cost accounting principles

cost accounting principles

Exploring the Principles of Cost Accounting

1. Introduction to Cost Accounting

1. Formulation of a plan. 2. Control of factory plants, sales activities, distribution of products, and other company operations. 3. Determination of the cost of products, product lines, departments, branches, agencies, and distribution territories. 4. Helps management make routine decisions, sometimes referred to as “routine problems and opportunities.” 5. Helps management make non-routine decisions, sometimes referred to as “projects.”

The broad purposes that cost accounting serves are:

In the business world, cost accounting is indispensable for many reasons. First, the money invested in inventory constitutes a very substantial portion of the total funds employed in the business, and therefore management must establish the policy with respect to its control and valuation. Secondly, salaries, wages, and other benefits paid to employees comprise, in many industries, the largest or next-to-largest item of cost. Thirdly, it is money that keeps the factory in operation, and management must know how much is to be spent on such items as rent, taxes, insurance, utilities, supervision, factory depreciation, and corporate office expense. Then there are such specific product costs as material and freight-in, which are outgo of cash, but which are for costs of items to be manufactured. Another essential reason cost accounting is of ultimate interest is that the business depends on the availability of these specific product costs. If a product does not contain a certain minimum of direct material, direct labor, and applied factory overhead, it will not be competitive in the market, and perhaps should not even be offered for sale. Finally, cost accounting is the primary tool for determining the efficient use of plant, materials, and labor and helps in providing the means, the data, and the techniques for determining the efficiency of the individual employee or the individual operation.

The distinguishing feature of cost accounting is that it was developed to help management make decisions and perform functions related to the producing or purchasing of goods and services. In this respect, cost accounting is generally distinguished from financial accounting, although both of them rely upon management’s decisions regarding financial transactions.

1. Accumulation, analysis, and evaluation of cost data to accomplish four broad functions: planning and control, product costing, decision making, and financial reporting. 2. Calculation of the cost of goods or services produced for use in financial reporting and in inventory valuation. 3. Ascertainment of costs and the bearing of such costs to ascertain the relation between input and output by various processes and implements. 4. The construction of information and accounting systems by means of which an officer of an organization is, or may be, made responsible and accountable for all costs and revenues; and the control of operations through such plans as will assure a reasonable profit.

Since the publication of the first textbook over seventy years ago, cost accounting has been defined in several different ways. For some, it has been full absorption of manufacturing costs for external reporting. For others, it has been a technique for product pricing as long as sales cover all costs plus a profit. Numerous explanations of cost accounting are contained in the literature; nevertheless, certain aspects of cost accounting are found in most definitions. These include:

1. Identify the distinguishing features of cost accounting. 2. Indicate why the study of cost accounting is important. 3. Show the relationship of cost accounting terminology to financial accounting terminology. 4. Provide examples of how each primary element of cost (direct materials, direct labor, and factory overhead) is measured in cost accounting.

Learning Objectives

2. Key Principles and Concepts in Cost Accounting

To be useful, cost needs to be communicated in some form or another – the number – to others. The rules for communicating cost in specific ways are embodied in the principles of cost accounting. Certain key principles that you need to know as you study cost accounting include the following: Measurement principle: in the profession of accounting, monetary amounts are seen as the best way of expressing what happens in a business. Business transactions and activities are measured and recorded in terms of money – a monetary unit of account. Conversion principle: like a trip to the money changer, all business activities have to be converted into monetary amounts. Relevance principle: the specific pieces of data that comprise the monetary amounts should be timely and closely related to decisions. Full disclosure principle: because managers and others rely on cost information to make decisions, and because decisions have consequences, the reports should include all relevant information. Cost information may be incomplete but can never be misleading. Cost accounting tries to adhere to these principles.

Primarily, cost accounting is all about cost – the way we track and use cost information. Cost accounting serves a number of different masters: The legal and tax authorities require that costs be determined and reported in standard ways; investors and lenders want to see that financial resources are being used effectively and that assets are not being consumed or mismanaged; and managers need to know about costs in order to make good decisions. Cost accounting provides the information that managers use to control operations and costs. It’s interesting, actually, that cost accounting seems to have just one major focus – cost.

3. Cost Classification and Behavior

In the case of variable costs, they tend to vary with production or output levels at normal operations. These are in contrast to fixed costs. A variable cost increases/decreases with increases or decreases in the volume of production over normal activities (not extremes). These costs are incurred by businesses to produce inventories or goods for resale; therefore, they can be classed as part of the cost of goods manufactured. Examples include variable direct labor wages, direct materials, and commissions for sales staff. They vary in total amount when production varies. When total production falls to zero, this cost becomes zero too. These costs, in their original form, are also referred to as total variable costs since their values change in total when production changes. Examples of variable costs include shipping charges, direct labor costs, direct materials costs, and production supplies such as light bulbs and packing materials at a manufactured goods firm. In a factory, the more products that are produced, the more packing materials are used. Similarly, as production rates increase, additional light bulbs are used as production line machinery is used more.

Fixed costs remain constant no matter the level of activity or production over time, despite production levels or activities. This means if a firm produces nothing, the fixed costs remain. Examples include rent, property tax, salaries of permanent staff, information technology fixed costs, and travel costs. These must be incurred to start and operate a business and do not vary with output changes.

4. Cost Allocation Methods

The cost accounting system must also furnish managers with reports that will enable them to better plan, control, and evaluate the performances of their organization activities. Managers must be provided with timely and accurate feedback to be able to perform these functions effectively. In the development of the cost accounting system, consideration must be given to the particular needs of a firm’s managers, internal operating characteristics, the enabling capabilities of record-keeping systems, and peculiarities which are associated with the application of suggested systems. The selected method of cost accumulation must recognize the particular production characteristics represented by the firm’s mix of products and services.

During the development of a product, cost accumulation systems are used to measure and record the amounts of costs incurred by the firms in retrieving their services or products. During the planning stage of production, these systems assist the managerial in making decisions about the design of the product, in selecting appropriate materials and production methods, and in securing manufacturing equipment and personnel. During the production and marketing stages, the systems are used to manage products, control the production process, schedule production, maintain quality, and measure the output of employees. In addition, the cost accumulation systems aid accountants in the calculation of costs for inventory valuation and for preparing financial statements. The cost accumulation system must produce cost data in accordance with the financial accounting requirements imposed by generally accepted accounting principles.

5. Costing for Decision Making

The first step in any decision, whether it is for planning a project, introducing a new product, or making use of a scarce resource, is to define the objective. Specifying the objective determines the range of possible solutions since these solutions can often be judged against the extent to which the objective is met. Cost information has a pivotal role to play in decision making. As per the objective, a particular decision may place an activity on cost minimization, cost adequacy, or cost effectiveness. Managers can set out alternatives and choose the most appropriate one consistent with the firm’s policies, goals, and financial constraints.

In cost accounting, costing is not only a means for valuing work-in-progress and finished stocks, but also aids in pricing for new contracts, contract variations, and settlement disputes. The prime product of a costing exercise is to provide costs for different levels of production in the factory. Part of it will be used internally by management for decision making, control, and performance measurements, and part may be relevant to external parties such as shareholders, government, and employees, etc. Therefore, this chapter looks at these aspects by taking up some of the techniques used in shorter production runs, planning and control, and performance measurements.