Learning Cost Accounting

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Cost Accounting

 

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Cost Accounting

 

Rationale

Cost Accounting is the process of tracking, recording and analyzing costs associated with the products or activities of an organization, where cost is defined as 'required time or resources'. 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 physical movement of products) into financial value to support decision making to improve costs and cash flows.

There are at least four approaches:

 

Introduction to Managerial Accounting, Cost Accounting and Cost Management Systems

 

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Introduction to Cost and Management Accounting in a Global Business Environment

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Management Accounting is concerned with the provisions and use of accounting information to managers within organizations, to provide them with the basis in making informed business decisions that would allow them to be better equipped in their management and control functions. Unlike financial accountancy information (which, for the most part, is public information), management accounting information is used within an organization (typically for decision-making) and is usually confidential and access to which is only available to a select few.

 

Global Success and the Role of Strategic Steering and Management Accounting Systems

 

 

 

 

Introduction to Cost Management Systems

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Readings

Strategic Enterprise Management (SEM) refers to the management techniques, metrics and related tools (such as computer
software) designed to assist companies in making high-level (strategic) decisions.

Typically, a business using SEM would incorporate a strategic information system, to manage information and assist in strategic decision making. A strategic information system has been defined as, "The information system to support or change enterprise's strategy." by Charles Wiseman (Strategy and Computers 1985).

 

Sprague has defined three classifications of strategic information systems:

  1. Competitive system
  2. Cooperative system
  3. The system changes operations of organization

 

Key concepts in strategic enterprise management include:

1. Setting specific strategic goals which will improve the position of the company, rather than more general goals such as increased profit or reduced costs.

2. Measuring performance in terms of defined goals, and making the information available to those making strategic decisions.

3. Measuring and managing "intellectual capital", the skill and knowledge base of the companies workforce.

4. Activity-based management (ABM), which seeks to evaluate customers and projects in terms of their total cost and benefit to the organisation, rather than assuming that the most important projects are those bringing the highest revenue.
How do I want to do it?

 

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Translating Strategy to Action: Strategic Enterprise Management

 

 

Organizational Cost Flows

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Readings

INTRODUCTION TO COSTS ACCOUNTING:
Methods and Techniques

 Economics Interactive Tutorial - Cost Concepts

 

In economics and finance, Marginal Cost is the change in total cost that arises when the quantity produced changes by one unit. Mathematically, the marginal cost (MC) function is expressed as the derivative of the total cost (TC) function with respect to quantity (Q). Note that the marginal cost may change with volume, and so at each level of production, the marginal cost is the cost of the next unit produced.

 

A typical Marginal Cost Curve
A typical Marginal Cost Curve

 

MC=\frac{dTC}{dQ}

 

In general terms, marginal cost at each level of production includes any additional costs required to produce the next unit. If producing additional vehicles requires, for example, building a new factory, the marginal cost of those extra vehicles includes the cost of the new factory. In practice, the analysis is segregated into short and long-run cases, and over the longest run, all costs are marginal. At each level of production and time period being considered, marginal costs include all costs which vary with the level of production, and other costs are considered fixed costs.

It is a general principle of economics that a (rational) producer should always produce (and sell) the last unit if the marginal cost is less than the market price. As the market price will be dictated by supply and demand, it leads to the conclusion that marginal cost equals marginal revenue. These general principles are subject to a number of other factors and exceptions, but marginal cost and marginal cost pricing play a central role in economic definitions of efficiency.

Marginal cost pricing is the principle that the market will, over time, cause goods to be sold at their marginal cost of production. Whether goods are in fact sold at their marginal cost will depend on competition and other factors, as well as the time frame considered. In the most general criticism of the theory of marginal cost pricing, economists note that monopoly power may allow a producer to maintain prices above the marginal cost; more specifically, if a good has low elasticity of demand (consumers are insensitive to changes in price) and supply of the product is limited (or can be limited), prices may be considerably higher than marginal cost. Since this description applies to most products with established brands, marginal pricing may be relatively rare; an example would be in markets for commodities.

A number of other factors can affect marginal cost and its applicability to real world problems. Some of these may be considered market failures. These may include information assymetries, the presence of negative or positive externalities, transaction costs, price discrimination and others.

 

 

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Activity-Based Cost Systems for Management

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Activity-based Costing (ABC) is a method of allocating costs to products and services. It is generally used as a tool for planning and control. This is a necessary tool for doing value chain analysis.

The concepts of ABC were developed in the manufacturing sector of the U.S. during the 1970s and 80s. During this time, the Consortium for Advanced Manufacturing-International, now known simply as CAM-I (www.cam-i.org), provided a formative role for studying and formalizing the principles that have become more formally known as Activity-Based Costing. Robin Cooper and Robert Kaplan, proponent of the Balanced Scorecard, brought notice to these concepts in a number of articles published in Harvard Business Review beginning in 1988. Cooper and Kaplan described ABC as an approach to solve the problems of traditional cost management systems. These traditional costing systems are often unable to determine accurately the actual costs of production and of the costs of related services. Consequently managers were making decisions based on inaccurate data especially where there are multiple products.

Instead of using broad arbitrary percentages to allocate costs, ABC seeks to identify cause and effect relationships to objectively assign costs. Once costs of the activities have been identified, the cost of each activity is attributed to each product to the extent that the product uses the activity. In this way ABC often identifies areas of high overhead costs per unit and so directs attention to finding ways to reduce the costs or to charge more for costly products.

 

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Why ABC Focus activity based costing

 

 

Job Order Costing. Process Costing

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Process Costing traces and accumulates direct costs, and allocates indirect costs, through a manufacturing process. Costs are assigned to products, usually in a large batch, which might include an entire month's production. Eventually, costs have to be allocated to individual units of product.

Process costing is a type of operation costing which is used to ascertain the cost of a product at each process or stage of manufacture. CIMA defines process costing as "The costing method applicable where goods or services result from a sequence of continuous or repetitive operations or processes. Costs are averaged over the units produced during the period". Process costing is suitable for industries producing homogeneous products and where production is a continuous flow. A process can be referrwed to as the sub-unit of an organization specifically definde for cost collection purpose.

Reasons for use

Companies need to allocate total product costs to units of product for the following reasons:

1. A company may manufacture thousands or millions of units of product in a given period of time.

2. Products are manufactured in large quantities, but products may be sold in small quantities, sometimes one at a time (automobiles, loaves of bread), a dozen or two at a time (eggs, cookies), etc.

3. Product costs must be transferred from Finished Goods to Cost of Goods Sold as sales are made. This requires a correct and accurate accounting of product costs per unit, to have a proper matching of product costs against related sales revenue. *Managers need to maintain cost control over the manufacturing process. Process costing provides managers with feedback that can be used to compare similar product costs from one month to the next, keeping costs in line with projected manufacturing budgets.

4. A fraction-of-a-cent cost change can represent a large dollar change in overall profitability, when selling millions of units of product a month. Managers must carefully watch per unit costs on a daily basis through the production process, while at the same time dealing with materials and output in huge quantities.

5. Materials part way through a process (e.g. chemicals) might need to be given a value, process costing allows for this. By determining what cost the part processed material has incurred such as labour or overhead an "equivalent unit" relative to the value of a finished process can be calculated.

 

Normal Historical Job Order Costing

 

 

 

Special Production Issues: Lost Units and Accretion

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In microeconomics, Production is the act of making things, in particular the act of making products that will be traded or sold commercially. Production decisions concentrate on what goods to produce, how to produce them, the costs of producing them, and optimizing the mix of resource inputs used in their production. This production information can then be combined with market information (like demand and marginal revenue) to determine the quantity of products to produce and the optimum pricing.

(In macroeconomics, production is measured by gross domestic product and other measures of national income and output.)

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Implementing Quality Concepts

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Readings

Quality can refer to:

  1. A specific characteristic of an object (the qualities of ice - i.e. its properties)
  2. The essence of an object (the quality of ice - i.e. "iceness")
  3. The achievement or excellence of an object (good quality ice - i.e. not of inferior grade)
  4. The meaning of excellence itself

 

The first meaning is technical, the second philosophical, the third practical, and the fourth metaphysical. The last two meanings are those most commonly used. Therefore, whereas the first two meanings admit that Quality can be positive, negative or neutral, the overwhelming association is that Quality is something to be desired.

Philosophy and common sense tend to see quality as related either to subjective feelings or to objective facts. The subject-object in question might be a concrete and functional (e.g. Arisotelian) value to be learnt and applied (a and b), or a psychic (e.g. platonic) ideal to be apprehended and represented (c). A third view tends to see quality not as a secondary value that something has, rather a primary truth which comprises apparent subjects and objects (d).

So the quality of something depends on the criteria being applied to it. Something might be good because it is useful, because it is beautiful, or simply because it exists. Determining or finding quality therefore involves an understanding of use, beauty and existence - what is useful, what is beautiful and what exists.

 

In business

Many different techniques and concepts have evolved to improve product or service quality, including SPC, Zero Defects, Six Sigma, Malcolm Baldrige National Quality Award, quality circles, TQM, Theory of Constraints(TOC), Quality Management Systems (ISO 9000 and others) and continuous improvement.

 

The meaning for the term quality has developed over time. Various interpretations are given below:

"Degree to which a set of inherent characteristic fulfils requirements" as ISO 9000

"Conformance to requirements" (Quality in the 1980s). The difficulty with this is that the requirements may not fully represent what the customer wants; Crosby treats this as a separate problem.

"Fitness for use" (Joseph M. Juran). Fitness is defined by the customer.

A two-dimensional model of quality (Noriaki Kano and others). The quality has two dimensions: "must-be quality" and "attractive quality". The former is near to the "fitness for use" and the latter is what the customer would love, but has not yet thought about. Supporters characterise this model more succinctly as: "Products and services that meet or exceed customers' expectations". One writer believes (without citation) that this is today the most used interpretation for the term quality.

"Value to some person" (Gerald M. Weinberg)

(Quality), "Costs go down and productivity goes up, as improvement of quality is accomplished by better management of design, engineering, testing and by improvement of processes. Better quality at lower price has a chance to capture a market. Cutting costs without improvement of quality is futile." "Quality and the Required Style of Management" 1988 See http://www.deming.org/

"The loss a product imposes on society after it is shipped" (Genichi Taguchi). Taguchi's definition of quality is based on a more comprehensive view of the production system.

Energy quality, associated with both the energy engineering of industrial systems and the qualitative differences in the trophic levels of an ecosystem.

One key distinction to make is there are two common applications of the term Quality as form of activity or function within a business. One is Quality Assurance which is the "prevention of defects", such as the deployment of a Quality Management System and preventative activities like FMEA. The other is Quality Control which is the "detection of defects", most commonly associated with testing which takes place withn a Quality Management System typically referred to as Verification and Validation.
Six Sigma Methodology

 

However, the American Society for Quality defines "quality" as "a subjective term for which each person has his or her own definition. In technical usage, quality can have two meanings:

1. the characteristics of a product or service that bear on its ability to satisfy stated or implied needs.

2. a product or service free of deficiencies. " Source: http://www.asq.org/glossary/q.html

 

Quality

 

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Cost Allocation for Joint Products and By-Products

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When a product or service contains ineligible components, a Cost Allocation may be used so that support can be provided for the eligible portion.

A cost allocation is appropriate when a clear delineation can be made between the eligible and ineligible components. Several methods of cost allocation can be used, but they must meet the criteria of being based on tangible criteria that provide a realistic result. The price for the eligible portion must be the most cost-effective means of receiving the eligible service. Specific examples of cost allocations are provided below.

In isolated cases, ineligible features are an insubstantial and inseparable part of a product or service. For example, a Private Branch Exchange (PBX) is a telephone switching system that often includes an ineligible intercom feature. If certain limited conditions are satisfied, the cost of the intercom functionality need not be cost allocated. For further information about this "ancillary use" provision, see "Ancillary Use" of Ineligible Components.

 

Allocation of Cost of Goods Sold

 

 

Standard Costing

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Readings

In modern Cost Accounting, the concept 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 Generally Accepted Accounting Principles (GAAP) as established by the Financial Accounting Standards Board for reporting results of publicly owned companies. It also enabled managers to effectively 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 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.

 

Standard Costing Model

 

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.

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CVP stands for Cost-Volume-Profit. The CVP analysis helps understanding the financial impact of basic business decisions.

 

The Theoretical Non-linear and Conventional Linear Cost-Volume-Profit Models

 

The main tools used for a CVP analysis are

1. Break even analysis

2. Contribution margin analysis, which compares the profitability of production lines

3. Operating leverage, i.e. to which extent a business uses fixed costs in operations. With help of breakeven points the organization can examine the effects of increases or decreases in fixed costs.

CVP is a management accounting tool that express relationship between sales volume, cost and profit. CVP can be used in the form of graph or an equation.

 

Accounting Cost-Volume-Profit Analysis

 

Approaches to CVP analysis

Cost and revenue equations contribution margin profit graph

Objectives of CVP analysis

In order to forecast profits accuratley, it is essential to assertain the relationship between profit and cost on one hand and volume on the other.

CVP analysis is helpful in producing a flexible budget

This will help in determining the pricing decisions that should be made for the product

 

The Master Budget

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Diagram of a Master Budget

Financial Planning is the task of determining how a business will afford to achieve its strategic goals and objectives. Usually, a company creates a Financial Plan immediately after the vision and objectives have been set. The Financial Plan describes each of the activities, resources, equipment and materials that are needed to achieve these objectives, as well as the timeframes involved.

 

Financial Planning Process

The Financial Planning activity involves the following tasks;-

  • Assess the business environment
  • Confirm the business vision and objectives
  • Identify the types of resources needed to achieve these objectives
  • Quantify the amount of resource (labor, equipment, materials)
  • Calculate the total cost of each type of resource
  • Summarize the costs to create a budget
  • Identify any risks and issues with the budget set

 

Performing Financial Planning is critical to the success of any organization. It provides the Business Plan with rigor, by confirming that the objectives set are achievable from a financial point of view. It also helps the CEO to set financial targets for the organization, and reward staff for meeting objectives within the budget set.

 

Capital Budgeting (or investment appraisals) are the planning processes used to determine a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research and development projects.

 

Capital Budgeting: eight steps

 

Many formal methods are used in capital budgeting, including the techniques such as

 

method, using the incremental cash flows from each potential investment, or project. Techniques based on accounting earnings and accounting rules are sometimes used - though economists consider this to be improper - such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as well, such as payback period and discounted payback period.

 

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Financial Management

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Readings

Corporate Finance is a specific area of finance dealing with the financial decisions corporations make and the tools as well as analysis used to make these decisions. The primary goal of Corporate finance is to enhance corporate value, without taking excessive financial risks.

 

Financial Management

 

The discipline may be divided among long-term and short-term decisions and techniques. Capital investment decisions comprise the long-term choices about which projects receive investment, whether to finance that investment with equity or debt, and when or whether to pay dividends to shareholders. Short-term corporate finance decisions are called working capital management and deal with the balance of current assets and current liabilities; the focus here is on managing cash, inventories, and short-term borrowing and lending (e.g., the credit terms extended to customers).

The time frames, and the goal of the discipline, are inter-related: value is enhanced when return on capital, a function of working capital management, exceeds cost of capital, a function of previous capital investment decisions.

Corporate finance is closely related to managerial finance, which is slightly broader in scope, describing the financial techniques available to all forms of business enterprise, corporate or not.

 

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External links and references

General

 

Valuation and Capital Budgeting

 

Capital Structure and Dividend Policy

 

Working Capital Management

 

Real options

 

Decision Tree Analysis

 

Financial risk management

 

Related Professional Qualification

 

 

Innovative Inventory and Production Management Techniques. Emerging Management Practices

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Readings

The term Management characterizes the process of and/or the personnel leading and directing all or part of an organization (often a business) through the deployment and manipulation of resources (human, capital, natural, intellectual or intangible).

 

According to the Oxford English Dictionary, the word "manage" comes from the Italian maneggiare (to handle — especially a horse), which in turn derives from the Latin manus (hand). The French word mesnagement (later ménagement) influenced the development in meaning of the English word management in the 17th and 18th centuries.

Management has to do with power by position, whereas leadership involves power by influence. Compare stewardship.

 

See also

Why Managers Suck

 

 

Responsibility Accounting and Transfer Pricing in Decentralized Organizations

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Readings

Transfer Pricing refers to the pricing of goods and services within a multi-divisional organization, particularly in regard to cross-border transactions. For example, goods from the production division may be sold to the marketing division, or goods from a parent company may be sold to a foreign subsidiary, with the choice of the transfer price affecting the division of the total profit among the parts of the company. This has led to the rise of transfer pricing regulations as governments seek to stem the flow of taxation revenue overseas, making the issue one of great importance for multinational corporations.

 

Transfer Pricing

 

 

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Measuring Short-Run Organizational Performance

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Readings

Performance Management may mean:

Performance measurement is the process of assessing progress toward achieving predetermined goals, while performance management is building on that process adding the relevant communication and action on the progress achieved against these predetermined goals (Bourne, M.,Franco, M. and Wilkes, J. (2003). Corporate performance management. Measuring Business Excellence; 2003; 7, 3; p. 15)

1. In network performance management, (a) a set of functions that evaluate and report the behavior of telecommunications equipment and the effectiveness of the network or network element and (b) a set of various subfunctions, such as gathering statistical information, maintaining and examining historical logs, determining system performance under natural and artificial conditions, and altering system modes of operation. Source: from Federal Standard 1037C and from MIL-STD-188.

2. In organizational development (OD), performance can be thought of as Actual Results vs Desired Results. Any discrepancy, where Actual is less than Desired, could constitute the performance improvement zone. Performance management and improvement can be thought of as a cycle:

Performance planning where goals and objectives are established

Performance coaching where a manager intervenes to give feedback and adjust performance

Performance appraisal where individual performance is formally documented and feedback delivered

3. A performance problem is any gap between Desired Results and Actual Results. Performance improvement is any effort targeted at closing the gap between Actual Results and Desired Results.

4. Application Performance Management (APM) refers to the discipline within systems management that focuses on monitoring and managing the performance and availability of software applications. APM can be defined as workflow and related IT tools deployed to detect, diagnose, remedy and report on application performance issues to ensure that application performance meets or exceeds end-users’ and businesses’ expectations.

5. Business performance management (BPM) is a set of processes that help businesses discover efficient use of their business units, financial, human and material resources.

6. Operational performance management (OPM) focus is on creating methodical and predictable ways to improve business results, or performance, across organizations.

7. Simply put, performance management helps organizations achieve their strategic goals. Rather than discarding the data accessibility previous systems fostered, performance management harnesses it to help ensure that an organization’s data works in service to organizational goals to provide information that is actually useful in achieving them.

 

Organizational Performance comprises the actual output or results of an organization as measured against its intended outputs (or goals and objectives).

 

Conceptual View of Financial Performance

Specialists in many fields are concerned with organizational performance including strategic planners, operations, finance, legal, and organizational development.

In recent years, many organizations have attempted to manage organizational performance using the balanced scorecard methodology where performance is tracked and measured in multiple dimensions such as: financial performance (e.g. shareholder return) - customer service - social responsibility (e.g. corporate citizenship, community outreach) - employee stewardship

 

See also

 

People involved in research

 Going Beyond Conventional Wisdom: Designing Executive Pay to Balance

 

Performance measurement is the use of statistical evidence to determine progress toward specific defined organizational objectives.

There are lots of ways to measure performance, such as turnover and profits.

 

 

Recommended Texts

Cost Accounting: Traditions and Innovations

Cost Accounting: Traditions and Innovations, 4e by Jesse Barfield, Cecily Raiborn, and Michael Kinney

 

Cost Accounting: Traditions and Innovations

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Introduction to Management Accounting Introduction to Management Accounting

Charles T. Horngren, Stanford University
Gary L. Sundem, University of Washington
William O. Stratton, Pepperdine University

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Introduction to Managerial Accounting Introduction to Managerial Accounting
Ray H. Garrison, Brigham Young University
Eric W. Noreen, University of Washington
Suresh S. Kalagnanam, University of Saskatchewan
Ganesh Vaidyanathan, University of Saskatchewan

ISBN: 0070916179
Copyright year: 2005

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Resources

 

 

 

 

 

The Five Parts of a Cost Accounting System