cost accounting concepts

cost accounting concepts

Exploring Key Concepts in Cost Accounting

1. Introduction to Cost Accounting

Before discussing the cost of a product or service and the factors that affect those costs, it is imperative to draw a basic distinction among the more common costs associated with producing a product or service. Differences exist because the factors employed to produce various services and products are different. Similarly, the costs associated with the production of these services and products are different. Accomplishing this task involves defining what a service or product is and establishing a basic understanding of various cost terms. In short, cost accounting is an important part of the management information system, and must be congruent with the unique objectives, strategies, and policies of the enterprise using the information.

Any business exists to produce and sell a product or a service at a profit. Cost accounting is concerned with ascertaining the costs of products, services, and other items produced by an organization. The information obtained from cost accounting goes beyond direct and indirect costs and production. This information is used in a variety of ways. For example, cost accounting provides the detailed cost data necessary to prepare budgets for business operations. Presenting cost data at the desired level of detail, rather than in the aggregated form frequently shown in financial statements, assists managers in the performance of their responsibilities. Aside from cost ascertainment, actual and projected costs of producing and selling particular volumes of goods are necessary for planning purposes. Furthermore, cost data is frequently used in decision-making. This is particularly true in pricing, make-or-buy, and similar decisions. Good managers are careful to justify, stress-test, and therefore ensure the quality of their cost data before using it in decision-making.

2. Types of Costs in Cost Accounting

In this discussion, we emphasize costs that have a direct association with manufacturing operations. This focus underscores the importance of developing an understanding of product costs, upon which much managerial and financial accounting data depends. Direct material costs are the costs of the materials/products purchased and used in the production process. Direct labor costs are the cash wages and the cost of company-paid medical, pension, and other required payments in addition to cash wages. Manufacturing overhead costs include all costs of production other than direct materials and direct labor. These costs include the indirect materials and indirect labor costs plus other costs, such as those of maintenance, communication, lighting, and security.

In cost accounting, total cost includes the cost of all inputs used. More commonly, cost is the economic value of the person or thing being sacrificed for a certain utility or purpose. In accounting, costs are the monetary value of expenditures for supplies, services, labor, products, equipment, and other items purchased for use by a business or other accounting entity.

3. Cost-Volume-Profit Analysis

The traditional accounting approach considers that the cost structure of a company consists of two types of costs. The first type of cost includes those seen as variable costs, and as such, costs are stated as a fixed percentage of sales. This mindset behind decision-making is one based on an assumption of linear costs. The second type of cost is those classified as fixed costs. Fixed costs are seen as expenses that do not vary with the level of activity within a company. Examples of fixed costs include rent, property tax, and insurance. When a cost is classified as being variable or fixed, these decisions can be detrimental to making informed decisions.

Cost-volume-profit (CVP) analysis provides managers with numerous insights to assist them in making better decisions. In particular, CVP aids in predicting how changes in costs and volume affect profits. Managers use CVP to better understand how changes in sales activity can influence profitability. With a full understanding of the cause and effect relationships within a company’s cost structure, managers can make better decisions.

4. Activity-Based Costing

Despite a wealth of case study evidence covering differences in the cost and management accounting practices between the West and East, relatively few longitudinal studies exist as a result of the scarcity of big data on changes in management accounting techniques over long term studies. Furthermore, the regime of rapid economic development in China has meant that there is much internal variation, making it difficult to generalise from intra-country differences. Moreover, little academic research appears to exist on the management performance implications of activity-based costing, especially the cost of quality (COQ) component, embedded in the tenure of a CEO.

The relatively dearth of research in some major branches of cost accounting such as activity-based costing (ABC) seems to be due to the information vacuum that exists. This may also explain why there are many varieties of ABC, none of which dominates the product costing or the management information literature. In parallel, with COQ and SCM, Forbes et al. argue that ABC implementations are typically designed to measure the costs of manufacturing and other support activities within an organisation, rather than to evaluate the underlying activities themselves with the purpose of continuous process improvement. They propose a “resource based” ABC methodology that is very similar to Lean Accounting practice, embodying time as the common denominator from both a resource perspective, as well as a business process perspective.

5. Budgeting and Variance Analysis

Variance analysis looks different for cost drivers and cost objects. Cost driver analysis is grounded in the relationship between independent variables and dependent variables. Independent variables are input levels, often measured in hours, feet, pounds, etc., while dependent variables, such as direct labor hours, floor space, and raw material usage, are performance measurements. Variance analysis, therefore, must examine the factors responsible for paying more or less for each cost driver. Given that the standard cost or standard price was used in the budget, variance analysis examines those factors that differ between the standard cost or standard price and the actual cost or actual price. Common allocations of actual costs to cost drivers will involve the identification of the responsible managers and the physical quantities of resources used. These managers will be accountable for the actual activities and have an incentive to monitor resources and costs to ensure results are consistent with plans. Only when the actual drivers used are easy to identify and obtain will the responsible managers possess the information needed for effective planning, budgeting, and control.

The objective of variance analysis is to identify variances between planned results and actual results and then analyze the factors that led to the variances. The investigation of the causes of variances is positive in the sense that it identifies reasons for performance not equaling expectations. A firm could use this information to change its operations so that there is better performance, reducing or eliminating variances, for example. However, firms could also use information gleaned from variance analysis in a negative manner. Managers may not be able to explain the reasons for variances, or the factors might be outside their control. Therefore, they could argue for changes in standards and budgets. Variance analysis and control may be used as a form of behavioral control, rather than as a method for improving operations. When this occurs, variance analysis would be considered a form of dysfunctional control, in the sense that it is being used in an ineffective manner.