A cost is generally understood to be that sacrifice incurred in an economic activity to achieve a specific objective, such as to consume, exchange, or produce. All types of organizations- businesses, not-for-profits, governmental- incur costs. To achieve missions and objectives, an organization acquires resources, transforms them in some manner, and delivers units of product or service to its customers or clients. Costs are incurred to perform these activities. For planning and control, decisions are made about areas such as pricing, program evaluation, product costing, outsourcing, and investment. Different costs are needed for different purposes. In each instance, costs are determined to help management make better decisions.
When incurred, costs are initially reviewed and accumulated by some classification system. Costs with one or more characteristics in common may be accumulated into cost pools. Costs are then reassigned, differently for specified purposes, from these cost pools to one or more cost objects. A cost object is an activity, a unit of product or service, a customer, another cost pool, or a segment of an organization for which management needs a separate measurement and accumulation of costs. Costs assigned to a cost object are either direct or indirect. A direct cost can be traced and assigned to the cost object in an unbiased, cost-effective manner. The incurrence of an indirect cost cannot be so easily traced. Without such a direct relationship to the cost object, an indirect cost requires an in-between activity to help establish a formula relationship. When the indirect cost is assigned through the use of this formula, the cost is considered allocated. The activity used to establish the in-between linkage is called the basis of allocation.
Cost allocations can involve ethical issues. Often the federal government issues contracts to the private sector on a cost-plus basis; that is, all the actual costs incurred to complete a contract plus a percentage of profit is reimbursed to the contractor performing the contract. A contractor completing both governmental and private-sector contracts may select a formula that tends to allocate more indirect costs to governmental contracts than to nongovernmental ones. A contractor may also try to include in reimbursement requests costs that are not allowable by the governmental agency. A contractor may even try to double-count a cost item by including it as a direct cost of the contract and as a part of an indirect cost pool allocated to the contract. Lastly, a contractor may attempt to have a reimbursement cover some of the costs of unused capacity. Audits are made of costs of government contracts to identify inappropriate costs.