term. 

In business strategy 

Say a shoe manufacturer has the option of investing in new equipment that is expected to provide a return of roughly 9% the first year. Alternatively, the company can put its money into securities that generate income of 3% a year. 

If the organization opts to put its money into the income-producing securities instead of the new equipment, the opportunity cost will be 6% of the principal invested in the first year. 

In everyday life 

Opportunity cost can cause individuals to forgo everyday luxuries and even regular experiences. For example, a person could spend $12 watching a matinee movie, or they could use it to buy lunch. If they opt for the former, they may not have money for the latter, and vice versa.

Opportunity cost vs. sunk costs

Another concept in cost accounting is sunk costs.

"Sunk cost refers to the past costs that you have incurred," says Ahren A Tiller, Esq., Bankruptcy Law Specialist. "Let's say you've invested in company X but gained nothing. The money you spent is a sunk cost, and it can't be recovered. You can't do anything about it, making it irrelevant in your decision-making."

In contrast, opportunity cost considers the loss of potential returns from an alternative investment decision.

For example, the money you've already spent on rent for your office space is a sunk cost. But the funds you haven't spent on office furniture yet would be considered an opportunity cost because you haven't actually spent the money yet. 

Ultimately, Tiller says, "considering the opportunity cost will help show the most profitable option to invest in, making the decision-making process easier for you."

Opportunity cost is whatever you pass up by choosing an option. In economics, everything comes at the cost of something else, so picking one option causes an individual or business to miss out on a different option. 

You can calculate opportunity cost by subtracting the return on the chosen option from the return on the option passed up. 

Opportunity cost can be applied to any kind of decision that involves a trade-off, whether that involves time, money or other resources. 

Consumers can harness opportunity cost to evaluate different choices and the value they will forgo by selecting those choices. 

Opportunity cost helps inform efficient business strategy by ensuring that companies allocate resources in the most effective manner possible in an effort to achieve their business objectives. 

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