fundamentals of cost accounting epub

fundamentals of cost accounting epub

The Fundamentals of Cost Accounting: A Comprehensive Guide

1. Introduction to Cost Accounting

Cost accounting is the art of accounting specifically for costs. Because virtually every transaction within a company affects costs in one way or another, the scope of cost accounting is wide indeed. Large and comprehensive computer programs can be used in both cost accounting and financial accounting, and some spend large sums on elaborate programs. However, in many cases, a simple general ledger, with sufficient space to list company accounts for costs as well as financial accounts, may be all that is needed. CIMA, at the end of 1994, reported that in a survey of the factors associated with choosing an accounting system that provided an indirect indication of the cost and sophistication of the accounting system, the third most generally important factor was considered to be the provision of accurate and reliable cost information.

Any successful business, large or small, makes a product from natural resources, labor, technological skills, machines, knowledge, money, and organization. Cost accounting simply summarizes the costs of these various elements. Production employees need to be told the cost of the materials they are working on. The fans of the company should be told the cost of marketing their products. The citizens of the communities where the company operates its facilities, and the society at large, should see the economic benefit of granting the company the privilege of creating wealth for itself and for its members. This does not mean that a company should ignore non-economic concerns about activities. Rather, well-documented cost information will allow the company’s decision-makers, and many other constituencies, to judge the impact of those decisions on wealth creation, profit and loss, and other economic concerns.

1.1 Cost Accounting: Need and Importance

2. Cost Concepts and Terminology

The foregoing definitions imply that a cost accounting system has two principal purposes: one is to provide cost control, and the second is to enable the costing of those activities necessary for the managerial functions of planning and decision-making. The essential thing is that cost accounting information is dependent upon, and emanates from, operational activities. Its role is to enshrine in its records enough economic information to make an intelligent appraisal of the significance of the facts recorded.

Cost accounting is a system of procedures for collecting, summarizing, and evaluating for the purpose of controlling and forecasting costs. It includes the ascertainment of costs, the relation of these costs to the activities, the personnel involved; the classification of costs, the accumulation of the costs of departments, processes, jobs, orders, etc.; the allocation of costs to those activities or cost objects; and the interpretation of the results of these efforts either to the persons interested in the activities, or to the actual or potential participants directly involved in the cost accounting activity and indirectly, but importantly, the top management of the entity.

3. Cost Classification and Behavior

Fixed costs equally do not vary with the level of production and remain the same regardless of changes in the activity level but vanish at zero levels of manufacturing. So the average fixed cost is not constant but decreases constantly as the production increases since it has to be spread over the increasing output. Sunk costs are past costs, a result of a mistake or an anticipatory outlay that cannot be recovered. Fixed costs never get the chance for sale or retrieval. Marginal costs are those costs incurred for the next unit of activity; the change in the total cost. It is the actual cost of producing one more unit. The change in cost is that of one additional unit, and it is important where there are choices to be made, such as in determining the optimal inventory level of finished goods. Differentiation allows a positive price spread for products sold now as against the future to encourage sales. Opportunity cost is the benefit expected from the best alternative sacrificed when a choice is made; this cost is also referred to as the shadow price.

Cost is a monetary valuation of effort, material, resources, time, and utilities consumed, risks incurred, and opportunity forgone in the production and supply of a good or service. It is thus a factor of production, which, in the course of business, becomes the expense of production. Cost is incurred or sacrificed, measured by the resources given up (such as cash, raw materials, time, unutilized capacity, etc.) to achieve a particular purpose and may be in the form of lost benefits in the business operation. Costs are classified in different ways, and this section draws on the most prevalent classification. Some concepts you need to be familiar with include variable costs, fixed costs, sunk costs, marginal cost, incremental cost, opportunity and replacement cost, explicit costs, and implicit costs, and so on. Variable costs are costs that vary with the quantity of output or the level of activity, while their unit costs remain constant. They increase or decrease in total amount in direct proportion to the change in activity level.

4. Cost-Volume-Profit Analysis

The CVP process uses the concepts of price, volume, and costs to show how the budgeted profit can change if the actual volume, price, or cost deviate from the budgeted figures. The next sections will show how these interrelations can be used in simple and complex profit settings. The CVP concepts in complex settings involve understanding the following terms: contribution margin, break-even point, margin of safety, volume, mixed costs, and activity-based costing systems.

Determining the relationship between profits, volume, prices, and costs is called cost-volume-profit analysis. The objective is to show how profits are affected by changes in selling prices, relative volume, and costs. The analysis involves the interaction of many business principles in terms of break-even analysis, cost behavior, sales mix, operating leverage, and margin of safety. Profit plays a major role in determining the changes in revenue, costs based on changes in customer purchasing patterns or changes in government policy. Profit is also the main goal for many businesses.

A thorough understanding of CVP analysis aids in cost prediction, deciding whether to lease or buy, determining inventory levels, deciding whether to outsource or perform a service in-house, strategies concerning fixed and variable costs, and setting performance measures and incentives. The data required for CVP analysis is accurate, and the assumptions of volume, variable per unit, total fixed, and sales price often require educated approximations for service operations.

Cost-volume-profit analysis refers to the relationship between profits, volume, price, and costs and involves analyzing the interaction among factors contributing to profit or loss. The analysis shows how changes in revenues, fixed costs, and variable costs affect net income before taxes. For example, changes in selling prices, changes in variable costs per unit, and changes in fixed costs result in a change in the break-even point or in the net income.

5. Budgeting and Variance Analysis

You will have noticed that we have talked as if there is one standard cost per product, but standard costs are more usually calculated for a group of products. One might set up a standard for each range of products produced by a particular production process.

The business will budget rather separately for several aspects of performance, such as sales, production costs, stock levels, capital expenditure, and dividend levels. Each budget will, therefore, be a constituent part of a company’s overall plan. Everyone involved in the process will identify the different items of planned costs involved in producing, marketing, selling, delivering, and administering a firm’s products, as well as the standard cost for each product. Standard costs, of course, sum together to give total budgeted costs.

Setting up a budget is something of a trial-and-error process, as we have seen. The art of budgeting, however, lies in striking and then maintaining a balance between motivating employees to exert the pressure necessary to reach top performance.

Budgets are a very common form of planning in business. A budget is a quantitative plan of action that management sets for its resources for planned activities over a particular time period. A budget is quite a formal type of plan, and some people have actually defined it as a formalized quantitative plan for a company’s activities over a given period of time. More commonly, budgets are defined as a coordinated plan that states the point and range of business activities over a given period of time.