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Are You Leveraging Your Resources? Separate Profitable and Non-Profitable Activities Using Cost Objects

written by: N Nayab•edited by: Jean Scheid•updated: 6/9/2011

A cost object is any tangible input for manufacture of products or providing a service. It may be a specific product, service, project, customer, or anything else where the company makes a separate measurement of cost, usually to identify the quantum of resources it consumes vis-a-vis returns.

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    Defining Costs

    Money A cost object is a method of categorization in accounting, and entails appropriating direct and indirect costs to specific products, projects, or any other activity. To lend further clarity on what is a cost object, consider the hypothetical case of a contracting company. The company may have several construction projects of varying size, magnitude, and terms with developers. The organization considers each such project as a separate cost object, and draws up the costs incurred on each such project separately.

    A cost object is tangible in nature, having the ability to attract costs. For instance, the cost of employing labor is expressible as "per man per hour" and as such, labor fits as a possible option. Similarly, products, raw materials, and projects all make for possible options as it remains possible to assign costs to such elements.

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    Types

    The reasons for categorization could be several, including budgetary pressure, degree of competition, need to charge user fees, risks associated with overspending budgetary allocations, identifying profitable and non-profitable activities, and so on. Regardless of the purpose, cost objects are operational, output, or relationship based. The categorization, however, remains subjective with no hard and fast rules.

    Operational: An organization may have many sub organizations or activities that require independent measure. For instance, the organization may consider each project or each function as a separate cost object and account likewise. The project to design a new product, the customer support process, and human resource support activity all become eligible as separate cost centers. Managerial cost accounting accounts are utilized for the expenses related to such objects separately, to identify the resources and cost required to sustain such processes and possible outsource or revamp them.

    Products/Services: The most common cost objects are products or services. For instance, a food manufacturing company might consider its product line of packaged snack foods as one cost object, and its product line of ready to cook meals as another cost object. This allows the management to derive baseline costs, and identify the quantum of costs or resources consumed by each products vis-à-vis the returns they generate.

    Relationships: Another basis of cost object is relationships, such as the supplier or customer. The organization considering the customer as a cost objective can measure the profitability of each customer or the costs incurred to maintain relationships with the customer, to concentrate resources on highly profitable customers. Similarly identifying each customer as a cost object allows the company to identify the most and least profitable suppliers

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    Appropriating Costs

    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.

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    Reference

    Geiger, Dale, R. "Practical Systems in Cost Object Selection and Measurement." http://managegov.org/yahoo_site_admin/assets/docs/Article_2_Cost_Objects.32781418.pdf. Retrieved June 05, 2011.

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