Cost accounting

Cost accounting is a task of collecting, analyzing, summarizing and evaluating various alternative courses of action. Its goal is to advise the management on the most appropriate course of action based on the cost efficiency and capability. Cost accounting provides the detailed cost information that management needs to control current operations and plan for the future.

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 for a particular environment. Cost accounting information is commonly used in financial accounting information, but its primary function is for use by managers to facilitate making decisions.

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 wide variety in the cost accounting systems of the different companies and sometimes even in different parts of the same company or organization.

Origins

All types of businesses, whether service, manufacturing or trading, require cost accounting to track their activities. 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, 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. 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 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.

Cost Accounting vs Financial Accounting

See also: Financial accounting

• Financial accounting aims at finding out results of accounting year in the form of Profit and Loss Account and Balance Sheet. Cost Accounting aims at computing cost of production/service in a scientific manner and facilitate cost control and cost reduction.
• Financial accounting reports the results and position of business to government, creditors, investors, and external parties.
• Cost Accounting is an internal reporting system for an organization’s own management for decision making.
• In financial accounting, cost classification based on type of transactions, e.g. salaries, repairs, insurance, stores etc. In cost accounting, classification is basically on the basis of functions, activities, products, process and on internal planning and control and information needs of the organization.
• Financial accounting aims at presenting ‘true and fair’ view of transactions, profit and loss for a period and Statement of financial position (Balance Sheet) on a given date. It aims at computing ‘true and fair’ view of the cost of production/services offered by the firm.

Types of cost accounting

The following are different cost accounting approaches:

• Standard cost accounting
• Lean accounting
• Activity-based costing
• Resource consumption accounting
• Throughput accounting
• Life cycle costing
• Environmental accounting
• Target costing

Elements of cost

Basic cost elements are:

1. Raw materials
2. Labor
3. expenses/overhead

• Material (Material is a very important part of business)
  • Direct material/Indirect material
• Labor
  • Direct labor/Indirect labor
• Overhead (Variable/Fixed)
  • Production or works overheads Factory Staff
  • Administration overheads Office Staff
  • Selling overheads - Catalogues,Advertising,Exhibitions,Sales Staff Costs
  • Distribution overheads
  • Maintenance & Repair (Office equipment/Factory machinery)
  • Supplies
  • Utilities Gas Electricity Water Rates
  • Other Variable Expenses
  • Salaries (Payroll - Wages, NI PAYE Pensions)
  • Occupancy (Rent)
  • Depreciation (Machinery/Office Equipment)
  • Other Fixed Expenses

(In some companies, machine cost is segregated from overhead and reported as a separate element)

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 Element: There are three elements of costing i.e. material, labor and expenses.
2. 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.
3. By Functions: production,administration, selling and distribution, R&D.
4. By Behavior: fixed, variable, semi-variable. Costs are classified according to their behavior in relation to change in relation to production volume within given period of time. Fixed Costs remain fixed irrespective of changes in the production volume in given period of time. Variable costs change according to volume of production. Semi-variable costs are partly fixed and partly variable.
5. By control ability: controllable, uncontrollable costs. Controllable costs are those which can be controlled or influenced by a conscious management action. Uncontrollable costs cannot be controlled or influenced by a conscious management action.
6. 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.
7. 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.
8. By Decision making Costs: These costs are used for managerial decision making.

• Marginal costs: Marginal cost is the change in the aggregate costs due to change in the volume of output by one unit.
• Differential costs: This cost is the difference in total cost that will arise from the selection of one alternative to the other.
• Opportunity costs: It is the value of benefit sacrificed in favor of an alternative course of action.
• Relevant cost: The relevant cost is a cost which is relevant in various decisions of management.
• 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.
• 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.
• 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.
• Sunken cost: cost already incurred
• Other costs

Standard cost accounting

Main article: 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

Main article: 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(bottle neck) in a JIT environment.

Mathematical formula

$\text{throughput} = \text{sales revenue} - \text{totally variable costs}$

$\text{throughput accounting ratio} = \frac{\text{return}}{\text {factory hours}}$

Activity-based costing

Main article: 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 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 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.

Integrating EVA and Process Based Costing

Recently, Mocciaro Li Destri, Picone & Minà (2012). 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

Main article: Lean accounting

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.

Marginal costing

See also: Cost-Volume-Profit Analysis and Marginal cost

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:

$\text{Contribution Margin Ratio} = (\text{Sales - Variable Costs}) / \text{Sales}$

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%).

See also

• Accountancy
• Cost overrun
• Fixed asset turnover
• Management accounting
• IT Cost Transparency
• Kaizen costing
• Profit model

Further reading

• 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).
• Kaplan, Robert S. and Bruns, W. Accounting and Management: A Field Study Perspective (Harvard Business School Press, 1987) ISBN 0-87584-186-4
• Nicholson, Jerome Lee, and John Francis Deems Rohrbach. Cost accounting. New York: Ronald Press, 1919.
• Blocher, Stout, Juras and Cokins,Cost Management - A Strategic Emphasis, 7th Edition (McGraw-Hill 2016).

External links

• Accounting Systems, introduction to Cost Accounting, ethics and relationship to GAAP.
• National Conference on College Cost Accounting