Cost Accounting
From GTwM
Cost accounting is the process of tracking, recording and analyzing costs associated with the products or activities of an organization. In modern accounting, costs are measured in accordance with the Generally Accepted Accounting Principles (GAAP). GAAP reporting records historical events and assigns a monetary value to each event that has taken place. Costs are measured in units of currency by convention. Cost accounting could also be defined as a kind of management accounting that translates the Supply Chain (the series of events in the production process that, in concert, result in a product) into financial values. Managers use cost accounting to support decision making to reduce a company's costs and improve its profitability.
There are four main approaches:
- Standard cost accounting
- Throughput Accounting
- Activity-based Costing
- Marginal Costing
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Origins
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 "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.
Standard cost accounting
Allocating a 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 is called Standard cost accounting.
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 than planned and take appropriate action to correct the situation.
Weaknesses of standard cost accounting for management decision making
By the twenty-first century "fixed costs" had often become more important than the variable cost of a product, and allocating them to a broad range of products often lead to bad decision making. Fixed costs tend to remain the same even during busy periods, unlike variable costs which rise and fall with volume of work. Examples of fixed costs include the depreciation of plant and equipment, and the cost of departments such as maintenance, production control, purchasing, quality control, storage and engineering. 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.
As time went on, standard cost accounting lost its usefulness for management decision making due to a variety of other 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 companies have become more complex and begun producing a variety of products, the use of cost accounting to make decisions to maximize profitability has come under question. Managers learned in the 1980's about the Theory of Constraints and began to understand that every production process has a limiting factor somewhere in the chain of production. As managers learned to identify the constraints, they learned to use throughput accounting to manage them and maximize the throughput dollars 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 railway coach. The buyer offered to pay $280 per streetcar. The company had a firm order for 40 railway 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 Metalshop $ 3,300.00 160 $20.63 Total $10,600.00 320 $33.13
The company was at full capacity making 40 railway 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 Railway 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 operations manager had just made improvements in the foundry equipment, and she knew there was idle time for the workers making coaches there. The constraint 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 maximizing "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 Metalshop 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
The president saw that the metalshop capacity was limiting the company's profitability. They could make only 40 railway 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 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. "Delivering a Degree in Engineering" is an example of an activity performed inside most universities.
ABC came to the fore in the 1980's as organisations struggled to see which service or products made or lossed money.
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 maximise contribution per unit. If constraints exist on resources, then Managerial Accounting dictates that marginal cost analysis be employed to maximise contribution per unit of the constrained resource (see Development of Throughput Accounting, above).
Other costing methods
More varieties of costing methods have been proposed in order to tailor for different aspects of the business. Some of the uprising ones include inventory costing method, process costing method, average costing method, target costing method.
