cost accounting

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cost accounting

cost accounting: see accounting.

The Columbia Electronic Encyclopedia Copyright © 2004.
Licensed from Columbia University Press

In management accounting, cost accounting is that part of management accounting which establishes budget and actual cost of operations, processes, departments or product and the analysis of variances, profitability or social use of funds. Managers use cost accounting to support decision making to reduce a company's costs and improve its profitability. As a form of management accounting, cost accounting need not follow standards such as GAAP, because its primary use is for internal managers, rather than external users, and what to compute is instead decided pragmatically.

Costs are measured in units of nominal currency by convention. Cost accounting can be viewed as translating the Supply Chain (the series of events in the production process that, in concert, result in a product) into financial values.

There are at least four approaches:

Standardized Cost Accounting
Activity-based Costing
Throughput Accounting
Marginal Costing / Cost-Volume-Profit Analysis

Classical Cost Elements are:

Raw Materials
Labor
Indirect Expenses / Overhead

Origins

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.

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.

Weaknesses of Standard Cost Accounting for Management Decision Making

As time went on, standard cost accounting lost its usefulness for management decision making due to a variety of reasons:

The practice of paying workers on a 'set-piece' basis changed in favour of paying on an hourly rate.
Modern companies tend to have relatively low truly variable costs (primarily raw material, commissions or casual workers) and very high fixed costs (worker salaries, engineering costs, quality control, etc.).
Equipment has become more complex and specialized and may be a very significant proportion of total costs.
Changes in the level of full cost inventory create swings in profitability that are difficult to explain or understand. An increase in inventory can "absorb" costs of production and increase profits, while a decrease in inventory level will decrease profits.
Organizations with a wide range of products or services have processes which are common to several finished items, making cost allocation irrelevant or misleading.

As a result of the above, using standard cost accounting to analyze management decisions can distort the unit cost figures in ways that can lead managers to make decisions that do not reduce costs or maximize profits. For this reason, managers often use the terms "direct costs" and "indirect costs" to replace the standard costing, to better reflect the way allocation of overhead is actually calculated. Indirect costs (often large) are usually allocated in proportion to either labor cost, other direct costs, or some physical resource utilization.

For example: If the railway coach company now paid its workforce a fixed monthly rate of $8,000 (total) and its other fixed costs had risen to $2,600/month, the total fixed costs would then be $10,600/month. The unit cost to make 40 coaches per month would still be $325 per coach ($60 material + ($10,600/40)), but producing 100 coaches would result in a unit cost of $166 per coach ($60 + ($10, 600/100)), provided the company had the capacity to increase production to that level.

Managers using the standard cost for 40 coaches per month would likely reject an order for 100 coaches (to be produced in one month) if the selling price was only $300 per unit, seeing that it would result in a loss of $25 per unit. If they analyzed the fixed vs. variable cost distinction, they would see clearly that filling this order would result in a contribution to fixed costs of $240 per coach ($300 selling price less $60 materials) and would result in a net profit for the month of $13,400 (($240 x 100) - 10,600).

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 which 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 company 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 streatcars 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

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 performed 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 improvement efforts. For example, a job based manufacturer may find that a high percentage of their workers are spending their time trying to figure out a hastily written customer order. Via ABC, the accountants now have a currency amount that will be associated with the activity of "Researching Customer Work Order Specifications". Senior management can now decide how much focus or money to budget for the resolutions of this process deficiency. Activity-based management includes (but is not restricted to) the use of activity-based costing to manage a business.

Marginal Costing

This method is used particularly for short-term decision-making. Its principal tenets are:

Revenue (per product) - Variable Costs (per product) = Contribution (per product)
Total Contribution - Total Fixed Costs = Total Profit or (Total Loss)

Thus it does not attempt to allocate fixed costs in an arbitrary manner to different products. The short-term objective is to maximize contribution per unit. If constraints exist on resources, then Managerial Accounting dictates that marginal cost analysis be employed to maximize contribution per unit of the constrained resource (see Development of Throughput Accounting, above).

References

^ 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 ^ Sapp, Richard, David Crawford and Steven Rebishcke "Article title?" Journal of Bank Cost and Management Accounting (Volume 3, Number 2), 1990. ^ Author(s)? "Article title?" Journal of Bank Cost and Management Accounting (Volume 4, Number 1), 1991.