Cost categories

Hello everyone, I would like to welcome you to this HSTalks lecture series on "Managerial Accounting". My name is Alexander Himme, and I'm an Assistant Professor for Managerial Accounting at the Kuhne Logistics University in Hamburg, Germany. In the second module, we will talk about different types of costs.

The distinction of different cost categories is very important, and constitutes a fundamental basis for the following modules. For example, distinguishing different types of cost is relevant for determining the unit costs of product or a service. A topic we cover in module number three. It is also a basic prerequisite for understanding cost-volume profit analysis, a topic we cover in module six, or budgeting which we'll cover in module number nine.

Let's have an overview of how costs are typically distinguished. In the following, we will then discuss each category in detail. The first category is based on the criterion if cost can be directly assigned to a cost object. Based on this question, we will distinguish between so-called direct and indirect costs. The second category refers to the question whether the incurred costs are related to the production activities or not. Based on this question, you will distinguish between so-called product and period costs. The third and last category is linked to the question if costs vary with production output or not. Here, you will distinguish between variable and fixed costs.

Let us look at the first cost category. The first category answers the question whether cost can be directly assign to a cost object or not. What does this mean? First of all, what is a cost object? A cost object is anything of which managers need a separate breakdown of its component costs. For example, product, a department, sales territory, or an activity. In manufacturing, cost objects are usually the units of a product. Now, in management accounting in general, we are always interested to what extent these cost objects cause costs. In order to determine this, we need to trace the cost to the cost objects. If this can be easily and cost-effectively done, we call these costs direct costs. Let us take this, an example, a manufacturer of wooden chairs. The wood needed for producing one chair is known, and thus the cost for the wood can be easily and cost-effectively traced to one chair. We call this kind of costs direct materials. In addition, the production of someone who is cutting the woods and assembles the chair, since you would typically know how much time is needed on average to assemble one chair, and since you also know how much the workers earn, we can easily and cost-effectively trace these costs to one unit of a chair. We call these costs direct labor. But now there are also a significant number of costs that cannot be easily and cost-effectively traced to cost object. We call these the indirect costs. Examples, the salary of the production supervisor is an example of an indirect cost. The production supervisor manages effective operations for all of the products the company manufactures. Therefore, it is difficult to trace the costs of the supervisor to a specific product. The same is true for factory rent or insurance on the factory and the equipment. Depreciation on the factory or equipment and utilities are further examples. Also consider that not all material used for production is direct material. Think of the screws needed for producing one wooden chair, they may be easy to trace, but will it be cost effective? These, they're only minor components of the product. You call these kinds of material costs that we do not directly trace to a cost object, indirect material. Also not every labor cost is direct cost. Think of forklift operators, or janitors needed in this production. It is difficult to trace these costs to the production of one wooden chair. That is why these kind of costs are considered to be indirect labor costs. All these costs are called manufacturing overheads. These costs are all the costs for supporting production activities.