Aug. 21, 2000 (Pro2Net) — As we identified in several of our previous articles it is important that those who work in the field of Accounting establish clear terminology related to work within General Accounting and also within Internal Accounting.

This is especially recommended for those working in the new field of Internal Accounting. It is essential to establish clear terms - words that will help us to better communicate when we discuss Internal Accounting transactions, for example:

Today we will talk about the Final Cost Object that each company will have to identify for the purpose of their Internal Accounting structure.

Each manufacturing industry - or any service company (such as an airline) - will have their specific Final Cost Object. This Cost Object refers to the product (or service) that the company produces and also sells. All activities realized within the company will finally serve this basic Cost Object.

All our Cost Elements, that we credit the different accounts in Class 2, are created within our company with the purpose of fulfilling our Cost Object. Based upon this important statement - we should identify our Cost Elements into the following two basic and principal groups:

1. Those Cost Elements that are directly related to our Cost Object
2. Those Cost Elements that are indirectly related to our Cost Object

This basic rule, will help us to avoid identifying cost with origin in some department - as direct cost of this department.

Let us clarify this statement: Today we have many Cost Accounting books that, for example, tell students the salary of the Supervisor of a Direct Production Department, is a direct cost toward this department. Such a statement does not follow the basic rule that identifies the production as our Final Cost Object - and not activities realized in the Direct Production Department. The payments of these activities are not directly related to the final Cost Object - these payments are indirectly related toward our final Cost Object.

We should clearly establish that this basic concept should control our terminology.

If we continue with such mix up of terminology, the consequence would be that every time we say that this is a "direct cost" - we would have to clarify if the cost is to the production or to some department. This, naturally, is not a favorable situation.

Let us also remember, that not only the Direct Production Departments have indirect costs that will finally have to be applied (or absorbed) to the final Cost Object. We also have indirect cost that we have to charge to many other departments.

There will be Indirect Production Departments - such as Maintenance and Repair - that must finally also guide their departmental operating cost to the final Cost Object. There are also several Service Departments that have cost charged to their accounts, as a consequence of their departmental operating activity. These indirect production cost will have to be guided by the Internal Accounting procedures to the final Cost Object. We will discuss and analyze this problem in detail in our next article on Pro2Net.

To take these indirect production activity costs to the Direct Production Departments, we will use the so-called Re-Allocation procedure. Re-Allocation is the basic tool to fulfill the ABC systems instructions.

The Activity Based Costing system says we should charge (apply) to the Production Cost account not only the Direct Cost and the Indirect Cost of the Department that is working with this production, but also the Departmental Operating Costs of the Indirect Production Departments and the Service Departments, which we have in our Industry.

Different Final Cost Object in an Industry
Normally the production or service the company produces, will be identified as the Final Cost Object. But we have to recognize that with the development of the new Internal Accounting structure, we have created a specific Class of Accounts where we identify the different activities' costs.

In previous articles I have discussed the different Classes of Accounts that are included in the structure of Internal Accounting. The Class of Accounts that is specifically prepared to give Management information about the different Production Costs is Class 5. This class is called: Functional Activities. This name is given with the purpose to clarify that under this Class 5 we will have not only the Production Cost accounts but also other accounts that will give Management information of the cost of other Functional Activities that the company has, including:

1. Preventive Maintenance cost
2. Repair cost
3. Production cost for internal use
4. Construction cost for internal use

Toward each of these specific Groups of Accounts within Class 5 - we will be able to identify cost directly related to these functional activities.

Here are some examples of Direct Cost related to functional activities:

Repair: The company purchases spare parts that are necessary to repair some machine.

Production cost for internal use: The company produces specific tools for their own use and their own machine for production.

Construction cost for internal use: The company assembles their distinct building and produces their specific air-conditioning system.

With this presentation our Reader will be able to recognize again how important it is to create an Internal Accounting structure - totally separated from External Financial Accounting.