This article explains the essential concepts of cost accounting. The overview provides an introduction to the basic cost accounting objectives and techniques, the roles of the controller and cost accountant within the corporate management structure and the ethical considerations that guide cost accountants. This article also explains the basic cost accumulation methods that are used in cost accounting systems. These methods include job order costing, process costing, backflush costing, hybrid costing and joint and by-product costing. Further, explanations of the most common costs that companies must plan for and control are included, such as direct labor, direct material and factory overhead costs. Finally, this overview describes how cost accounting techniques affect business considerations in areas such as budgeting, pricing and inventory costing methods, which include throughput, direct, absorption and activity-based costing systems.
Keywords Activity-Based Costing; Activity-based Management (ABM); Actual Cost System; Backflush Costing; Balance Sheet; By-product; Controller; Cost Accounting; Cost Accumulation; Cost Driver; Direct Labor; Direct Materials; Factory Cost; Factory Overhead; Fixed Cost; Indirect Cost; Job Order Costing; Joint Cost; Labor Productivity; Process Costing; Sunk Cost; Variable Cost
Accounting: Cost Accounting
Cost accounting is the application of accounting and costing principles to the tracking, recording and analysis of the costs associated with the products or services a business produces and the activities involved in the production process. Broadly speaking, cost accounting objectives include the preparation of statistical data, application of cost accumulation and cost control methods to production processes and analysis of an organization's profitability as compared with previous periods of time and projected budgets. Cost accountants use basic accounting techniques to compile and analyze data to meet these objectives. In performing these tasks, cost accountants work within the controller's office or the accounting department of most companies. And in addition to any internal company policies that govern their duties, cost accountants must consider the ethical principles that guide the accounting and financial reporting industries. The following sections provide a more in-depth explanation of these concepts.
Introduction to Cost Accounting
Cost accounting identifies, defines, measures, reports and analyzes the various elements of direct and indirect costs associated with producing and marketing goods and services. Cost accounting also measures performance, product quality and productivity. Direct costs can be directly traced to producing specific goods or services, such as the cost of raw materials used in the production of a final consumer good. Indirect costs are expenditures on labor, materials or services that cannot be economically identified with a specific saleable cost unit. Indirect costs include salaries for employees and rental or lease payments for office or factory space.
Cost Accounting Objectives
The main objective of cost accounting is to compile, analyze and transmit both financial and non-financial information to management for planning, controlling and operational evaluation purposes. At its most basic, cost accounting measures the economic sacrifice an organization makes to achieve its goals. Costs are generally categorized by expenditure type. For instance, product costs represent the monetary measurement of resources an organization uses, such as material, labor and overhead. Service costs are the monetary sacrifices it makes to provide the goods or services. Cost accounting tracks these costs and provides this information to management so that the management team can make more informed business and administrative decisions. For this reason, modern cost accounting often is called management accounting because managers use accounting data to guide their decisions. In addition, managers oversee and distribute resources to most efficiently meet an organization's goals. Managers use the information produced by cost accounting techniques to direct day-to-day operations and supply feedback to evaluate and control performance.
To compile data for management, cost accountants obtain cost information on product and service costs from a variety of sources. For instance, they may use vendor invoices, engineering studies of production processes, employee timesheets and planning schedules from production supervisors. Once they have compiled sufficient records, cost accountants use various means of analyzing the data, depending on the results they are seeking to obtain. Cost analysis techniques include: Break-even analysis, comparative cost analysis, capital expenditure analysis and budgeting techniques.
- The break-even point for a product is the point at which the total revenue generated equals the total costs associated with the production and sale of a given product.
- Break-even analysis is the study of when it is profitable for a business to introduce a new product as opposed to modifying an existing product so that it becomes more lucrative.
- Comparative cost analysis involves identifying the costs associated with the baseline materials and processes and any available alternatives, and calculating the comparative costs between them.
- Capital expenditure analysis involves reviewing the funds spent for the acquisition of long-term assets.
After performing their analyses, cost accountants then use their professional judgment to interpret the results of each costing technique as they apply to different aspects of a company's financial analysis. For example, although breakeven analysis indicates the capacity at which operations become profitable, it assumes a static condition in which sales prices and expenses are constant. However, such factors do not remain constant in the real world. Inflation, supply, and demand cause sales prices and expenses to vary. Cost accountants therefore work with many people in other departments of a company (such as marketing, engineering, manufacturing, financial accounting and human resources personnel) to obtain current information that may account for some of these fluctuations.
Finally, cost accountants collect all costs involved in the process of making goods or providing services and use such cost data for income measurement and inventory valuation. This information also helps management plan and make operational decisions. Because of these responsibilities, cost accountants must exercise initiative and good judgment and meet high ethical standards. Further, cost accountants must provide management with information that may indicate adverse economic conditions when these situations arise, such as reports about poor product quality, cost overruns or abuses of company policies.
Roles of Controllers
A controller is the title that is often given to a company's chief accounting officer or manager of the accounting department. A controller plays a significant role in planning and guiding a company's financial decisions and is often charged with the tasks of designing systems to prepare internal reports for management and external reports for public and government users. A cost accountant is a member of the controller's department and is responsible for collecting product costs and preparing accurate and timely reports to evaluate and control company operations. As such, cost accountants assemble, classify and summarize financial and economic data on the production and pricing of goods or services.
In addition, cost accountants play an important role in coordinating external and internal data so managers can formulate better planning and control activities. In the planning phases, cost accountants help management by preparing budgets that provide cost estimates of material, labor and technology. A company uses this data to review alternative courses of action and to select the best methods of achieving its goals and profit objectives. Cost accounting data are used for both planning and control activities. These activities differ in that planning activities are focused on future goals while control activities involve monitoring present production processes and tracking any variations from estimated budgets and plans. Cost accountants monitor these activities and issue progress reports that summarize the costs of these activities and the efficiency of the processes associated with them. By comparing actual results with the forecasted budget amounts, cost accountants are able to identify areas of deviation where problems may be developing. Cost accountants also compile and relay this information to management so that appropriate decisions can be made to shore up inefficient or failing processes within an organization.
Ethical Considerations Facing Cost Accountants
There are several types of ethical problems that cost accountants may face. One of the major ethical issues that a cost accountant must consider is confidentiality. This issue is particularly important because cost accountants typically have detailed access to sensitive information, such as payroll records, product costs and individual product or departmental profits. Cost accountants must carefully safeguard such information because if improperly disclosed, it could be improperly used by other entities or even by hostile personnel within an organization.
Another issue that cost accountants face is integrity, particularly when faced with difficult tasks that may surpass their training or level of experience. This is critical because the reports and analyses that cost accountants generate become the foundation upon which management teams stake critical decisions, and thus it is imperative that the information contained in these materials be complete and accurate. Finally, cost accountants must maintain the ability to view information and strategies objectively. Objectivity allows a cost accountant to present cost analyses in a fair, well-balanced format that discloses all relevant information pertaining to a decision. Cost accountants may face considerable pressure from managers whose operations are being reviewed to skew reported information in such a way as to make the departments or products they oversee appear to be in better financial standing than they actually are. Thus, ethical considerations such as confidentiality, integrity and objectivity are an important part of the responsibilities that cost accountants face and their observance, or lack thereof, can have a significant impact on a company's future.
One of the most important tasks that cost accountants must accomplish is to gather or accumulate cost information and then assign that information to appropriate products or orders or other processes using a cost management system. The most commonly used costing methods are job order costing and process costing. However, many companies also use joint product or by-product costing or a hybrid costing system. The nature of the activities being analyzed determines which cost management system is most appropriate. The following sections describe these systems in more detail.
Job Order Costing
Job order costing is the typical method for compiling cost accounting information into a usable format. In job order costing systems, costs are assigned to each job, which may be an order, a contract, a unit of production or a batch that is processed according to customer specifications. Thus, job order costing is appropriate for manufacturing and service industries such as design or publishing companies, manufacturing companies that produce special order products, accounting firms that perform audits or any organization producing a tailor-made good or service according to customers’ specific requirements. For example, a graphic design company would likely use job order costing because graphic designers usually produce each design order to a specific customer request. Thus, job costing links all material and direct labor costs directly to a job or batch and all direct and overhead costs associated with that job or batch are accumulated for closer analysis (Bragg, 2005).
One of the major benefits of job costing is that a company’s management team can easily determine all of the various costs being generated for each job being completed. This information allows management to examine each cost to determine why it was necessary and how it can be managed better in the future, thereby contributing to greater levels of profitability in the future. Another reason that companies use job costing is that they can more closely track the costs for each job as it is being fulfilled. Accounting software available today allows companies to use a job costing system to track costs as they arise rather than waiting until the job is complete to compile and assess overall costs. This is advantageous in that a company can oversee the costs incurred for more complex jobs during the production process so that there is sufficient time to make changes to the production process or sales price before the jobs close, based on the costing information provided by the job costing system (Bragg, 2005).
However, there are also considerable problems associated with job costing. An initial problem is that it concentrates attention on the costs incurred by specific products rather than on costs associated with different departments or activities. Another difficulty is that job costing is not always relevant. For example, some software manufacturers have high development costs but little direct costs associated with the marketing or advertising of its products. Finally, job costing requires a significant amount of data entry and data accuracy for the analysis to tender significant results. Minute data related to materials, labor, overhead, indirect labor, scrap, spoilage and supplies must be entered into a system that can accurately assign these costs to their corresponding jobs. This process is open to errors stemming from keying errors or the misidentification of jobs or customers (Bragg, 2005).
Process costing is used in many industries where there are such large quantities of similar products that it makes no sense to track the cost of individual or small batches of products. Instead, costs are averaged over large quantities of production, which yields the same unit costs for all items in a production run. This type of costing requires accounting calculations that are considerably different from those used for job costing. Using a process costing system, accountants accumulate costs for each department for a time period and allocate these costs among all the products manufactured during that period. Companies that mass produce similar goods such as chemicals, bakery goods, or canned food in a continuous production process use process accounting. Direct material, direct labor and factory overhead costs are accumulated for each department for a set period of time; usually a month. At the end of the period, departmental cost is...
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