Cost Accounting

Part 1 Notes
Cost accounting for tough (modern) times
Cost accounting systems provide information (both financial and non-financial) that can
help decision-makers in companies (and NGOs and institutions) to achieve the objectives
of their organization and enhance its performance. Most companies today aim primarily
to maximize their profits. However, this objective is increasingly problematic for a
variety of reasons related to the global financial crisis and its aftermath, modern times
that many analysts compare to the economic recession of the 1930s, which followed the
Wall Street crash and Charlie Chaplin depicted in the film Modern Times. Challenges
facing contemporary firms include the following:
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Weak consumer confidence (salaries not matching inflation) and buying power
High inflation
Low employee morale/ motivation (conflicts of interests between employees and
owners)
Public criticism and distrust
Environmental crises
Poor credit availability
Capital kings: little investment, companies buying back stock/shares
Lack of understanding of the root causes of current crises and recessions

These are major systemic problems (i.e. attached to capitalism our current socioeconomic system) that cost accounting cannot solve. However, throughout this course
we will gain a better understanding of these and other problems and challenges facing
organizations, and how decision-makers (like you) can make use of accounting to
respond to them in effective, innovative ways.
and the importance of theory
This course emphasizes theory to enable you to understand todays corporations, their
limits and their possibilities. So that you are not just number crunchers, but actors who
can develop new interpretations and respond to ever changing economic, social, and
political environments. We will see that the numbers part of cost accounting is
straightforward and in practice is supported by a wide range of technologies. However,
computers cannot manage people to achieve, or re-define the aims of a company.
Sustainability as a new business model of performance?
The textbook we draw on in this course, Cost accounting: A managerial emphasis
(Horngren et al., 2012), is the latest edition of an established series. This provides useful
information about terms and methods but is less helpful for understanding the problems
facing companies internally and externally. Nevertheless, one of the novelties of this
edition is an idea of sustainability: the development and implementation of strategy to

achieve long-term financial, social, and environmental performance. This new business
model is a focus of debate in business, academia, and media circles as people question
how substantial a change it really is. Focusing on the cost accounting practices of
companies can help us answer this question, as we learn about their short and long-term
strategies.
Strategy, the rise cost accounting the fall of financial accounting?
Because cost accounting is a tool for managerial decision-making and strategy, this
course aims to give you a broad understanding of management and the roles of cost
accounting systems.
Top managers and researchers increasingly recognize the
importance of cost accounting in developing and implementing strategy how a
company uses its specific capacities to meet opportunities in the market and satisfy
customers. Some researchers, such as Johnson and Kaplan (1986, 2010), argue that
reliance on financial accounting information leads to bad strategy, mistakes, and poor
performance. In contrast, researchers adopting a critical perspective attribute the rise of
strategic cost management to conflict between the interests of employees who earn
salaries and bonuses (including managers), and employers (including investors) who take
the profits generated by their efforts. From this critical perspective, cost management
systems (such as flexible budgets, activity-based-management, and performance
measures) aim to control employees to ensure the maximization of private profit and
capital accumulation. In practice, many managers and employees may agree with this
perspective and resent the budgets and performance targets that superiors give them.
However, there are also cases of organizations in which employees and managers view
cost accounting systems as a means of influencing their working lives, the aims of their
organization, and its impact on wider social and economic structures.
The course therefore aims for you to understand both the potentials and limits of cost
accounting in organizations. Regarding the differences between cost accounting and
financial accounting, it is clear that cost accounting provides a more effective means of
planning and evaluating profitability than financial reporting. We will see that the key
planning tool is a budget, along with budgeted targets. Financial accounting, by contrast,
only gives us past data (though this is useful for setting budgets).
Main differences:
Another important difference between financial accounting and cost accounting is that
whereas financial accounting systems provide information for external groups such as
the government, groups in society, and investors cost accounting enables entrepreneurs,
managers, and other members of an organization, to control how their activities use
resources. While financial accounting reports past information (reports on 2011
performance prepared in 2012), cost accounting is future orientated (budget for 2012
prepared in 2011). This is because of its emphasis on planning and evaluation by the
members of an organization. Cost management describes how managers use resources
effectively to create value for customers and achieve organizational goals.

Adding value not just cutting costs

Value is the real and perceived usefulness of a service or product in short, its social
usefulness. Companies add value to products and services by improving the key success
factors:

Cost and efficiency - target cost

Quality - performance measures
Time - performance measures
Innovation coordination
Sustainability

By constantly improving these factors, companies can achieve sustainability strategy to

achieve long term financial, social, and environmental performance.
The value chain describes how accounting enables a company to track how each
business activity (or function) of an organization uses resources to achieve its goals.
These activities comprise R&D, Design, Production, Marketing, Distribution, and
Customer Service. The aim of monitoring these activities is to reduce costs and improve
efficiency in terms consistent with the objectives of the business. This task often
involves finding ways to improve coordination and integration of activities and aims of a
business. Improving the integration of activities may improve the cost and efficiency,
quality, time, and innovation, of a company, the key success factors necessary to
achieve sustainability.
The following guidelines indicate generally accepted approaches to cost accounting in the
current historical context:

Cost benefit approach: Companies should use resources if the expected benefits
outweigh the costs. These benefits are not easily quantifiable, depending instead
on the specific strategy of the company
New emphasis on behavioral & technical considerations including the
sustainability model
Different costs for different purposes, for example:

a. Preparing financial statements for external reporting under generally accepted

accounting principals (GAAP) require only inventoriable costs,
b. Contracts with government agencies demand a broader set of costs e.g. R&D, as well
as production costs, or
c. Pricing and product mix decisions need a still broader set of costs including all the
functions of the value chain.
Decision makers in organizations usually need to know the total costs of a particular
activity or product (cost object). Understanding how to compute total costs in order to
work out operating income (often through the gross margin measure) is a focus of this
course.
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Basic cost terminology

An actual cost is the cost incurred (a historical or past cost), as distinguished from a
budgeted cost, which is a predicted or forecasted cost (a future cost). We tend to think of
finding the cost of a particular thing; we call this thing a cost object anything for which
a measurement of costs is desired. Cost objects include products, services, activities,
processes, departments, and customers.
How does a cost system determine the costs of various cost objects? Typically in two
stages: accumulation, followed by assignment. Cost accumulation is the collection of
cost data in some organized way through an accounting system. BMW, for example,
collects (accumulates) costs in various categories such as different types of material,
labor, and costs incurred for supervision. Managers and accountants then assign these
accumulated costs to designated cost objects, such as different models of car etc.
By computing the budgeted and actual costs of their operations, organizations can
evaluate their performance and look for ways to manage resources more effectively to
attain organizational goals. These goals may change and imply different levels and kinds
of activity, which use resources in different ways. Cost management allows an
organization to monitor and control how the costs that it incurs change in relation to
levels or volume of activity to achieve specific aims. We call this managing cost
behavior.
Cost behavior patterns: There are two main patterns of cost behavior recognized by
costing systems. A variable cost changes in total in proportion to changes in total activity
or volume. A fixed cost remains unchanged in total for a given time period, despite
changes in the related total activity or volume. Costs are defined as variable or fixed with
respect to a particular activity and for a given time period.
To illustrate these two basic types of cost behavior consider the BMW plant.
1. Variable costs: the steering wheel cost is variable because the total costs of steering
wheels changes in proportion to changes in the amount of cars produced. It is precisely
because the variable cost per steering wheel is the same for each steering wheel that the
total cost varies proportionately with the number of X5 cars produced.
2. Fixed costs: consider total cost incurred for supervisors that work exclusively on the
X5 range. The total costs remain unchanged with respect to the total activity (number of
cars produced). Because total supervisor costs are fixed (1), fixed supervision cost per
X5 produced decreases (3) as the number of X5 increases (2), as the same fixed cost is
spread over a larger number of X5s (3=12). Again, it is that total costs of supervision
remain unchanged with respect to changes in the level of total activity or volume.
Managing cost behaviour: When using cost systems, it is important to recognize that
individual costs are not inherently variable or fixed. In other words, the ways in which a

resource is used in relation to a companys activity levels can be managed to better

achieve its objectives.
Labour costs are a good example. Labour costs can be variable with respects to units
produced when workers are paid on a piece-unit basis (piece-rate). Garment workers
may be paid in relation to shirt sown. In contrast, labour costs at a plant in the coming
year might be appropriately fixed. Union agreements night set annual salaries and
conditions, contain a no-layoff clause etc. Japanese companies, in particular, are known
for their successful policy of lifetime employment. What might be some of the benefits
of this policy? Benefits could include increased loyalty, motivation, and dedication to the
company, thus enabling higher productivity.
Cost drivers: An important way to develop the strategy of an organization and create
value is by identifying cost drivers. A cost driver is a variable, such as the level of
activity or volume, which causally affects costs over a given time span. For example, if
product design costs change with the number of parts in a product, the number of parts is
a cost driver. Miles driven is often a cost driver of distribution costs.
Relevant range: Relevant range is the band of normal activity level or volume in which
there is a specific relationship between the level or activity or volume and the cost in
question. For example, a fixed cost is only fixed in relation to a wide range of total
activity or volume (at which the company is expected to operate) and only for a given
time span (usually a particular budget period). Fixed costs may change from one year to
the next. For example, if the rental costs of hiring delivery trucks increase.
The basic assumption of relevant range also applies to variable costs. That is, outside of
the relevant range, variable costs, such as materials, may not change proportional with
changes in production volume. Above a certain volume, for example, material costs may
increase at a lower rate because of price discounts on purchases greater than a certain
quantity.
Total costs and unit costs: So far, we have looked at cost behavior in terms of total costs
and levels of activity. However, in some contexts such as preparing financial reports or
making product mix and pricing decisions calculating a unit cost is essential.
Accounting systems usually report both total-cost amounts and average-cost-per-unit
amounts. A unit cost, also called an average cost, is computed by dividing the total cost
by the number of units, which might be expressed in different ways (e.g. cars assembled,
packages delivered or hours worked).
Direct costs and indirect costs (overhead): Understanding costs in terms of direct and
indirect costs can enable decision-makers to gain a more accurate understanding of the
resources used by their organizations activities. This knowledge is vital for an
organization to develop the critical capacities that differentiate it from competitors.
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Direct or prime costs of a cost object can be traced to it in a cost effective way
(economically feasible). For example, the cost of steel is a direct cost of the

BMW X5, and can be easily traced to it. The workers on this line record the time
spent working on the X5 on time sheets. The cost of this labour can be easily
traced and is another example of direct costs. The term cost tracing is used to
describe the assignment of direct costs to a particular cost object.
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Indirect costs or overheads are related to a cost object but cannot be traced to
the cost object in an economically feasible way. For example, the salaries of plant
managers who oversee production of many different cars at the plant are an
indirect cost of the X5 because they also oversee production of other products.
The notion indirect can be misleading, as they are necessary for computing the
total costs of a companys operations. The term cost allocation is used to describe
the assignment of indirect costs to a cost object.

Costing is an averaging process, which enables a company to measure its performance

against social benchmarks. Calculating indirect costs is crucial for a company to monitor
its performance. Cost allocation is also central to fostering motivation in an organization,
and can improve the management of resources to achieve a wide range of social goals.
Costs may simultaneously be:
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Direct and variable

Direct and fixed
Indirect and variable
Indirect and fixed

Different types of companies use resources in different ways, and therefore face different
accounting issues. They are typically defined in three main sectors: manufacturing,
merchandising, and service-sector companies
Manufacturing companies purchase labour and materials, and transform them into
various types of finished good. They often have one or more of the following types of
inventory:
1. Direct materials inventory direct materials in stock and awaiting use in the
manufacturing process.
2. Work-in-process inventory goods partially laboured on but not yet completed.
3. Finished goods inventory goods completed but not yet sold.
Merchandising companies purchase tangible products then sell them without changing
their basic form they hold one type of inventory which is products in their original
purchased form; merchandise inventory. Service-sector companies provide services or
intangible products and so dont hold inventories.
Inventoriable costs are all costs of a product that are considered as assets in the balance
sheet when they are incurred, and that become cost of goods sold only when the product
is sold. When the finished good is sold the cost of producing it is matched against

revenues, which are inflows of assets (usually cash if accounts receivable) received for
products or services provided to customers. The costs of goods sold include all
manufacturing costs incurred to produce them (direct material, direct labour, and factory
overhead costs).
Goods may be sold in a different accounting period than the period in which they were
manufactured. Thus, inventorying manufacturing costs in the balance sheet during the
accounting period that they were made and expensing the manufacturing costs in a later
income statement when they are sold matches revenues and expenses.
Period costs are all costs in an income statement other than cost of goods sold (e.g. R&D
costs, design costs etc). Period costs are treated as expenses of the accounting period in
which they were incurred as they are expected to benefit revenues in that period, not in
future periods. Expensing these costs in the period they incurred matches revenues to
expenses.