Let's talk now about cost systems. What do I mean when I say cost systems? Well, cost system is a system that assigns costs to products, or services, or some other cost object. Well, what is a cost object? Well, that's anything that we want to determine the cost of. Could be a product, the service, department, customer process, many more things. It's important to know that companies are rarely required to determine the cost of any specific cost object. But oftentimes doing so can enhance management's ability to make better decisions. However, there is one situation in which a company is required for financial accounting purposes to do this. Manufacturing companies are required to ensure that all manufacturing, or product costs are assigned to the units of product that are in inventory and eventually sold. So, how do they do that? How do these cost systems work? Let's take a look. Suppose we make three products, and we need to know the cost of each of them. In cost system terminology, those three products are our cost objects. Now there are probably a lot of costs that we can trace easily to each of these products. Those you may recall are called direct costs. They would include things like direct material and direct labor. And you can see here that each of these three products has its own direct material, and its own direct labor traced directly to it. But then there are a lot of other costs that we cannot easily trace directly to those products. You probably recall that those are the indirect costs, or overhead. In cost system terminology, we might call this a cost pool. New term. What is a cost pool? Well, it's a group or a pool of costs. Here we have a group or pool of indirect costs that we can't easily trace to our individual cost objects. We really need to know what products those indirect costs are associated with. Why? Well, there are two reasons I can think of at the moment. First, if we're a manufacturing company, we have to find a way to associate the indirect manufacturing cost with each product, so that we can include it in inventory as part of the inventories cost on the balance sheet. But second, from a managerial perspective, we need to find a way to determine how much indirect costs, maybe both manufacturing and non-manufacturing, are associated with each product so that we can make good management decisions about each product that we make. That was just one example. We want to make sure we set a price on each product that's greater than all the costs that product causes us to incur. The only way we can do that is to know how much costs the product causes us to incur. Now, let's look at a T-shirt maker. Let's say, the T-shirt maker makes two different types of shirts, a basic model and a deluxe model. So we have to cost objects, the basic T-shirt and the Deluxe T-shirt. We can easily trace to the T-shirts the cost of the material and labor to make the shirts. But there are many more costs the company incurs. Let's say $26,000 in additional manufacturing costs that it can't trace easily to those shirts. But to make good decisions, the managers really need to know how much of the indirect manufacturing costs are associated with each type of T-shirt. But we can't easily trace into those products. So, what do we do? Well, we find a way to allocate that $26,000 to those products. Now, how could we do that? Well, one thing we could do is to allocate or assign the exact same amount of overhead to each individual T-shirt. So the company has the $26,000 of overhead, and is making 12,000 T-shirts. So we could just simply allocate each T-shirt, $2.17 an overhead. If we did that, this results in an estimated cost of 8.17 for the basic T-shirt, and 10.17 for the deluxe T-shirt. Simple, huh? Yep. It's a piece of cake. So why don't we just do that? Well, because it's unlikely that a basic and a deluxe T-shirt both cause the company to incur the same amount of overhead costs. Chances are that the manufacturing process is somewhat different for deluxe T-shirts than for basic T-shirts. And if so, then those two types of T-shirts would likely use overhead resources differently. And if that's the case, the company could make better management decisions if the product cost estimates reflected those differences.