Cost accounting

From Academic Kids

Cost accounting is the process of tracking, recording and analyzing costs associated with the activity of an organization, where cost is defined as 'required time or resources'. Costs are measured in units of currency by convention.

There are now at least three approaches: standard costing, activity-based costing (discussed here), and throughput accounting.



Costs were originally considered fixed (the term comes from a Latin root meaning "constant"). In larger organizations, some costs tend to remain the same even during busy periods, while others rise and fall with volume of work. A more convenient way of categorizing these costs is to define them as either fixed or variable. Fixed costs were associated with the business administration, and did not change during quiet or busy times. Variable costs were associated with productive work, and naturally rose and fell with business activity.

In the early twentieth century, as organizations began getting more complex, managers needed a simple way to make decisions about products and pricing. Since most costs at the time were variable, managers could simply total the variable costs for a product and use this as a rough guide for decision-making.

For example: In order to make a railway coach a company needed to buy $60 in raw materials and components, and pay 6 labourers $40 each: total variable costs of $300. If managers knew that making a coach required spending $300, then they couldn't sell below that level without losing money. Any price above $300 became a contribution to the fixed costs of the company (say $1000 per month for rent, insurance and owner's salary). So the company could sell 5 coaches for $3000 or 10 coaches for $4500 and make a profit of $1500 in both cases.

Standard costing

Standard costing took the idea further, by dividing the fixed costs by the number of items produced, and treating the result as if it were a variable cost. This enabled managers to effectively ignore the fixed costs, simplifying the decision process even more.

For example: if the railway coach company 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 unit 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 10 coaches, then the unit cost = $400 per coach ($300 + ($1000/10)), a relatively minor difference.

Evolution of standard costing

  • As time went on, the practice of paying workers on a 'set-piece' basis changed in favour of paying on an hourly rate.
  • Organizations with a wide range of products or services have many tasks common to several finished items, making set-piece impractical.
  • Costs of materials may vary over time.
  • Equipment has become more complex and specialized and may be a significant variable in overhead costs.
  • Modern companies tend to have relatively low truly variable costs (primarily raw material, commissions or casual workers) and very high fixed costs (interest payments, salaries, insurance).

As a result, the terms "direct costs" and "indirect costs" often replace the variable/fixed terminology, to better reflect the way allocation of overhead is actually calculated. Indirect costs (often large) are usually allocated in proportion to either direct costs, or some physical resource utilization.

One effect of the above is that the practice of allocating fixed costs has a far more distorting impact on unit cost figures than it ever used to have.

For example: say the railway coach company paid its workforce a fixed monthly rate of $8000 (total) and its other fixed costs had risen to $2600/month making the total fixed costs = $10600/month. The unit cost to make 40 coaches per month is still $325 per coach ($60 material + (10600/40)), while 100 coaches would have a unit cost of $166 per coach ($60 + ($10600/100)), and 10 coaches would 'cost' $1120 each. Managers using the unit cost figure based on 20 coaches per month would likely reject an order for 100 coaches if the selling price was only $300 per unit. If they used the original fixed/variable cost distinction, they would see clearly that this order contributes to the fixed costs by $240 per coach ($300-$60 materials) and would result in a net profit of over $10,000.

Activity-based costing

Activity-based costing (ABC) is costing by activities. In this case, activities are those regular actions performed inside a company. "Talking with customer regarding invoice questions" is an example of an activity performed inside most companies.

Accountants assign 100% of each employees time to the different activities performed inside a company (many will use surveys to have the workers themselves assign their time to the different activities). The accountant then can determine the total cost spent on each activity by summing up the percentage of each worker's salary spent on that activity.

Each product or service is produced and delivered via the activities performed in the company. The accountant can then assign the different activities to the different products using an appropriate allocation method.

A company can use the resulting activity cost data to determine where to focus their operational improvement efforts. For example, a job based manufacturer may find that a high percentage of their workers are spending their time trying to figure out a hastily written customer order. Via ABC, the accountants now have a dollar amount that will be associated with the activity of "Researching Customer Work Order Specifications". Senior management can now decide how much focus or money to budget for the resolutions of this process deficiency. The use of activity-based costing to manage a business is called activity-based management.

Other costing methods

In recent years, more varieties of costing methods have been proposed in order to tailor for different aspects of the business. Some of the uprising ones include inventory costing method, process costing method, average costing method, target costing method.

Still the standard methods and normal costing methods are the best established methods in the accounting world.

See also

Accountancyde:Kosten- und Leistungsrechnung es:Contabilidad de costes ja:原価計算


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