The first step of any costing process is to decide the cost of what you want to know, i.e. the cost object. Cost objects can be products, services, pieces of equipment, distribution channels, customer segments, individual customers, territories, outlets, product divisions, functions or departments. Now, for inventory valuation purposes, cost objects are products and in some circumstances departments.
A cost object is anything for which decision-makers desire a separate measurement of costs.
Once the cost objects have been decided, costs must be recognized and accumulated. Financial accounting typically classifies transactions based on the specific contractual arrangement it creates between the organization and the third party. Indeed, it is mostly interested in the kind of rights or duties generated by the transaction towards third parties.
Management accounting is less interested in what a transaction is, i.e. the origin of a resource, and more interested in what the transaction was made for, the purpose, destination or usage of this resource. It is this purpose which justifies (or not) the acquisition and the consumption of the resource in the first place.
Therefore, when either financial or management accountants receive or produce a source document attesting of a transaction, they give it a code which does not only tell the nature of the transaction (e.g. materials, labor, services, utilities, lease, depreciation), but also its purpose (e.g. research, production, sales, administration). This process is called cost accumulation.
A source document is an explicit evidence of a transaction, such as sales slips, purchase invoices, and employee time records.
Cost accumulation is the collection of costs in an organized way through an accounting system. It consists in collecting costs and classifying costs based on a predefined set of categories indicating their nature and purpose.
For asset valuation, financial accounting serves as the basis for cost accumulation. I will specify later what is recognized as a cost and what is not based on financial accounting requirements. Now, you will also see that broader or slightly different cost definitions or valuations can be used when asset valuation is not the main purpose of costing.
The whole process of costing consists then in progressively dividing the flow of accumulated costs into various streams and channeling these streams towards the cost objects consuming these resources. In other words, costing models of the journey of resources within the organization until they leave it, i.e. until they are once again captured by financial accounting because they are either exchanged with a third party or lost (in either case these resources leave the organization). The quality of a costing system depends on how faithfully it manages to represent this flow of resources.
The process of costing for inventory valuation involves several steps. First costs are classified based on whether they follow products in the inventory (inventoriability). Then they are classified based on whether they can unambiguously be assigned to a specific product (traceability). Costs which should follow products in the inventory and can be assigned unambiguously to a specific product (direct manufacturing costs) are traced directly to that product. However, costs which should follow products in the inventory but cannot be assigned unambiguously to a specific product (indirect manufacturing costs) must be allocated.
Cost assignment consists in associating costs with the cost objects for which the resources were consumed. It is the general term which encompasses both cost tracing and cost allocation.
Cost tracing consists in assigning direct manufacturing costs incurred unambiguously for a specific cost object to that cost object.
Cost allocation consists in assigning indirect manufacturing costs to cost object in proportion to the cost object’s use of another resource.
Cost allocation is “a process in the process” and involves itself several steps. The flow of indirect manufacturing costs is subdivided into streams which are poured in separate cost pools where they wait for allocation. An allocation base must be chosen for each cost pool and then allocation rates can be computed. Only then can indirect manufacturing costs be allocated from cost pools to cost objects proportionally to their use of the allocation base.
Once direct manufacturing costs have been traced and indirect manufacturing costs allocated to products, the units produced and the corresponding production costs are added to the inventory of each product. They stay there until they are sold. Then, they go out of the inventory and expended as costs of goods sold. By contrast, all the costs which cannot follow products in the inventory are expended in the income statement as costs of the period in which they were incurred.
This is it for a brief description of the costing process. Now we will dive into all the choices cost system designers must make at every step and discuss their meaning and consequences…
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