The two major types of costs associated with any entity are direct and indirect costs. Direct costs relate to the particular cost object under consideration, and easy to appropriate. For example, a company considering different projects as separate cost objects, the salary of employees engaged in each project finds appropriation to the respective project cost object. Indirect costs or overheads are costs of a general nature, not directly traceable to a particular cost object. Examples include office rent, support services such as human resources, energy charges, and others. Activity based costing, where each activity is charged for the quantum of resources it consumes remains a good method to assign indirect costs.
The three methods to translate raw accounting data to cost objects, regardless of whether such data happens to include direct or indirect costs are:
- Estimation, based on gut instincts
- Record keeping or tracking costs associated with each object
- Allocation, based on assumption that distributed costs are on par with cost drivers.
Detailed record keeping is the most accurate way to appropriate costs, but remains a costly option, requiring separate billing, and tracking mechanism for each object. The estimation method is the simplest and most popular method, especially to appropriate indirect costs, but also remains the least accurate. The selection of cost objects and allocation of overhead costs can cause large distortions if done inaccurately.
The level of detail for each cost depends on managerial requirements. Higher management might require an aggregated view of costs associated with each cost object, while lower management, concerned with improving operational efficiency would require detailed views.
An understanding of what is a cost object helps business managers separate profitable and loss-making activities, projects, or products, and end the system of profitable elements cross-subsidizing non-profitable elements. This allows them to leverage greater financial control over the different ventures or activities, identify the most economical and profitable activities, find out which activity acts as a drag on company resources, and more. In short, it helps in leveraging resources to undertake the most profitable ventures and improve organizational performance.