Elements of Cost: Management Accounting Costs Profitability Gaap

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In management accounting, cost accounting 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 cut a company's costs and
improve profitability. As a form of management accounting, cost accounting need not to follow
standards such as GAAP, because its primary use is for internal managers, rather than outside
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.

Elements of cost

 1. Material (Material is a very important part of business)


 A. Direct material
 B. Indirect material
 2. Labor
 A. Direct labor
 B. Indirect labor
 3. Overhead
 A. Indirect material
 B. Indirect labor

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

They are grouped further based on their functions as,

 1. Production or works overheads


 2. Administration overheads
 3. Selling overheads
 4. Distribution overheads
Costs are the necessary expenditures that must be made in order to run a
business. Every factor of production has a cost associated with it: labor, fixed
assets, and capital, for example. The cost of labor used in the production of goods
and services is measured in terms of wages. The cost of a fixed asset used in
production is measured in terms of depreciation. The cost of capital used to
purchase fixed assets is measured in terms of the interest expense associated with
raising the capital.

Businesses are vitally interested in measuring their costs. Many types of costs are
observable and easily quantifiable. In such cases there is a direct relationship
between cost of input and quantity of output. Other types of costs must be
estimated or allocated. That is, the relationship between costs of input and units
of output may not be directly observable or quantifiable. In the delivery of
professional services, for example, the quality of the output is usually more
significant that the quantity, and output cannot simply be measured in terms of
the number of patients treated or students taught. In such instances where
qualitative factors play an important role in measuring output, there is no direct
relationship between costs incurred and output achieved.

OR

DIFFERENT WAYS TO CATEGORIZE COSTS


Costs can have different relationships to output. Costs also are used in different
business applications, such as financial accounting, cost accounting, budgeting,
capital budgeting, and valuation. Consequently, there are different ways of
categorizing costs according to their relationship to output as well as according to
the context in which they are used. Following this summary of the different types
of costs are some examples of how costs are used in different business
applications.

FIXED AND VARIABLE COSTSThe two basic types of costs incurred by businesses
are fixed and variable. Fixed costs do not vary with output, while variable costs
do. Fixed costs are sometimes called overhead costs. They are incurred whether a
firm manufactures 100 widgets or 1,000 widgets. In preparing a budget, fixed
costs may include rent, depreciation, and super-visors' salaries. Manufacturing
overhead may include such items as property taxes and insurance. These fixed
costs remain constant in spite of changes in output.

Variable costs, on the other hand, fluctuate in direct proportion to changes in


output. Labor and material costs are typical variable costs that increase as the
volume of production increases. It takes more labor and material to produce
more output, so the cost of labor and material varies in direct proportion to the
volume of output. The direct proportionality of variable costs to level of output
may break down with very small and very large production runs.

In addition, some costs are considered mixed costs. That is, they contain
elements of fixed and variable costs. In some cases the cost of supervision and
inspection are considered mixed costs.

DIRECT AND INDIRECT COSTSDirect costs are similar to variable costs. They can
be directly attributed to the production of output. The system of valuing
inventories called direct costing is also known as variable costing. Under this
accounting system only those costs that vary directly with the volume of
production are charged to products as they are manufactured. The value of
inventory is the sum of direct material, direct labor, and all variable
manufacturing costs.
Indirect costs, on the other hand, are similar to fixed costs. They are not directly
related to the volume of output. Indirect costs in a manufacturing plant may
include supervisors' salaries, indirect labor, factory supplies used, taxes, utilities,
depreciation on building and equipment, factory rent, tools expense, and patent
expense. These indirect costs are sometimes referred to as manufacturing
overhead.

Under the accounting system known as full costing or absorption costing, all of
the indirect costs in manufacturing overhead as well as direct costs are included
in determining the cost of inventory. They are considered part of the cost of the
products being manufactured.

PRODUCT AND PERIOD COSTSThe concepts of product and period costs are
similar to direct and indirect costs. Product costs are those that the firm's
accounting system associates directly with output and that are used to value
inventory. Under a direct or variable cost accounting system, only direct or
variable costs are charged to production. Indirect costs such as property taxes,
insurance, depreciation on plant and equipment, and salaries of supervisors are
considered period costs. Period costs are charged as expenses to the current
period. Under direct costing, period costs are not viewed as costs of the products
being manufactured, so they are not associated with valuing inventories.

If the firm uses a full cost accounting system, however, then all manufacturing
costs—including fixed manufacturing overhead costs and variable costs—become
product costs. They are considered part of the cost of manufacturing and are
charged against inventory.

OTHER TYPES OF COSTSThese are the basic types of costs as they are used in
different accounting systems. In addition, other types of costs are used in
different business contexts. In budgeting it is useful to identify controllable and
uncontrollable costs. This simply means that managers with budgetary
responsibility should not be held accountable for costs they cannot control.
Financial managers often use the concepts of out-of-pocket costs and sunk costs
when evaluating the financial merits of specific proposals. Out-of-pocket costs
are those that require the use of current resources, usually cash. Sunk costs have
already been incurred. In evaluating whether or not to increase production, for
example, financial managers may take into account the sunk costs associated
with tools and machinery as well as the out-of-pocket costs associated with
adding more material and labor.

Financial planning also utilizes the concepts of incremental, opportunity, and


imputed costs. Incremental costs are those associated with switching from one
level of activity or course of action to another. Incremental costs represent the
difference between two alternatives. Opportunity costs represent the sacrifice
that is made when the means of production are used for one task rather than
another, or when capital is used for one investment rather than another. Nothing
can be produced or invested without incurring an opportunity cost. By making
one investment or production decision using limited resources, one necessarily
forgoes the opportunity to use those resources for a different purpose.
Consequently, opportunity costs are not usually factored into investment and
production decisions involving resource allocation.

Imputed costs are costs that are not actually incurred, but are associated with
internal transactions. When work in process is transferred from one department
to another within an organization, a method of transfer pricing may be needed
for budgetary reasons. Although there is no actual purchase or sale of goods and
materials, the receiving department may be charged with imputed costs for the
work it has received. When a company rents itself a building that is could have
rented to an outside party, the rent may be considered an imputed cost.

OR

COST ACCOUNTING
INTRODUCTION TO MANUFACTURING OPERATIONS
In manufacturing, raw material is transformed with the help of labor and machinery. In a merchandising firm,
only one type of inventory is maintained, and only few costs are added to the purchase price of goods to
arrive at cost of goods sold. In a manufacturing firm, many and different types of costs are incurred:
1- direct material,
2- direct labor, and
3- factory or manufacturing overhead.
These costs are accumulated in three inventories:
1- materials,
2- work in process, and
3- finished goods.

INVENTORY ACCOUNTS The three inventory accounts used in manufacturing operations are
1- materials inventory: these are raw materials which have not yet entered the processing phase;
2- work in process: this accounts for all goods in the process of manufacturing;
3- finished goods: these are completed goods ready to be sold. Combined, they represent the inventory in
the balance sheet.

TYPES OF COSTS
To control costs, the different types of costs are identified: 1- direct materials: these make up the major
component of and are easily traceable to a given finished product;
2- direct labor: that portion of labor which is assignable to a specific product;
3- factory overhead: all costs other than direct materials and direct labor; this includes fixed costs such as
rent and depreciation, but also indirect materials and indirect labor.
Direct materials and direct labor are the prime costs. Direct labor and factory overhead are conversion costs.
All the above costs are product costs, as opposed to period cost which are not part of the cost of products
and are classified as expenses.

COST OF GOODS MANUFACTURED


The cost of goods manufactured statement combines all the direct materials, direct labor and factory with
beginning work in process inventory, minus the ending work in process inventory, to report the total cost of
the goods which have been manufactured during the period. In order to prepare the statement, a
manufacturing summary is debited for all the costs during the year, and credited for the cost of goods
manufactured and ending inventories. The cost of goods manufactured is added to finished goods inventory
to sum to the goods available for sale, which gives the cost of goods sold when ending finished inventory is
deducted.

COST ACCOUNTING SYSTEM


The cost accounting system provides a much more effective means of controlling costs than a general
accounting system, and offers information on unit costs useful for product pricing and promotion. The cost
accounting system uses perpetual inventories. There are two types of cost accounting systems:
1- job order cost systems used when one-of-a-kind products or batches of products are manufactured,
2- process cost systems applicable when uniform and identical products are manufactured on a continuous
basis.

JOB ORDER DIRECT MATERIALS COST


A purchase requisition triggers a purchase order to a supplier from the purchasing department, and when
the goods are delivered, a receiving report showing the quantity and condition of the goods. After
verification, the material inventory account is debited. A materials requisition causes goods to be transferred
from the storeroom or warehouse to the manufacturing department, and thereupon the materials inventory
account is credited. A separate account is often maintained for each type of material.

JOB ORDER DIRECT LABOR COST


Time tickets are used to record the labor cost for each individual job. Hours worked are verified by
comparing time tickets and clock cards. Labor costs are recorded by debiting work in process and/or factory
overhead (depending on whether it is direct or indirect labor), and crediting wages payable.

JOB ORDER FACTORY OVERHEAD COST


Factory overhead consists of all manufacturing costs other than direct materials and direct labor. Factory
overhead costs are both fixed and variable. The factory overhead controlling account is debited when costs
are incurred and credited when factory overhead is "applied" (i.e. allocated) to various job orders. The
overhead application rate can be based on either direct labor hours, direct labor cost or machine hours.
Total credits rarely equal debits. A remaining credit indicates the overhead was underapplied (or
underabsorbed), a debit indicates the overhead was overapplied. If this difference is small, it is closed to
cost of goods sold. If it is large, it is allocated to the various inventory accounts.

JOB ORDER WORK IN PROCESS


The work in process account receives debits for direct materials, direct labor and factory overhead costs.
The work in process account is a controlling account. Cost ledgers maintain details on the costs of each
individual job. A individual cost ledger account is called a job cost sheet. It provides extensive information on
each job direct materials, direct labor, and factory overhead costs. When a job is completed, total costs are
added up and divided by the number of units finished to determine cost per unit.

FINISHED GOODS
The finished goods account is a controlling account, with a subsidiary ledger called the stock ledger or the
finished goods ledger. The finished goods ledger provides detailed information on goods manufactured and
shipped on quantity, price, date, and unit cost. When finished goods are sold, the cost of goods sold is
debited and finished goods credited. In the event goods are returned by buyers, the finished goods account
is debited and the cost of goods sold credited.

REVIEW OF JOB ORDER COST SYSTEMS


Three inventory accounts are used by manufacturing enterprises: 1) materials, 2) work in process, and 3)
finished goods. These inventory accounts record the costs of manufacturing goods. The materials account
records the costs of materials purchased for production purposes. When materials are used in production,
the work in process account is debited. The work in process inventory records materials, labor, and factory
overhead costs. When goods are completed the finished goods account is debited. When goods are sold the
cost of goods sold accounts is debited. Each of these accounts are controlling accounts, and the detailed
information is present is subsidiary ledgers.

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