fundamentals of cost accounting

fundamentals of cost accounting

Exploring the Fundamentals of Cost Accounting

1. Introduction to Cost Accounting

Traditionally, cost accounting is referred to as an accounting system that is designed to ascertain the cost of a product or service, whereas managerial accounting provides cost information for the manager. However, as Williamson articulated, cost accounting is referred to as a set of techniques and procedures which are used for accounting, identifying and analyzing the pattern of costs so as to facilitate cost control and cost reduction. In a similar vein, Kaplan and Johnson described cost accounting as a set of procedures and techniques that are used to accumulate information about the costs of producing goods and services to aid the management in making more effective decisions. Nigam beautifully articulated that cost accounting in the modern context is also being referred to as a modern form of accounting with a future orientation, used for decision making aimed at maximizing the collective welfare.

Cost accounting is a key information system that provides valuable insights into the operations of an enterprise and helps in making necessary adjustments for achieving optimal profitability. From a scope perspective, cost accounting encompasses planning the future, understanding the present, and traditionally includes recording, classifying, and analyzing the actual variances between cost and the budgeted cost. Hence, cost accounting is not only about costs but also about revenue and profitability as well. The primary objective of this chapter is to understand the fundamentals of cost accounting – meaning of cost accounting, its advantages, key concepts, and cost accounting standards.

2. Cost Classification and Behavior

Classification of costs is a way of expressing the total cost to meet specific purposes. The fundamental classification results from identifying fixed, variable, and semi-variable costs. Costs can also be classified as direct or indirect. Direct materials can be traced directly to a specific product, so their costs are charged to that product. Indirect materials cannot be readily traced to a product, so they are charged to the factory-wide manufacturing overhead account. Classification based on behavior is the most important type of classification in cost accounting because it is closely related to the items included and excluded in various costs. Once we have classified our costs by type, we must then assign them to operations and products. Such classifications provide a useful basis for analysis and decision-making. The classification of costs reflects their nature and responds to the specific information and measurement needs of management.

In addition, cost items are divided into direct and indirect costs according to the ease of cause-and-effect relation. Overwork may arise in labor-use assignments for these cost items when cost accounting is applied to job orders and process costing systems, which involve complicated patterns and high labor-use assignments.

Items are classified into different cost categories to suit individual information needs. However, in all classifications, all items that represent the outflow of benefits and are related to the output of goods and services are considered cost items. It should be noted that cost items are classified into fixed, variable, and semi-variable costs according to whether or not the total cost changes with the change in the volume of production in a specific period. Fixed costs do not change no matter how much the volume of production changes in a specific period. Variable costs increase as production expands, and semi-variable costs are made up of fixed and variable components.

3. Costing Methods and Techniques

The importance of meeting revenue needs through cost accounting varies among firms. While some firms focus on ensuring accurate pricing on invoices, others prioritize the improvement and control function of cost accounting. One fundamental problem in cost accounting is how to achieve both goals simultaneously. Various solutions have been identified, with significant pragmatic importance. Evolving cost accounting systems have primarily used two approaches: one focuses on designing cost classifications to provide specific decision-making information, while the other emphasizes detailed level standards. This section traces the development of these approaches, highlighting their strengths and weaknesses. The main purpose is to identify current inherent problems and propose approaches that address the gaps while leveraging existing strengths.

Cost accounting systems require two costing systems: one for breaking down revenue expenses to ensure accurate income tracking, and another for improving company management and operational efficiency. The methods and techniques of cost accounting have evolved over time to enhance cost control and reduce waste. Modern approaches aim to use cost system information to optimize asset utilization and align with the company’s strategy.

4. Cost Analysis and Decision Making

Broadly speaking, cost behavior is either variable or fixed. Two basic classifications of costs are based on their behavior. They distinguish between costs that remain the same in total regardless of the level of activity and those that change. The latter costs may change in total, change in proportion to a change in volume, or change in response to a change in volume, but not in direct proportion. These three types of cost responses are known as fixed, variable, and mixed cost behavior, respectively.

Cost analysis and decision making are the primary responsibilities of management accounting. They involve decisions such as accepting or rejecting orders, setting selling prices, determining the most profitable product mix, and adding or dropping product lines. These decisions necessitate an in-depth understanding of cost behavior, or in other words, the way in which costs respond to changes in volume or activity.

5. Emerging Trends in Cost Accounting

Following Deming’s and Juran’s teachings on quality management, many organizations are spending massive amounts of money to develop and certify product-service quality under ISO 9000, 14000, or the Malcolm Baldridge Award. These activities have a cost component called, not surprisingly, total quality costing (TQC). Japanese companies have minimized TQC, gaining competitive advantage. A review of articles from the Journal of Cost Management over the last five years suggests that TQC is not a one-time special costing study; it is the management accounting focus for nearly every day. TQC forces organizations to rethink and redesign their corporate control systems. They are no longer following the Industrial Age command and control logic, not exactly a virtual organization, but the virtual ability to respond rapidly to unpredictable customer-based change. TQC shackles an organization to two strategic quality management strategies. First, starting with internal design-build measures based on what is value-added or required by the customer. Second, costing the present and future value-change gained from purchase-money spent on R&D, raw material, or services. These quality management concepts do not receive the attention given to product-service excellence.

Total Quality Management:

Fundamental changes throughout business have also influenced the accounting function. The current emphasis on total quality costing and customer profitability is forcing accounting to come to grips with basic changes. These changes in the business environment have the potential to revolutionize the way we view cost accounting. However, until we pay more attention to proper understanding of existing cost accounting basics, we cannot successfully deal with these management accounting phenomena or the emerging trends that impact the system. Nonetheless, the purpose here is to introduce these trends, not abandon cost accounting basics. This section identifies broad corporate management challenges and trends that are affecting cost accounting.