- Cost accounting
Accountancy Key concepts Accountant · Accounting period · Bookkeeping · Cash and accrual basis · Cash flow management · Chart of accounts · Journal · Special journals · Constant Item Purchasing Power Accounting · Cost of goods sold · Credit terms · Debits and credits · Double-entry system · Mark-to-market accounting · FIFO & LIFO · GAAP / IFRS · General ledger · Goodwill · Historical cost · Matching principle · Revenue recognition · Trial balance Fields of accounting Cost · Financial · Forensic · Fund · Management · Tax Financial statements Statement of financial position · Statement of cash flows · Statement of changes in equity · Statement of comprehensive income · Notes · MD&A · XBRL Auditing Auditor's report · Financial audit · GAAS / ISA · Internal audit · Sarbanes–Oxley Act Accounting qualifications CA · CPA · CCA · CGA · CMA · CAT · CFA · CIIA · ACCA · CIA · CTP · ICAEW · CIMA · IPA · ICAN
Cost accounting information is designed for managers. Since managers are taking decisions only for their own organization, there is no need for the information to be comparable to similar information from other organizations. Instead, the important criterion is that the information must be relevant for decisions that managers operating in a particular environment of business including strategy make. Cost accounting information is commonly used in financial accounting information, but first we are concentrating in its use by managers to take decisions. The accountants who handle the cost accounting information generate add value by providing good information to managers who are taking decisions. Among the better decisions, the better performance of your organization, regardless if it is a manufacturing company, a bank, a non-profit organization, a government agency, a school club or even a business school. The cost-accounting system is the result of decisions made by managers of an organization and the environment in which they make them.
The organizations and managers are most of the times interested in and worried for the costs. The control of the costs of the past, present and future is part of the job of all the managers in a company. In the companies that try to have profits, the control of costs affects directly to them. Knowing the costs of the products is essential for decision-making regarding price and mix assignation of products and services.
The cost accounting systems can be important sources of information for the managers of a company. For this reason, the managers understand the forces and weaknesses of the cost accounting systems, and participate in the evaluation and evolution of the cost measurement and administration systems. Unlike the accounting systems that help in the preparation of financial reports periodically, the cost accounting systems and reports are not subject to rules and standards like the Generally Accepted Accounting Principles. As a result, there is a wide variety in the cost accounting systems of the different companies and sometimes even in different parts of the same company or organization.
The following are different cost accounting approaches:
- standardized or standard cost accounting
- lean accounting
- activity-based costing
- resource consumption accounting
- throughput accounting
- marginal costing/cost-volume-profit analysis
Classical cost elements are:
- Raw materials
- Indirect expenses/overhead
Cost accounting has long been used to help managers understand the costs of running a business. Modern cost accounting originated during the industrial revolution, when the complexities of running a large scale business led to the development of systems for recording and tracking costs to help business owners and managers make decisions.
In the early industrial age, most of the costs incurred by a business were what modern accountants call "variable costs" because they varied directly with the amount of production. Money was spent on labor, raw materials, power to run a factory, etc. in direct proportion to production. Managers could simply total the variable costs for a product and use this as a rough guide for decision-making processes.
Some costs tend to remain the same even during busy periods, unlike variable costs, which rise and fall with volume of work. Over time, the importance of these "fixed costs" has become more important to managers. Examples of fixed costs include the depreciation of plant and equipment, and the cost of departments such as maintenance, tooling, production control, purchasing, quality control, storage and handling, plant supervision and engineering. In the early twentieth century, these costs were of little importance to most businesses. However, in the twenty-first century, these costs are often more important than the variable cost of a product, and allocating them to a broad range of products can lead to bad decision making. Managers must understand fixed costs in order to make decisions about products and pricing.
For example: A company produced railway coaches and had only one product. To make each coach, the company needed to purchase $60 of raw materials and components, and pay 6 laborers $40 each. Therefore, total variable cost for each coach was $300. Knowing that making a coach required spending $300, managers knew they couldn't sell below that price without losing money on each coach. Any price above $300 became a contribution to the fixed costs of the company. If the fixed costs were, say, $1000 per month for rent, insurance and owner's salary, the company could therefore sell 5 coaches per month for a total of $3000 (priced at $600 each), or 10 coaches for a total of $4500 (priced at $450 each), and make a profit of $500 in both cases.
Elements of cost
- Material (Material is a very important part of business)
- Direct material
- Direct labor
- Overhead (Variable/Fixed)
- Indirect material
- Indirect labor
- Maintenance & Repair
- Other Variable Expenses
- Occupancy (Rent)
- Other Fixed Expenses
(In some companies, machine cost is segregated from overhead and reported as a separate element)
They are grouped further based on their functions as,
- Production or works overheads
- Administration overheads
- Selling overheads
- Distribution overheads
- Financial Expenses
Classification of costs
Classification of cost means, the grouping of costs according to their common characteristics. The important ways of classification of costs are:
- By nature or element: materials, labor, expenses
- By functions: production, selling, distribution, administration, R&D, development,
- By traceability: direct and indirect
- By variability: fixed, variable, semi-variable
- By controllability: controllable, uncontrollable
- By normality: normal, abnormal
Standard cost accounting
In modern cost accounting, the concept of recording historical costs was taken further, by allocating the company's fixed costs over a given period of time to the items produced during that period, and recording the result as the total cost of production. This allowed the full cost of products that were not sold in the period they were produced to be recorded in inventory using a variety of complex accounting methods, which was consistent with the principles of GAAP (Generally Accepted Accounting Principles). It also essentially enabled managers to ignore the fixed costs, and look at the results of each period in relation to the "standard cost" for any given product.
- For example: if the railway coach company normally produced 40 coaches per month, and the fixed costs were still $1000/month, then each coach could be said to incur an overhead of $25 ($1000 / 40). Adding this to the variable costs of $300 per coach produced a full cost of $325 per coach.
This method tended to slightly distort the resulting unit cost, but in mass-production industries that made one product line, and where the fixed costs were relatively low, the distortion was very minor.
- For example: if the railway coach company made 100 coaches one month, then the unit cost would become $310 per coach ($300 + ($1000 / 100)). If the next month the company made 50 coaches, then the unit cost = $320 per coach ($300 + ($1000 / 50)), a relatively minor difference.
An important part of standard cost accounting is a variance analysis, which breaks down the variation between actual cost and standard costs into various components (volume variation, material cost variation, labor cost variation, etc.) so managers can understand why costs were different from what was planned and take appropriate action to correct the situation.
The development of throughput accounting
As business became more complex and began producing a greater variety of products, the use of cost accounting to make decisions to maximize profitability came under question. Management circles became increasingly aware of the Theory of Constraints in the 1980s, and began to understand that "every production process has a limiting factor" somewhere in the chain of production. As business management learned to identify the constraints, they increasingly adopted throughput accounting to manage them and "maximize the throughput dollars" (or other currency) from each unit of constrained resource.
- For example: The railway coach company was offered a contract to make 15 open-topped streetcars each month, using a design that included ornate brass foundry work, but very little of the metalwork needed to produce a covered rail coach. The buyer offered to pay $280 per streetcar. The company had a firm order for 40 rail coaches each month for $350 per unit.
- The cost accountant determined that the cost of operating the foundry vs. the metalwork shop each month was as follows:
Overhead Cost by Department Total Cost Hours Available per month Cost per hour Foundry $ 7,300.00 160 $45.63 Metal shop $ 3,300.00 160 $20.63 Total $10,600.00 320 $33.13
- The company was at full capacity making 40 rail coaches each month. And since the foundry was expensive to operate, and purchasing brass as a raw material for the streetcars was expensive, the accountant determined that the company would lose money on any streetcars it built. He showed an analysis of the estimated product costs based on standard cost accounting and recommended that the company decline to build any streetcars.
Standard Cost Accounting Analysis Streetcars Rail coach Monthly Demand 15 40 Price $280 $350 Foundry Time (hrs) 3.0 2.0 Metalwork Time (hrs) 1.5 4.0 Total Time 4.5 6.0 Foundry Cost $136.88 $ 91.25 Metalwork Cost $ 30.94 $ 82.50 Raw Material Cost $120.00 $ 60.00 Total Cost $287.81 $233.75 Profit per Unit $ (7.81) $116.25
- However, the company's operations manager knew that recent investment in automated foundry equipment had created idle time for workers in that department. The constraint on production of the railcoaches was the metalwork shop. She made an analysis of profit and loss if the company took the contract using throughput accounting to determine the profitability of products by calculating "throughput" (revenue less variable cost) in the metal shop.
Throughput Cost Accounting Analysis Decline Contract Take Contract Coaches Produced 40 34 Streetcars Produced 0 15 Foundry Hours 80 113 Metal shop Hours 160 159 Coach Revenue $14,000 $11,900 Streetcar Revenue $ 0 $ 4,200 Coach Raw Material Cost $(2,400) $(2,040) Streetcar Raw Material Cost $ 0 $(1,800) Throughput Value $11,600 $12,260 Overhead Expense $(10,600) $(10,600) Profit $1,000 $1,660
- After the presentations from the company accountant and the operations manager, the president understood that the metal shop capacity was limiting the company's profitability. The company could make only 40 rail coaches per month. But by taking the contract for the streetcars, the company could make nearly all the railway coaches ordered, and also meet all the demand for streetcars. The result would increase throughput in the metal shop from $6.25 to $10.38 per hour of available time, and increase profitability by 66 percent.
Activity-based costing (ABC) is a system for assigning costs to products based on the activities they require. In this case, activities are those regular actions performed inside a company. "Talking with customer regarding invoice questions" is an example of an activity inside most companies.
Accountants assign 100% of each employee's time to the different activities performed inside a company (many will use surveys to have the workers themselves assign their time to the different activities). The accountant then can determine the total cost spent on each activity by summing up the percentage of each worker's salary spent on that activity.
A company can use the resulting activity cost data to determine where to focus their operational improvements. For example, a job-based manufacturer may find that a high percentage of its workers are spending their time trying to figure out a hastily written customer order. Via ABC, the accountants now have a currency amount pegged to the activity of "Researching Customer Work Order Specifications". Senior management can now decide how much focus or money to budget for resolving this process deficiency. Activity-based management includes (but is not restricted to) the use of activity-based costing to manage a business.
While ABC may be able to pinpoint the cost of each activity and resources into the ultimate product, the process could be tedious, costly and subject to errors.
As it is a tool for a more accurate way of allocating fixed costs into product, these fixed costs do not vary according to each month's production volume. For example, an elimination of one product would not eliminate the overhead or even direct labor cost assigned to it. ABC better identifies product costing in the long run, but may not be too helpful in day-to-day decision-making.
Lean accounting has developed in recent years to provide the accounting, control, and measurement methods supporting lean manufacturing and other applications of lean thinking such as healthcare, construction, insurance, banking, education, government, and other industries.
There are two main thrusts for Lean Accounting. The first is the application of lean methods to the company's accounting, control, and measurement processes. This is not different from applying lean methods to any other processes. The objective is to eliminate waste, free up capacity, speed up the process, eliminate errors & defects, and make the process clear and understandable. The second (and more important) thrust of Lean Accounting is to fundamentally change the accounting, control, and measurement processes so they motivate lean change & improvement, provide information that is suitable for control and decision-making, provide an understanding of customer value, correctly assess the financial impact of lean improvement, and are themselves simple, visual, and low-waste. Lean Accounting does not require the traditional management accounting methods like standard costing, activity-based costing, variance reporting, cost-plus pricing, complex transactional control systems, and untimely & confusing financial reports. These are replaced by:
- lean-focused performance measurements
- simple summary direct costing of the value streams
- decision-making and reporting using a box score
- financial reports that are timely and presented in "plain English" that everyone can understand
- radical simplification and elimination of transactional control systems by eliminating the need for them
- driving lean changes from a deep understanding of the value created for the customers
- eliminating traditional budgeting through monthly sales, operations, and financial planning processes (SOFP)
- value-based pricing
- correct understanding of the financial impact of lean change
As an organization becomes more mature with lean thinking and methods, they recognize that the combined methods of lean accounting in fact creates a lean management system (LMS) designed to provide the planning, the operational and financial reporting, and the motivation for change required to prosper the company's on-going lean transformation.
The cost-volume-profit analysis is the systematic examination of the relationship between selling prices, sales, production volumes, costs, expenses and profits. This analysis provides very useful information for decision-making in the management of a company. For example, the analysis can be used in establishing sales prices, in the product mix selection to sell, in the decision to choose marketing strategies, and in the analysis of the impact on profits by changes in costs. In the current environment of business, a business administration must act and take decisions in a fast and accurate manner. As a result, the importance of cost-volume-profit is still increasing as time passes.
A relationship between the cost, volume and profit is the contribution margin. The contribution margin is the revenue excess from sales over variable costs. The concept of contribution margin is particularly useful in the planning of business because it gives an insight into the potential profits that can generate a business. The following chart shows the income statement of a company X, which has been prepared to show its contribution margin:
Sales $1,000,000 (-) Variable Costs $600,000 Contribution Margin $400,000 (-) Fixed Costs $300,000 Income from Operations $100,000
CONTRIBUTION MARGIN RATIO
The margin contribution can also be expressed as a percentage. The contribution margin ratio, which is sometimes called the profit-volume ratio, indicates the percentage of each sales dollar available to cover fixed costs and to provide operating revenue. For the company Fusion, Inc. the contribution margin ratio is 40%, which is computed as follows:
- Contribution Margin Ratio = (Sales - Variable Costs) / Sales
The contribution margin ratio measures the effect on operating income of an increase or a decrease in sales volume. For example, assume that the management of Fusion, Inc. is studying the effect of adding $80,000 in sales orders. Multiplying the contribution margin ratio (40%) by the change in sales volume ($80,000) indicates that operating income will increase $32,000 if additional orders are obtained. To validate this analysis the table below shows the income statement of the company including additional orders:
Sales $1,080,000 (-) Variable Costs $648,000 (1,080,000 x 60%) Contribution Margin $432,000 (1,080,000 x 40%) (-) Fixed Costs $300,000 Income from Operations $132,000
Variable costs as a percentage of sales are equal to 100% minus the contribution margin ratio. Thus, in the above income statement, the variable costs are 60% (100% - 40%) of sales, or $648,000 ($1'080,000 X 60%). The total contribution margin $432,000, can also be computed directly by multiplying the sales by the contribution margin ratio ($1'080,000 X 40%).
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- Maher, Lanen and Rahan, Fundamentals of Cost Accounting, 1st Edition (McGraw-Hill 2005).
- Horngren, Datar and Foster, Cost Accounting - A Managerial Emphasis, 11th edition (Prentice Hall 2003).
- Consortium for Advanced Manufacturing-International
- Kaplan, Robert S. and Bruns, W. Accounting and Management: A Field Study Perspective (Harvard Business School Press, 1987) ISBN 0-87584-186-4
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