Cost accounting

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Cost accounting is defined as "a systematic set of procedures for recording and reporting measurements of the cost of manufacturing goods and performing services in the aggregate and in detail. It includes methods for recognizing, classifying, allocating, aggregating and reporting such costs and comparing them with standard costs." (IMA) [1] Often considered a subset of managerial accounting, its end goal is to advise the management on how to optimize business practices and processes based on cost efficiency and capability. Cost accounting provides the detailed cost information that management needs to control current operations and plan for the future. [2]

Contents

Since managers are making decisions only for their own organization, there is no need for the information to be comparable to similar information from other organizations. Instead, information must be relevant to a particular environment. Cost accounting information is commonly used in financial accounting, but its primary function is for use by managers to facilitate their decision-making.

Origins

All types of businesses, whether service, manufacturing or trading, require cost accounting to track their activities. [2] 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 labour, raw materials, the 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, these "fixed costs" have 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. [3]

In the early nineteenth century, these costs were of little importance to most businesses. However, with the growth of railroads, steel and large scale manufacturing, by the late nineteenth century these costs were often more important than the variable cost of a product, and allocating them to a broad range of products led 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 labourers $40 each. Therefore, the 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.

Cost accounting vs financial accounting

Types of cost accounting

The following are some of the different cost accounting approaches:

Elements of cost accounting

Basic cost elements are:

  1. Material
  2. Labour
  3. Expenses and other overheads

Material (Inventory)

The materials directly contributed to a product and those easily identifiable in the finished product are called direct materials. For example, paper in books, wood in furniture, plastic in a water tank, and leather in shoes are direct materials. Other, usually lower cost items or supporting material used in the production of in a finished product are called indirect materials. For example, the length of thread used in a garment.

Furthermore, these can be categorized into three different types of inventories that must be accounted for in different ways; raw materials, work-in-progress, and finished goods. [5]

Labour

Any wages paid to workers or a group of workers which may directly co-relate to any specific activity of production, maintenance, transportation of material, or product, and directly associate in the conversion of raw material into finished goods are called direct labour . Wages paid to trainee or apprentices does not come under the category of direct labour as they have no significant value.

Overheads

Overheads include:

These categories are flexible and sometimes overlapping. For example, in some companies, machine cost is segregated from overhead and reported as a separate element altogether, and payroll costs are sometimes separated from other production costs.

Classification of costs

Classification of cost means, the grouping of costs according to their common characteristics. The important ways of classification of costs are:

  1. By Nature or Traceability: Direct Costs and Indirect costs. Direct Costs are Directly attributable/traceable to Cost object. Direct costs are assigned to Cost Object. Indirect Costs are not directly attributable/traceable to Cost Object. Indirect costs are allocated or apportioned to cost objects.
  2. By Functions: production, administration, selling and distribution, R&D.
  3. By Behavior: fixed, variable, semi-variable. Costs are classified according to their behaviour in relation to change in relation to production volume within a given period of time. Fixed Costs remain fixed irrespective of changes in the production volume in a given period of time. Variable costs change according to the volume of production. Semi-variable costs are partly fixed and partly variable.
  4. By control ability: controllable, uncontrollable costs. Controllable costs are those which can be controlled or influenced by conscious management action. Uncontrollable costs cannot be controlled or influenced by conscious management action.
  5. By normality: normal costs and abnormal costs. Normal costs arise during routine day-to-day business operations. Abnormal costs arise because of any abnormal activity or event not part of routine business operations. E.g. costs arising of floods, riots, accidents etc.
  6. By Time: Historical costs and predetermined costs. Historical costs are costs incurred in the past. Predetermined costs are computed in advance on basis of factors affecting cost elements. Example: Standard Costs.
  7. By Decision making Costs: These costs are used for managerial decision making. And these are :
    1. Marginal costs: Marginal cost is the change in the aggregate costs due to change in the volume of output by one unit.
    2. Differential costs: This cost is the difference in total cost that will arise from the selection of one alternative to the other.
    3. Opportunity costs: It is the value of benefit sacrificed in favour of an alternative course of action.
    4. Relevant cost: The relevant cost is a cost which is relevant in various decisions of management.
    5. Replacement cost: This cost is the cost at which existing items of material or fixed assets can be replaced. Thus this is the cost of replacing existing assets at present or at a future date.
    6. Shutdown cost: These costs are the costs which are incurred if the operations are shut down and they will disappear if the operations are continued.
    7. Capacity cost: These costs are normally fixed costs. The cost incurred by a company for providing production, administration and selling and distribution capabilities in order to perform various functions.
    8. Sunken cost: cost already incurred
    9. Other costs

Standard Cost Accounting

In modern cost account 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 Operating Cost/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 into 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. Throughput accounting aims to make the best use of scarce resources(bottleneck) in a (JIT) Just in time environment. [6]

Mathematical Formula

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(20/10)

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. [7] "Talking with the customer regarding invoice questions" is an example of activity inside most companies.

Companies may be moved to adopt ABC by a need to improve costing accuracy, that is, understand better the true costs and profitability of individual products, services, or initiatives. ABC gets closer to true costs in these areas by turning many costs that standard cost accounting views as indirect costs essentially into direct costs. By contrast, standard cost accounting typically determines so-called indirect and overhead costs simply as a percentage of certain direct costs, which may or may not reflect actual resource usage for individual items.

Under ABC, 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 its 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) Activity-based costing, 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) Activity-based costing 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 a product, these fixed costs do not vary according to each month's production volume. For example, the elimination of one product would not eliminate the overhead or even direct labour cost assigned to it. Activity-based costing (ABC) better identifies product costing in the long run, but may not be too helpful in day-to-day decision-making.

Integrating EVA and Process-Based Costing

Recently, Mocciaro Li Destri, Picone & Minà (2012). [8] proposed a performance and cost measurement system that integrates the Economic Value Added criteria with Process-Based Costing (PBC). The EVA-PBC methodology allows us to implement the EVA management logic not only at the firm level, but also at lower levels of the organization. EVA-PBC methodology plays an interesting role in bringing strategy back into financial performance measures.

Lean accounting

Lean accounting [9] 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:

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.

Marginal costing

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.

CONTRIBUTION MARGIN

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 a business can generate. 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 contribution margin 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:

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%).

See also

Related Research Articles

Management accounting Field of business administration, part of the internal accounting system of a company

In management accounting or managerial accounting, managers use the provisions of accounting information in order to better inform themselves before they decide matters within their organizations, which aids their management and performance of control functions.

Cost value of money that has been used up to produce something

In production, research, retail, and accounting, a cost is the value of money that has been used up to produce something or deliver a service, and hence is not available for use anymore. In business, the cost may be one of acquisition, in which case the amount of money expended to acquire it is counted as cost. In this case, money is the input that is gone in order to acquire the thing. This acquisition cost may be the sum of the cost of production as incurred by the original producer, and further costs of transaction as incurred by the acquirer over and above the price paid to the producer. Usually, the price also includes a mark-up for profit over the cost of production.

Inventory goods held for resale

Inventory or stock is the goods and materials that a business holds for the ultimate goal of resale.

Cost of goods sold carrying value of goods sold during a particular period

Cost of goods sold (COGS) is the carrying value of goods sold during a particular period.

Break-even (economics) Equality of costs and revenues

The break-even point (BEP) in economics, business—and specifically cost accounting—is the point at which total cost and total revenue are equal, i.e. "even". There is no net loss or gain, and one has "broken even", though opportunity costs have been paid and capital has received the risk-adjusted, expected return. In short, all costs that must be paid are paid, and there is neither profit nor loss.

Activity-based costing method of measuring economic consumption

Activity-based costing (ABC) is a costing method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each. This model assigns more indirect costs (overhead) into direct costs compared to conventional costing.

Fixed cost

In economics, fixed costs, indirect costs or overheads are business expenses that are not dependent on the level of goods or services produced by the business. They tend to be time-related, such as interest or rents being paid per month, and are often referred to as overhead costs. This is in contrast to variable costs, which are volume-related and unknown at the beginning of the accounting year. For a simple example, such as a bakery, the monthly rent for the baking facilities, and the monthly payments for the security system and basic phone line are fixed costs, as they do not change according to how much bread the bakery produces and sells. On the other hand, the wage costs of the bakery are variable, as the bakery will have to hire more workers if the production of bread increases. Economists reckon fixed cost as an entry barrier for new entrepreneurs.

Throughput accounting

Throughput accounting (TA) is a principle-based and simplified management accounting approach that provides managers with decision support information for enterprise profitability improvement. TA is relatively new in management accounting. It is an approach that identifies factors that limit an organization from reaching its goal, and then focuses on simple measures that drive behavior in key areas towards reaching organizational goals. TA was proposed by Eliyahu M. Goldratt as an alternative to traditional cost accounting. As such, Throughput Accounting is neither cost accounting nor costing because it is cash focused and does not allocate all costs to products and services sold or provided by an enterprise. Considering the laws of variation, only costs that vary totally with units of output e.g. raw materials, are allocated to products and services which are deducted from sales to determine Throughput. Throughput Accounting is a management accounting technique used as the performance measure in the Theory of Constraints (TOC). It is the business intelligence used for maximizing profits, however, unlike cost accounting that primarily focuses on 'cutting costs' and reducing expenses to make a profit, Throughput Accounting primarily focuses on generating more throughput. Conceptually, Throughput Accounting seeks to increase the speed or rate at which throughput is generated by products and services with respect to an organization's constraint, whether the constraint is internal or external to the organization. Throughput Accounting is the only management accounting methodology that considers constraints as factors limiting the performance of organizations.

Variable cost costs that change in proportion to the good or service that a business produces

Variable costs are costs that change as the quantity of the good or service that a business produces changes. Variable costs are the sum of marginal costs over all units produced. They can also be considered normal costs. Fixed costs and variable costs make up the two components of total cost. Direct costs are costs that can easily be associated with a particular cost object. However, not all variable costs are direct costs. For example, variable manufacturing overhead costs are variable costs that are indirect costs, not direct costs. Variable costs are sometimes called unit-level costs as they vary with the number of units produced.

Net income Measure of the profitability of a business venture

In business and accounting, net income is a measure of the profitability of a venture. It is an entity's income minus cost of goods sold, expenses, depreciation and amortization, interest, and taxes for an accounting period. It is computed as the residual of all revenues and gains over all expenses and losses for the period, and has also been defined as the net increase in shareholders' equity that results from a company's operations. It is different from the gross income, which only deducts the cost of goods sold.

In business, operating margin—also known as operating income margin, operating profit margin, EBIT margin and return on sales (ROS)—is the ratio of operating income to net sales, usually presented in percent.

Operating leverage is a measure of how revenue growth translates into growth in operating income. It is a measure of leverage, and of how risky, or volatile, a company's operating income is.

Gross margin relating gross profits to net sales

Gross margin is the difference between revenue and cost of goods sold (COGS) divided by revenue. Gross margin is expressed as a percentage. Generally, it is calculated as the selling price of an item, less the cost of goods sold. Gross Margin is often used interchangeably with Gross Profit, but the terms are different. When speaking about a monetary amount, it is technically correct to use the term Gross Profit; when referring to a percentage or ratio, it is correct to use Gross Margin. In other words, Gross Margin is a percentage value, while Gross Profit is a monetary value.

Contribution margin

Contribution margin (CM), or dollar contribution per unit, is the selling price per unit minus the variable cost per unit. "Contribution" represents the portion of sales revenue that is not consumed by variable costs and so contributes to the coverage of fixed costs. This concept is one of the key building blocks of break-even analysis.

Overhead (business) overhead

In business, overhead or overhead expense refers to an ongoing expense of operating a business. Overheads are the expenditure which cannot be conveniently traced to or identified with any particular cost unit, unlike operating expenses such as raw material and labor. Therefore, overheads cannot be immediately associated with the products or services being offered, thus do not directly generate profits. However, overheads are still vital to business operations as they provide critical support for the business to carry out profit making activities. For example, overhead costs such as the rent for a factory allows workers to manufacture products which can then be sold for a profit. Such expenses are incurred for output generally and not for particular work order; e.g., wages paid to watch and ward staff, heating and lighting expenses of factory, etc. Overheads are also very important cost element along with direct materials and direct labor.

Cost–volume–profit analysis

Cost–volume–profit (CVP), in managerial economics, is a form of cost accounting. It is a simplified model, useful for elementary instruction and for short-run decisions.


Conditional budgeting is a budgeting approach designed for companies with fluctuating income, high fixed costs, or income depending on sunk costs, as well as NPOs and NGOs. The approach builds on the strengths of proven budgeting approaches, leverages the respective advantages for situations of fluctuating incomes, and at the same time reduces possible negative impacts.

The profit model is the linear, deterministic algebraic model used implicitly by most cost accountants. Starting with, profit equals sales minus costs, it provides a structure for modeling cost elements such as materials, losses, multi-products, learning, depreciation etc. It provides a mutable conceptual base for spreadsheet modelers. This enables them to run deterministic simulations or 'what if' modelling to see the impact of price, cost or quantity changes on profitability.

IAS 2 is an international financial reporting standard produced and disseminated by the International Accounting Standards Board (IASB) to provide guidance on the valuation and classification of inventories.

Standard cost accounting is a traditional cost accounting method introduced in the 1920s, as an alternative for the traditional cost accounting method based on historical costs.

References

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  3. Performance management, Paper f5. Kaplan Publishing UK. Pg 3
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  6. Performance management, Paper f5. Kaplan Publishing UK. Pg 17
  7. Performance management, Paper f5. Kaplan Publishing UK. Pg 6
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  9. Maskell & Baggaley (December 19, 2003). "Practical Lean Accounting". Productivity Press, New York, NY.

1. Cost Accounting, 3rd edition - Md. Omar Faruk, Sohel Ahmed, Sharif Hossain.

Further reading