COST ACCOUNTING



Cost Accounting 47
Photo by: Olga Miltsova

Cost accounting, often referred to as managerial or management accounting, is the branch of accounting that provides economic and financial information to decision makers within a company. The idea of providing information for use within the company (to aid management to plan, direct, and control operations) differentiates cost accounting from other segments of the accountancy profession. For example, financial accounting serves the public by providing financial reporting via financial statements, financial press releases and such. This public information is prepared and presented based on generally accepted accounting principles (GAAP), the broad rules that assure the user of the underlying framework supporting the information.

On the other hand, cost accounting is limited predominantly to use within the company to aid management in the process of making choices that will benefit the stockholders by maximizing company profits that translate into maximizing stockholder wealth. Since the information is used internally, the information may be presented on any logical basis just so long as it will aid the manager to reach an appropriate, informed decision.

A few concepts in cost accounting, however, form the bridge between financial and managerial accounting topics. One such concept is that of product costing for a manufacturing company. Not only is this information used internally in decision making (e.g., does a company make or buy a component?), product costing is also used to determine the historical basis to account for the cost of products sold during a period and the cost of the unsold inventory that remains as an asset on the statement of financial position at the end of the period.

OVERVIEW

Numerous cost accounting concepts can benefit management in decision-making, both for manufacturing and service companies. While many of the concepts discussed below are applicable to both types of companies, the basis for ease of discussion will be that of a manufacturing company. Therefore, some of the concepts to be discussed include understanding the distinction between manufacturing and non-manufacturing costs (and how these are disclosed in the financial statements), computing the cost of manufacturing a product (or providing a service), identifying cost behavior in order to utilize cost-volume-profit relationships, setting prices, budgeting and budgetary controls, and capital budgeting. These topics will be briefly discussed below.

MANUFACTURING VS.
NON-MANUFACTURING COSTS

Manufacturing costs are those costs incurred by a producer of goods that are needed to transform raw materials into finished products, ready to sell. These costs consist of the cost of basic materials and components, plus the costs of labor and factory overhead needed to convert the materials into finished products.

Materials and labor can be classified as either direct or indirect in relation to the final product. Direct materials are those major components that can be easily traced to the finished good and are accounted for carefully due to their significance to the product. In the case of manufacturing a lawn mower, for example, these types of materials would include the engine, housing, wheels, and handle. Indirect materials would include those minor items that are essential but which cannot be easily traced to the finished product. Examples of these would be screws, nuts, bolts, washers, and lubricants. One might say that the cost of keeping an account of each of these indirect items exceeds the benefit derived from having the information. Consequently, the costs of these items are accumulated as part of factory overhead and prorated to products on some appropriate basis.

Direct labor refers to the efforts of factory workers that can be directly associated with transforming the materials into the finished product, such as laborers who assemble the product. Indirect laborers are those whose efforts cannot be traced directly or practically to the finished product. The indirect laborers would include maintenance personnel and supervisors.

Factory overhead includes all factory costs that can only be indirectly associated with the finished inventory, that is, all factory costs incurred in making a product other than the costs of direct materials and direct labor. In terms of cost behavior, some of these costs do not change in total even if the number of products manufactured increases or decreases from period to period; the behavior of these costs is said to be a fixed cost. For example, the amount of the monthly factory rent would not fluctuate based on the number of units produced during a particular month.

Other factory overhead costs that change in total in direct proportion to changes in the number of products manufactured are known as variable costs. For example, the number of nuts and bolts needed to assemble lawn mowers would increase and decrease exactly in proportion to the number of mowers produced and are therefore considered to be a variable cost. In summarizing this brief discussion of factory overhead costs, these costs include such things as depreciation of factory buildings and machinery, factory utilities, factory insurance, indirect materials, and indirect labor; some of these costs are variable while others are fixed in total for a specific time period.

All material, labor, and factory overhead costs are summarized into totals that represent the cost of the goods manufactured during a period of time. The cost of products that have been completed and sold during a time period are deducted from the related sales revenue total in order to determine the gross profit for the period. Thus it is logical that these manufacturing costs are referred to as product costs. The cost of unsold completed units at period's end is shown as finished goods on the balance sheet. Any costs of goods that are only partially completed at period's end are shown as work in process inventory, and any materials that have not yet entered into the manufacturing process are disclosed as raw materials inventory.

All the costs incurred by a manufacturing company other than the cost of factory operations are collectively known as non-manufacturing costs. These include all selling, administrative, and financing costs and these costs are deducted as expenses from sales revenues as they are incurred each period. Costs other than manufacturing costs are called period costs for this reason. None of the period costs are deferred to a future period because none of them represent an asset as defined by the accounting profession.

The discussion above has focused on the costs incurred by a manufacturer of goods. The discussion is also pertinent to a business that provides a service to its customers. Providers of services still incur material costs (such as cleaning supplies), labor costs, and general overhead related to providing the services. The major distinction is that, since no tangible product is created, no "product" costs can be deferred to a later period in which they will be sold.

COMPUTING THE COSTS OF PRODUCING
A PRODUCT OR SERVICE

Manufacturing companies use a variety of production processes in creating goods. These processes include job shops, batch flows, machine-paced line flows, worker-paced line flow, continuous flows, and hybrids that consist of more than one of the previous separate flow process. The type of production process to a certain extent determines the type of product costing system that a company utilizes.

Job shops, such as machine shops, receive orders for products that are manufactured to the unique blue-print specifications of the requesting customer. As such, it would be rare for these products to meet the needs of any other customer. Thus each "job" must be accounted for separately as the goods are produced and no goods would be produced on a speculative basis. An appropriate method to determine the cost of each unique item produced is activity-based costing (ABC). This method is discussed in detail elsewhere in this publication; please see Activity-Based Costing. The essence of ABC costing is that the exact costs of materials and labor, and a highly accurate estimate of factory overhead costs based on the specific activities (cost drivers) incurred to produce the goods, are determined for each unique product.

Batch flow processes (such as clothing manufacturers use) and worker-paced line flows (such as found in fast food operations) can both use traditional product costing. This product costing system captures the exact costs of materials and labor while using some predetermined overhead rate to associate an appropriate amount of overhead with each product made. A very common basis for determining the overhead rate is the amount of labor time required to produce each unit of product. To determine the overhead rate, management must first estimate the total overhead costs for the upcoming year. Then an estimate of direct labor hours expected for the same period must be made. Finally the estimated overhead is divided by the estimated total direct labor hours and the resulting over-head rate per hour can be established. As each batch of products is completed and the total direct labor hours used is made known from time cards, the overhead rate is multiplied by the actual hours and the overhead is said to be "applied" to the products.

The traditional product costing method was especially popular in the United States until the mid-1980s when labor costs were still a significant portion of the total cost of products. However, with technological changes (such as computer-integrated manufacturing) and more capital intensive approaches to production (such as robotics), the use of a dwindling labor component of product cost as a basis to apply overhead cost was no longer adequate. This was the impetus for the development of ABC costing mentioned above.

Machine-paced line flow processes (such as used by automobile manufacturers) lend themselves to process cost accounting. In this system of product costing, products' costs are accumulated during each of the numerous processes through which the products flow. In the case of an automobile manufacturer, some of the processes might include subassembly stations that reside offline from the main conveyor system where engine assembly, dashboard assembly and the like occur. These major components and their related material, labor, and overhead costs are then carried forward to the next process and new material, labor, and overhead costs are added in each successive process until completion. Thus the individual costs incurred in each process and the total costs incurred are available for financial statements and decision-making purposes.

Companies that use a continuous flow process of production, such as a paper manufacturing company that operates 24/7, would likely use a standard costs system. This product costing system not only accumulates the actual costs incurred in manufacturing the product, but it also determines the standard costs that should have been incurred (based on predetermined standards for material, labor, and factory overhead). By allowing comparisons between actual and standard totals, any discrepancy or variance can be noted and investigated. In particular, any unfavorable costs being incurred can be corrected in a timely manner.

COST BEHAVIOR

One of the critical steps in decision-making is the estimation of costs to be incurred for the particular decision to be made. To be able to do this, management must have a good idea as to how costs "behave" at different levels of operations; i.e., will the cost increase if production increases or will the cost remain the same? A common use of cost behavior information is the attempt by management to predict the total production costs for units to be manufactured in the upcoming month. There are several methods used to estimate total product costs: the high-low method, a scatter-graph, and least-squares regression. Each of these methods attempts to separate costs into components that remain constant (fixed) in total regardless of the number of units produced and those that vary in total in proportion to changes in the number of units produced. Once the behavior of costs is known, predictive ability is greatly enhanced.

Use of the high-low method requires the use of only two past data observations: the highest level of activity (such as the number of units produced during a time period) and the associated total production cost incurred at that level, and the lowest level of activity and its associated cost. All other data points are ignored and even the two observations used must represent operations that have taken place under normal conditions. The loss of input from the unused data is a theoretical limitation of this method.

The scatter-graph method requires that all recent, normal data observations be plotted on a cost (Y-axis) versus activity (X-axis) graph. A line that most closely represents a straight line composed of all the data points should be drawn. By extending the line to where it intersects the cost axis, a company has a fairly accurate estimate of the fixed costs for the period. The angle (slope) of the line can be calculated to give a fairly accurate estimate of the variable cost per unit. The inclusion of the effect of all data points is a strength of this method, but the unsophisticated eye-balling of the appropriate line is a weakness.

The most robust method is the least-squares regression method. This method requires the use of thirty or more past data observations, both the activity level in units produced and the total production cost for each. This technique is known for its statistical strengths but its sophistication requiring the use of software packages can be a hindrance.

For a more detailed description of how the high-low method, a scatter-graph, and least-squares regression aid in separating costs into fixed and variable components, see Cost-Volume-Profit Analysis else-where in this publication. Included therein is also a discussion of break-even analysis, contribution margin, and profit/loss projections using cost behavior estimates.

Assuming that a company has used one of the techniques above and has separated costs of manufacturing its products into fixed and variable components, it can use the following general model and substitute derived fixed and variable amounts to create a specific model:
General Model: Total Cost = Fixed Costs for a Month + Variable Cost per Unit
Specific Model: Total Cost Expected = $10,000 per Month + $5.00 per Unit

Given this specific model, a prediction can easily be made of the total costs expected when any number of units are budgeted, as long as the number of units far within the normal range of operations for the company. For example, if 5,000 units are budgeted for the next month's production, the total expected cost would be:
$10,000 + $5.00 (5,000) = Total Cost = $35,000

If the cost separation technique is fairly accurate, we are in a position to review whether actual costs are in line with our projected cost. Any significant variation between anticipated cost and actual costs should be investigated. The identification of any variances does not answer any questions; the variances merely note that investigation to ascertain the answers is needed.

One other idea is worth mentioning. Considering total production costs in the example above, the same techniques used to separate total costs into fixed and variable components can be utilized to separate any individual cost that isn't readily identifiable as being fixed or variable. A company could, for instance, take the past monthly factory electrical utility bills or the sales wages and use any of the three techniques to separate this individual cost into its fixed and variable components.

SETTING PRICES

Setting the price for goods and services involves an interesting interaction of several factors. The price must be sufficient to exceed the product and period costs and earn a desirable profit. For normal sales to external customers, most companies are unable to unilaterally set prices. Prices are typically set in these competitive markets by the laws of supply and demand. However, if a company manufactures a product unique to customer specifications, or if the company has a patent to its product, then the company can set its own price. One approach to accomplish this is cost-plus pricing. As discussed above, the company must have knowledge of the costs that it will incur. Then the company can apply the proper markup, given the competitive market conditions and other factors, to set its target-selling price.

Some companies add their markup to their variable costs, rather than using the full cost needed for cost-plus pricing. Variable cost pricing is especially useful in special instances such as in pricing special orders or when the company has excess capacity. In both of these cases, production and sales at normal prices to regular customers will be sufficient to cover the total fixed and variable costs for typical sales levels and the concern is only for the incremental units above normal sales levels.

Nissan Motors and other automobile manufacturers take what might be considered a "backward" approach to setting the prices of their vehicles relative to their expected costs. This approach is known as target costing. Once these companies determine what type of vehicle and market niche they wish to pursue, they test the market to see what "target price" the market will bear for their vehicle. From this number they deduct their "desired profit" in order to determine the "target cost" for their product. Then they gather the experts needed to ascertain if they will be able to produce the vehicle for this targeted cost.

If a company has two or more divisions and the output of one division can be used as input to a subsequent division, a price can be set for "sale" from one division to the next in order to measure profitability for each division. This internal transfer price should be set so as to encourage division managers to purchase and sell internally, thus maximizing overall company profits. Transfer prices can be determined based on negotiations between the affiliated divisions, based on the existence of excess capacity by the producing division, based on marking up the variable cost of the goods sold internally, or based on market prices for similar goods, and other approaches.

BUDGETING AND BUDGETARY
CONTROLS

Managers use budgets to aid in planning and controlling their companies. A budget is a formal written expression of the plans for a specific future period stated in financial terms. Jerry Weygandt, Donald Kieso and Paul Kimmel's book, Managerial Accounting: Tools for Business Decision Making lists the following benefits of budgeting:

  1. It requires all levels of management to plan ahead and formalize goals on a repetitive basis.
  2. It provides definite objectives for evaluating performance at each level of responsibility.
  3. It creates an early warning system for potential problems so that management can make changes before things get out of hand.
  4. It facilitates the coordination of activities within the company by correlating segment/division goals with overall company goals.
  5. It results in greater management awareness of the company's overall operations including the impact of external factors such as economic trends.
  6. It motivates personnel throughout the company to meet planned objectives.

The master budget is the set of interrelated budgets for a selected time period. The specific parts to the master budget are the operating budgets and the financial budgets. The operating budgets begin with a sales budget derived from the sales forecasts provided by the marketing department, followed by the related unit production budget with detail budgets for direct materials, direct labor, and factory overhead. Finally a budget for selling and administrative expenses provides the final information needed for a budgeted income statement. The financial budgets, based on data from the budgeted income statement, are composed of a cash budget, a budgeted balance sheet, and a budget for capital expenditures.

Budgetary control is the process of comparing actual operating results to planned operating results and thereby identifying problem areas in order to take corrective actions. A starting point in this effort is the conversion of the master budget (determined at the start of the period and based on the most probable level of operations) into a flexible budget for the actual level of operations attained. Developing a flexible budget requires identifying the variable costs and the fixed costs for the period as discussed above. Once these cost behavior determinations have been made, total variable costs for the actual level of operations and the total fixed costs for the period can be combined into a flexible budget that discloses the costs that should have been incurred for the actual level of operations achieved.

In taking corrective actions, one must be aware of whether or not a manager is responsible for a particular cost that has been incurred. While all costs are controllable at some level of responsibility within a company, only the costs that a manager incurs directly are controllable by them. Any costs that are allocated to the manager's responsibility level are non-controllable at the manager's level.

The information above focused on budgetary controls for total costs, including product costs for units being produced and sold, general and administrative expenses, selling expenses, and any financial expenses incurred during the period. When considering comparing actual to standard costs for material, labor, and factory overhead costs, the use of a standard product costing system is needed to provide the detail to analyze each separate product cost component.

CAPITAL BUDGETING

Companies with excess funds must make decisions as to how to invest these funds in order to maximize their potential. The choices that involve long-term projects require the use the technique of capital budgeting, that is, choosing among many capital projects to find those that will maximize the return on the invested capital. Several methods of capital budgeting are available to management; among these are the payback period method, the net present value method, and the internal rate of return method. All of these methods require the use of estimated cash flow amounts.

The payback period method is especially simple if future inflows from the project being considered happen to be equal in amount each year. In this case, the formula for computing the payback period is:
Cost of Capital Project ÷ Net Annual Cash Inflow = Payback Period

If the project has uneven cash flows, creating a table with a cumulative net cash flow column will identify the year and an estimate of the portion of a year in which the project recoups its cost. A weakness of this method is that it does not consider the time value of money over the life of the project. However, the shorter the payback period is, the sooner the project's cost is recovered and the more attractive the project is.

A strength of the net present value method is that it uses the same cash flow information as described above and it requires that each cash flow be discounted by an appropriate discount rate to allow for the time value of money. The appropriate discount rate could be the company's weighted average cost of capital or its required rate of return. After each cash inflow has been discounted to the point in time at which the investment is made, the total of the discounted cash inflows is compared to the cost of the capital project. If the present value of the net cash inflows equals the cost of the investment in the project, then the project is earning exactly the interest rate chosen for discounting. The exact discount rate at which the two values are equal is known as the internal rate of return. If the present value of the net cash inflows exceeds the cost of the capital project, the project is earning more than the discount rate. If the cost of the capital project exceeds the present value of the net cash inflows, that is, the net present value is negative; then the project is not earning at least the discount rate. While the project is profitable if the cash inflows exceed the cash outflows, it would be rejected since it is not earning the return that is needed.

Modern management theory stresses that setting and reaching goals requires that test readings and adjustments along the way are essential. The recent period of increased international competition has led to the need for cost cutting; some companies have been successful by downsizing, expanding globally, and capturing long-term contracts to minimize the increase in costs. Cost accounting can greatly benefit management by providing product or service cost information for use in planning, directing, and controlling the operations of the business.

SEE ALSO: Activity-Based Costing ; Cost-Volume-Profit Analysis ; Financial Ratios

John M. Alvis

FURTHER READING:

Eldenburg, Leslie G., and Susan K. Wolcott. Cost Management: Measuring, Monitoring, and Motivating Performance. John Wiley & Sons, 2004.

Hitt, Michael, Stewart Black, and Lyman Porter. Management. Prentice Hall. 2005.

Horngren, Charles T., Gary L. Sundem, and William O. Stratton. Introduction to Management Accounting. Prentice Hall, 2005.

Rasmussen, Nils H., and Christopher J. Eichom. Budgeting: Technology, Trends, Software Selections, and Implementation. John Wiley & Sons, 2004.

Robbins, Stephen P., and David A. DeCenzo. Fundamentals of Management. Prentice Hall, 2005.

Weygandt, Jerry J., Donald E. Kieso, and Paul D. Kimmel. Managerial Accounting: Tools for Business Decision Making. John Wiley & Sons, 2005.

Whitten, David A., and Kim Cameron. Developing Management Skills. Prentice Hall, 2005.



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