Cost Accounting Fundamentals: Fifth Edition: Essential Concepts and Examples 5th Edition
Book Preface
Cost Accounting Fundamentals describes the key cost accounting concepts that most concern the practicing cost accountant, and illustrates them with numerous examples to improve comprehension. The book is designed for both professional accountants and students, since both can benefit from its detailed descriptions of inventory valuation methods, product pricing techniques, cost analysis methods, and more. Cost Accounting Fundamentals addresses five major cost accounting topics, which are:
•Part I – Job Overview. Chapters 1 and 2 describe the nature of cost accounting and the details of the cost accountant job description.
•Part II – Inventory Valuation. Chapters 3 through 9 describe the various methods used to value inventory, including job costing, process costing, standard costing, joint and by-product costing, and accounting for waste products.
•Part III – Product Pricing. Chapters 10 through 12 describe the contribution of cost accounting to product pricing, including a lengthy discussion of how much a product costs for pricing purposes, how target costing works, and the mechanics of transfer pricing.
•Part IV – Cost Analysis Methods. Chapters 13 through 16 address a number of analysis methods, including direct costing, activity-based costing, constraint analysis, and capital budgeting analysis.
•Part V – Other Topics. Chapters 17 through 19 cover several additional topics – how to collect cost-related information, the variability of costs under different circumstances, and the cost of quality.
Cost Accounting Fundamentals is designed to give you a complete grounding in the essentials of cost accounting. As such it may earn a place on your bookshelf as a reference tool for years to come.
Centennial, Colorado
February, 2016
Introduction
At its simplest, cost accounting is about calculating the cost of a product or service. However, this viewpoint does a disservice to the cost accountant, who can use a broad array of methods to provide a great deal of additional information to management. In many respects, cost accounting is the only truly value-added activity in the accounting department, because it yields many insights that management can use to pursue the most profitable products, streamline expensive operations, and reallocate resources.
This chapter focuses on the primary cost accounting activities, and how they can improve a company’s tactical direction and profitability.
Financial Reporting
The cost accountant has an ongoing responsibility to calculate the cost of ending inventory. This calculation has a major impact on a company’s gross margin (which is revenues less the cost of goods sold), and so draws the attention of auditors, who comb through the cost accountant’s calculations to verify their accuracy. A small error in valuing the ending inventory can translate into a large change in a company’s financial results, so this is likely the highest-profile activity in which a cost accountant engages.
Valuing inventory is not a simple calculation. It is the culmination of a complicated series of steps that involve having a high level of inventory record accuracy (which may require counting the inventory), correctly using an inventory layering method (see the Inventory Valuation chapter), accounting for any obsolete inventory, and adjusting inventory costs as necessary. There are a vast number of transactions that impact inventory valuation, so the cost accountant will likely spend a large amount of time investigating problems and updating recordation systems to improve the quality of information.
Early in a cost accountant’s career, inventory valuation for financial reporting purposes is likely to be the central focus of his activities. Once he gains a working knowledge of how to deal with the intricacies of inventory valuation, he can move on to the other topics addressed in the remainder of this chapter.
Management Reporting
The cost accountant’s financial reporting responsibilities do not end with valuing inventory for a company’s financial statements. There are also an unending series of requests from management to provide information to them on many topics. Typical report requests are:
•Analysis of capital expenditure proposals. Department managers who want to spend large amounts on fixed assets usually provide documentation to management that supports their arguments. The cost accountant should review these proposals and comment on such factors as whether forecasts are reasonable, whether purchases will improve the company’s bottleneck operation, and whether all costs likely to be incurred are actually included in the documentation. This analysis may not extend to making an approval recommendation, but the cost accountant should provide enough information to clarify the issue for management.
•Cost center performance. There are many cost centers in a company (such as the accounting department!), for which the cost accountant should report on the trend of expenses incurred, as well as their related output, so that management can view their levels of efficiency. This information may be used to outsource selected cost centers.
•Cost trends for key commodities. The profitability of some companies is heavily dependent upon the cost of the commodities that they incorporate into their products, especially if it is difficult to pass along cost increases to customers. The cost accountant should monitor these cost changes closely.
•Customer performance. It is easy to report on revenues by customer, but much more difficult (and insightful) to report on profits by customer. It is also useful to report on such additional factors as customer backlog, customer returns, discounts given, and outstanding accounts receivable.
•Decision follow up. This is a general category of report that applies to many types of analysis. Whenever management makes a decision, the cost accountant may be called upon to return to the decision at some point in the future to investigate whether the assumptions used to make the decision were accurate, and what circumstances caused changes in the original forecasts.
•Metrics. Management may want a trend-line report of those metrics that relate most closely to a company’s critical success factors. It is not sufficient to simply present the information – the cost accountant should also investigate and provide explanations of why metrics have changed over time. Examples of commonly-used metrics are the return on assets, inventory turnover, and accounts receivable turnover.
•Profitability by department. These analyses tend to include a large amount of detail on all expense line items, and may include non-financial metrics, such as revenue or cost per employee, or transaction error rates pertaining to a specific department.
•Profitability by job or project. These reports generally do not include overhead costs, unless they can be reliably traced to specific jobs or projects. The cost accountant needs to have a good knowledge of what costs are truly relevant to determine what costs to include in these reports. Many jobs and projects have their own budgets, so these reports may include variances from their budgets, and why the variances occurred.
•Profitability by product. Reporting at the product level can be difficult, because such analyses should not include an overhead allocation in many instances, especially when management is deciding whether to drop a product. Instead, this analysis tends to focus on only those costs that vary directly with the presence or absence of a specific product.
•Profitability by product line. This is one of the best analyses, because it is usually possible to include a significant amount of overhead allocation; overhead costs are frequently incurred at the product line level, so overhead can be traced to a specific product line.
The advantage of internal reporting is that the cost accountant is not constrained by the dictates of generally accepted accounting principles or international financial reporting standards to present information in a certain format. Instead, it is quite allowable to add to or strip away information in accordance with the specific situation for which the cost accountant is creating a report. In many cases, it may be useful to use direct costing (see the Direct Costing chapter), which only includes information that will change as the result of a decision. Other possible reporting methods include job costing, process costing, standard costing, activity-based costing, and so on – in short, it is possible to select from a full palette of cost analysis methodologies.
In particular, the cost accountant will rarely have a need to use full absorption costing in a management report, since the inclusion of overhead costs that is required under full absorption costing is not only irrelevant to many situations, but may present misleading information. Absorption costing is a methodology under which all fixed and variable manufacturing costs are assigned to products, while all non-manufacturing costs are charged to expense in the current period.
EXAMPLE
Kelvin Corporation’s president asks the cost accountant to create an analysis of whether the company should drop its oldest product line, which is a series of mercury-based glass thermometers that are primarily sold into the elementary school market for chemistry classes for an average price of $5.25 each. The cost accountant investigates and finds the following costs on a per-unit basis:
The company intends to shut down the entire production line for these glass thermometers, so the variable overhead element of the cost will be eliminated if the product line is stopped. However, the fixed overhead cost is related to the cost of the entire facility in which the company operates, and these costs will not go away if the company drops the product line. Thus, though the total cost of a thermometer is $5.50, the cost relevant to this product elimination decision is $4.00. The $4.00 cost is less than the price being charged to customers, so the company will fare better if it retains the product line and uses its gross margins to help pay for fixed overhead.
Note:A relevant cost is a cost that relates to a specific management decision, and which will change in the future as a result of that decision.
A key issue to remember when reviewing the preceding array of possible internal reports is that the cost accountant should have a strong ability to present information clearly. Too frequently, an otherwise perfectly competent cost accountant presents a dense spreadsheet to management, and points out that the answer to their query is buried deep in the spreadsheet. It takes considerable experience to create management reports that display key information prominently and persuasively.
Problem Resolution
If a company uses just-in-time manufacturing systems, management needs to know about production and inventory issues as soon as they occur, not at the end of the month (which is when most of the reports listed in the last section are released). Accordingly, the cost accountant may become deeply involved on the production floor and warehouse in tracking down the causes of problems, reporting them to management, and actively participating in their resolution.
This type of problem solving may not involve any written report at all – perhaps just a verbal discussion or a brief note. This is the type of cost accounting work that production managers deeply appreciate, and which is the hallmark of a fully-involved cost accountant.
Price Setting
The marketing department is responsible for setting prices, which should be based on supply and demand, rather than the cost of a product. Nonetheless, the cost accountant is closely involved in price setting for four reasons:
•Incremental pricing. There may be situations where the company receives an offer from a customer for a one-time deal to provide products at a reduced price. The cost accountant provides input into whether or not this will be a good deal for the company.
•Cost-based pricing. Many companies still base their prices on costs incurred, with a profit margin added. In these situations, the cost accountant likely controls a substantial recordkeeping system that accumulates direct costs and allocates overhead costs in detail.
•Government contracts. Many governments order items on a cost-plus basis, where the supplier is reimbursed for all costs incurred, plus a reasonable profit. This situation arises when the government orders completely unique items that suppliers are uncomfortable setting a price for (such as in military equipment contracting). In this situation, the cost accountant must learn the intricate government costing rules, create a system that can verifiably accumulate the correct costs, and properly allocate approved overhead costs. A government auditor may reject certain costs, in which case the cost accountant must also prepare a justification for why the company is applying for cost reimbursement. Government billing is a significant sub-discipline that can swallow up all of a cost accountant’s time.
•Lowest possible price. The marketing manager does not want to inadvertently set a price below the company’s cost to produce it, so the cost accountant supplies cost information pertinent to this decision.
Providing cost information for pricing decisions is a significant topic that is dealt with in much greater detail in the “Product Pricing: What Does This Cost?” chapter.
Cost Investigation
Thus far, we have focused on reports and analyses that other parties have asked the cost accountant to complete. The cost accountant also has an ongoing obligation to investigate costs throughout the company, to decide if those costs are reasonable, and to report back to management when he sees an opportunity to reduce costs. Here are some tools to use in the cost investigation role:
•5S analysis. Review the efficiency of the workplace. The name of this analysis is derived from Sorting through all items in the workplace to dispose of unneeded items, Straightening furniture and equipment to improve the process flow, Scrubbing the area, Systematizing the operation to ensure ongoing cleaning activities, and Standardizing the 5S system so that it is used in all company operations.
•Fixed cost analysis. Examine the option of expending more on various fixed costs in order to spend less on variable costs (such as when funds are invested in production line automation). In many cases, it makes more sense to avoid the high fixed cost option, which would otherwise increase the company’s breakeven point and thereby make it more difficult to earn a profit if sales decline.
•Parts consolidation. Work with the engineering staff to reduce the variety of parts used in products. By designing the same components into multiple products, a company can achieve higher component purchasing volumes, which leads to higher volume discounts.
•Spend analysis. Work with the purchasing staff to summarize purchasing information by supplier and by commodity, and use the information to concentrate purchases with a small number of suppliers to achieve volume purchasing discounts.
•Spend compliance. Track the company’s ability to purchase from just those suppliers with whom the company has engaged in volume discount arrangements, and issue reminders to anyone deviating from the established purchasing plan. Also, compare the contractual prices that suppliers have committed to charge the company to their actual billings, and apply for pricing reductions where necessary.
•Waste analysis. Identify various types of waste throughout the organization for elimination. This can include non-value-added activities, errors and defects that must be researched and repaired, any type of inventory, excess employee motion, the production of excessive quantities, the transport of materials over excessive distances, and excessive employee wait times.
•Workforce cost analysis. Determine which costs are directly traceable to individual employees, such as their wages, payroll taxes, benefits, stock grants, and so forth, and have this information available when management needs to conduct a workforce reduction. This may involve a further analysis of what services will be eliminated or reduced as a result of the reduction. It may also be necessary to review alternatives to a workforce reduction, such as delaying new hires, delaying pay raises, cutting pay, reducing the work week, and reducing staff through attrition.
The number of tools noted above makes it clear that the cost accountant works in a “target rich environment” that is a massive source of cost reduction opportunities. Cost reduction alone can easily be a full-time job, even in a smaller company. See the author’s Cost Management book for more information.
The tools noted here can be used anywhere; it is perfectly acceptable to investigate costs in all departments, both in the production and administrative sides of a business.
Budget Formulation
The cost accountant is probably not responsible for creating the annual corporate budget, but he is certainly involved in supplying a large amount of the information used in the budget. The following information may be supplied or at least reviewed by the cost accountant:
•Production budget. Supply estimated materials, labor, and overhead costs. Also, comment on the validity of budgeted overtime, labor utilization, machine utilization, and efficiency.
•Capacity planning. If there is a capacity planning page in the budget, comment on whether the company has the capacity to achieve its budgeted goals.
•Department budgets. It may be necessary to derive estimated costs for any department, or to at least comment on the budgets proposed by department managers.
The cost accountant’s level of involvement in the budgeting process is substantial, and is based on his knowledge of the inner workings of the company – the work capacity of each department, where costs are incurred, and when additional step costs may be required. A step cost is a fixed cost that does not change within a specific range of utilization levels. Once utilization shifts outside of that range, additional costs must be incurred (for increased utilization levels) or can be eliminated (for decreased utilization levels).
Constraint Analysis
The true level of profitability of the typical organization is driven by its bottleneck operation, which is also known as its constrained resource. The cost accountant should know exactly where this constrained resource is located, and have an excellent knowledge of how that resource can be maximized, such as through the positioning of an inventory buffer in front of it to ensure the smooth inflow of materials, using excess staffing on the equipment, or implementing a quick changeover study to create faster setups. This crucial topic is addressed further in the Constraint Analysis chapter.
Cost Accumulation Systems
An immensely important item that tends to be ignored is the type of system that a company uses to accumulate costs. This system is grounded on the types of analyses that are needed to properly steer a company into profitability.
EXAMPLE
Kelvin Corporation sells 50% of its electronic thermometers to a weather-oriented website that demands discount pricing, drop shipping services, free delivery to customers, and promotional discounts. It also pays late, at inconsistent intervals. Since this customer comprises such a large part of Kelvin’s business, it is critical to determine the true cost of sales to it. Accordingly, Kelvin’s cost accountant creates a cost accumulation system that tracks customer-specific costs for discounts, drop shipping, and freight. Since late payments vary, he elects to manually calculate the interest cost of these payments, and add it to the results of the cost accumulation system.
It is particularly important to have a robust cost accumulation system if a company does business with government entities, since they may require detailed cost information if they are paying under cost-plus arrangements.
Another cost accumulation issue is how to properly structure overhead allocation systems. Allocation of overhead is the process of assigning overhead costs to products or services based on some relevant measure of activity. Though overhead allocation is not relevant in many decision-making situations (see the Direct Costing chapter), it is still important in cost-plus reimbursement contracts and for financial reporting to have a justifiable reason for allocating overhead to a product or service. Accordingly, the cost accountant needs to periodically verify which costs are defined as overhead, how they are being accumulated for allocation, and the basis upon which those allocations are calculated.
Summary
Much of the discussion in this chapter makes the cost accountant look like a glorified financial analyst who also happens to have a deep grounding in cost accounting. That impression is largely correct – the cost accountant is indeed the nearest thing to a financial analyst in many companies, since a multitude of analyses require a deep knowledge of cost data and how to manipulate it. The cost accountant then converts his findings into a report, along with an action recommendation.
Cost accounting is a considerably more interesting area than financial accounting. The cost accountant is involved in a broad range of daily decisions that impact the ongoing financial health of a corporation, whereas those accountants dealing with financial accounting are primarily concerned with producing financial statements in accordance with the rigid dictates of either generally accepted accounting principles or international financial reporting standards.
Table of Contents
Chapter 1 – Overview of Cost Accounting
Financial Reporting
Management Reporting
Problem Resolution
Price Setting
Cost Investigation
Budget Formulation
Constraint Analysis
Cost Accumulation Systems
Chapter 2 – The Cost Accountant Job Description
To Whom Does the Cost Accountant Report?
What Are the Principal Accountabilities of the Cost Accountant?
What Are the Qualifications of a Cost Accountant?
Who Does the Cost Accountant Supervise?
Chapter 3 – Types of Costs
Actual Costs
Avoidable Costs
Committed Costs
Conversion Costs
Deferred Costs
Differential Costs
Direct Costs
Discretionary Costs
Expired Costs
Fixed Costs
Historical Costs
Indirect Costs
Irrelevant Costs
Marginal Costs
Normal Costs
Period Costs
Replacement Costs
Semi-Fixed Costs
Step Costs
Sunk Costs
Traceable Costs
Variable Costs
Chapter 4 – Inventory Valuation
Valuation Step 1: The Quantity of Inventory on Hand
The Periodic Inventory System
The Perpetual Inventory System
The Gross Profit Method
Valuation Step 2a: Inventory Costing
The First In, First Out Method
The Last In, First Out Method
The Dollar-Value LIFO Method
The Link-Chain Method
The Weighted Average Method
Standard Costing
The Retail Inventory Method
Valuation Step 2b: Inventory Costing
Job Costing
Process Costing
By-Product and Joint Product Costing
Valuation Step 3: Overhead Allocation
Valuation Step 4: Inventory Valuation
The Lower of Cost or Market Rule
Obsolete Inventory Accounting
Chapter 5 – Job Costing
Overview of Job Costing
When Not to Use Job Costing
Accounting for Direct Materials in Job Costing
Accounting for Labor in Job Costing
Accounting for Actual Overhead Costs in Job Costing
Accounting for Standard Overhead Costs in Job Costing
The Importance of Closing a Job
The Role of the Subsidiary Ledger in Job Costing
Job Costing Controls
Chapter 6 – Process Costing
Overview of Process Costing
The Weighted Average Method
The Standard Costing Method
The First In, First Out Method
The Hybrid Accounting System
Process Costing Journal Entries
Problems With Process Costing
Chapter 7 – Standard Costing
Overview of Standard Costing
Advantages of Standard Costing
Disadvantages of Standard Costing
How to Create a Standard Cost
Historical, Attainable, and Theoretical Standards
How to Account for Standard Costs
Overview of Variances
The Purchase Price Variance
Material Yield Variance
Labor Rate Variance
Labor Efficiency Variance
Variable Overhead Spending Variance
Variable Overhead Efficiency Variance
Fixed Overhead Spending Variance
Selling Price Variance
Sales Volume Variance
Problems with Variance Analysis
The Controllable Variance
The Favorable or Unfavorable Variance
Where to Record a Variance
Which Variances to Report
How to Report Variances
Chapter 8 – Joint and By-Product Costing
Split-Off Points and By-Products
Why We Allocate Joint Costs
How to Allocate Joint Costs
How to Determine Prices
Special Concerns With By-Product Costing
Chapter 9 – Waste Accounting
Definition of Spoilage
Accounting for Normal Spoilage
Accounting for Abnormal Spoilage
Accounting for the Sale of Spoilage
Cost Allocation to Spoilage
Definition of Rework
Reporting Rework
Accounting for Rework
Definition of Scrap
Accounting for Scrap
Impact of Waste on Manufacturing Systems
Chapter 10 – Product Pricing
What Does This Cost?
The Issue of Pricing Duration
The Issue of Overhead Costs
The Issue of Overhead Application
Corporate Overhead Costs
What Does This Cost, Part Two
The Issue of the Bottleneck
What Does This Cost, Part Three
Chapter 11 – Target Costing
The Basic Steps of Target Costing
Value Engineering Considerations
The Cost Reduction Program
The Milestone Review Process
Problems with Target Costing
The Members of a Design Team
The Role of the Cost Accountant in Target Costing
Data Sources for Target Costing
The Product Life Cycle and Target Costing
Chapter 12 – Transfer Pricing
Overview of Transfer Pricing
Market Price Basis for Transfer Pricing
Adjusted Market Price Basis for Transfer Pricing
Negotiated Basis for Transfer Pricing
Contribution Margin Basis for Transfer Pricing
Cost Plus Basis for Transfer Pricing
Cost Anomalies in a Cost-Based Transfer Price
Pricing Problems Caused by Transfer Pricing
The Tax Impact of Transfer Prices
Chapter 13 – Direct Costing
Overview of Direct Costing
Contribution Margin versus Gross Margin
Direct Costing as an Analysis Tool
Direct Costing Pitfalls
Chapter 14 – Activity-Based Costing
The Problem with Overhead Allocation
Overview of Activity-Based Costing
Activity-Based Management
Advantages of Activity-Based Costing
Problems with Activity-Based Costing
The Incremental Cost Reduction Fallacy
The Bill of Activities
System Scope Issues
System Integration Issues
Chapter 15 – Constraint Analysis
Constraint Analysis Operational Terminology
Overview of Constraint Analysis
The Cost of the Bottleneck
Local Optimization
Constraint Analysis Financial Terminology
Constraint Analysis from a Financial Perspective
The Constraint Analysis Model
The Decision to Sell at a Lower Price
The Decision to Outsource Production
The Capital Investment Decision
The Decision to Cancel a Product
Comparison of ABC to Constraint Analysis
Chapter 16 – Capital Budgeting Analysis
Overview of Capital Budgeting
Bottleneck Analysis
Net Present Value Analysis
The Payback Method
Accounting Rate of Return
Capital Budget Proposal Analysis
The Outsourcing Decision
The Capital Budgeting Application Form
Capital Rationing
Capital Budgeting with Minimal Cash
The Post Installation Review
The Lease versus Buy Decision
Chapter 17 – Cost Collection Systems
Data Entry Accuracy
Data Entry with Bar Codes
Data Entry with Radio Frequency Identification (RFID)
Document Imaging
Special Considerations for Labor Tracking
The Duration of Cost Collection
The Chart of Accounts
Backflushing
Other Sources of Cost Information
Chapter 18 – Cost Variability
Mixed Costs
Labor-Based Fixed Costs
Costs Based on Purchase Quantities
Costs Based on Production Batch Sizing
Cost Based on Step Costs
Time-Based Costs
Experience-Based Costs
Incorporating Cost Variability into Reports
Chapter 19 – Cost of Quality
Types of Quality
Costs Impacted by Quality
Reporting on the Cost of Quality
Glossary
Index
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