trace them directly to a product or service.
Salespeople are often paid a salary plus a commission based on sales. The cost of a salesperson’s commission is normally traced to the product as a direct cost.
Why Are You Spending? Cost Drivers
A cost object is the product, service, or company department where you incur costs. Picture the cost object as a sponge that sucks up money. A cost driver is an item that changes costs. If the cost object is a sponge full of costs, the cost driver changes the size of the sponge.
If you manufacture leather baseball gloves, leather material is a cost driver. If you manage the human resources department, an increase in job interviews is a cost driver. More interviews require more time from your staff, and that labor time has a cost.
This section covers two related concepts: relevant range and inventoriable costs.
Pushing equipment too hard and relevant range
Relevant range is the area in which a set of assumptions about your costs hold true. By area, I mean a minimum and maximum level of use of an asset. As long as your use of the asset stays in that range, the cost assumptions apply. If you use the asset too much (out of the relevant range), it eventually breaks down. Breakdowns occur when you try to operate beyond your asset’s maximum capacity.
The bottom of a range is the minimum. For this book, you focus on the maximum.
At this point, you need to know about assets. An asset is anything you use to make money in your business (anything that provides your company with some benefit in the future). Essentially, you use up assets to make money.
Assume you’re a plumber. You have a truck that you use to carry equipment to homes to work on plumbing. The truck is an asset. As you drive the truck, two things happen. First, you’re doing plumbing work and making money. At the same time, the value of the asset is declining. The decline in value of a tangible asset is called depreciation.
Now, here’s where relevant range comes in. There’s a limit to how much you can use the asset. The truck can be driven only so many miles before it needs maintenance or a repair.
Say you’re planning your plumbing business for the month. Based on your experience, you know that your truck needs maintenance every 4,000 miles. The maintenance means the truck can’t be used for one day.
Because you perform plumbing work seven days a week, the day maintenance is performed on a day when you don’t earn revenue. The relevant range for your truck is up to 4,000 miles. Beyond that point, you need to take it out of service for a day. To work seven days a week, you may need to have another truck — another asset.
There’s relevant range for many assets. Maybe you can run your sewing machines for 10,000 hours before they need repairs. You might find that your commercial printing press has a maximum number of print jobs it can perform without breaking down. If you need production capacity above the relevant range, you need to invest in another asset. That investment is a cost.
Relevant range isn’t just about breakdowns and maintenance. Even if your machinery works as expected, there’s only so much capacity you can handle. Say you have machine capacity to produce 1,000,000 gloves a year. If you want to increase production to 1,200,000 gloves, you need more machines. That means an investment in more fixed assets.
Previewing inventoriable costs
Inventoriable costs are costs that can be traced to your inventory. That includes the purchase price of the inventory item. However, there are other costs that should be added to the asset’s cost. You refer to these costs as inventoriable.
Let’s say you own a furniture store that sells lamps. You carry an expensive model of lamp in your store. Parts of the lamp can break easily. As a result, it’s expensive to ship the lamps. When the lamps arrive, they’re stored carefully to prevent breakage.
Your inventory value for the lamp obviously includes the purchase price. It should also include all costs to prepare the asset for sale, such as the shipping cost and any extra costs you incur to store and display the lamp.
Now consider the impact of including more costs in inventory. Inventory costs aren’t posted as expenses (expensed) until the asset is sold. All the lamp costs remain in inventory until a lamp is sold. At that point, the lamp cost is posted to cost of sales (also called cost of goods sold).
Other costs are expensed as soon as they are incurred. A good example is marketing costs. Marketing costs are immediately expensed, because it’s difficult to know if and when the costs generated a sale.
If you run a million-dollar ad during the Super Bowl for running shoes, it’s not possible to know how many shoes were sold as a result of running the ad. So you expense it sooner than later. This is the principle of conservatism, which is explained in the next section.
Following the Rules of the Cost Accounting Road
Accountants are big on rules and guidelines. When you have to make a decision as an accountant, you first check for rules and guidelines. Some rules are regulations or laws. This section talks about some critical guidelines you should use in accounting.
Understanding generally accepted accounting principles (GAAP)
Generally accepted accounting principles (GAAP) refer to the rules that accountants must follow when preparing financial statements. The Financial Accounting Standards Board (FASB) is the industry organization that issues GAAP requirements.
The accounting industry’s goal is to generate financial statements that are easier to understand. If every business follows GAAP requirements, the financial statements are comparable between companies. The focus of GAAP is on financial statement users.
Considering the needs of stakeholders
You have a number of stakeholders who need timely and accurate financial statements, including these two groups:
Creditors: If you take out a business loan, your banker will need to see your firm’s financial statements. Your financial performance determines whether you can make principal and interest payments on your loan.
Investors: An investor can profit from selling an investment for a profit, or by receiving a share of a company’s earnings as a dividend. Your investors want to know if your firm is profitable, and if sales are growing over time.
To apply GAAP standards, you need to know the basics. Remember that the goal of using GAAP is to create financial statements that are clear and consistent, so that stakeholders understand company results.
Mulling over consistency
GAAP allows financial statements readers to make “apples to apples” comparisons. A good example is accounting for fixed assets. Generally speaking, fixed assets must be valued at historical cost, meaning the amount paid for the asset. The cost of the asset includes acquisition cost (the check you write for the asset), plus shipping and other costs required to prepare the asset for use.
Say, for example, that two trucking companies each list ten trucks as fixed assets in the balance