Cost accounting

In management accounting, cost accounting is that part of management accounting which establishes budget and actual cost of operations, processes, departments or product and the analysis of variances, profitability or social use of funds. Managers use cost accounting to support decision making to reduce a company's costs and improve its profitability. As a form of management accounting, cost accounting need not follow standards such as GAAP, because its primary use is for internal managers, rather than e ternal users, and what to compute is instead decided pragmatically. !osts are measured in units of nominal currency by convention. !ost accounting can be viewed as translating the "upply !hain #the series of events in the production process that, in concert, result in a product$ into financial values. %here are at least four approaches&

"tandardi'ed !ost Accounting Activity(based !osting %hroughput Accounting Marginal !osting ) !ost(*olume(Profit Analysis

!lassical !ost +lements are& ,. -aw Materials .. /abor 0. Indirect + penses ) 1verhead

Contents

, 1rigins . "tandard !ost Accounting

o

.., 2eaknesses of "tandard !ost Accounting for Management 3ecision Making ... %he 3evelopment of %hroughput Accounting

0 Activity(based costing 4 Marginal !osting 5 -eferences 6 "ee also

Origins

!ost accounting has long been used to help managers understand the costs of running a business. Modern cost accounting originated during the industrial revolution, when the comple ities of running a large scale business led to the development of systems for recording and tracking costs to help business owners and managers make decisions. In the early industrial age, most of the costs incurred by a business were what modern accountants call 7variable costs7 because they varied directly with the amount of production. Money was spent on labor, raw materials, power to run a factory, etc. in direct proportion to production. Managers could simply total the variable costs for a product and use this as a rough guide for decision(making processes. "ome costs tend to remain the same even during busy periods, unlike variable costs which rise and fall with volume of work. 1ver time, the importance of these 7fi ed costs7 has become more important to managers. + amples of fi ed costs include the depreciation of plant and e8uipment, and the cost of departments such as maintenance, tooling, production control, purchasing, 8uality control, storage and handling, plant supervision and engineering. In the early twentieth century, these costs were of little importance to most businesses. 9owever, in the twenty(first century, these costs are often more important than the variable cost of a product, and allocating them to a broad range of products can lead to bad decision making. Managers must understand fi ed costs in order to make decisions about products and pricing. :or e ample& A company produced railway coaches and had only one product. %o make each coach, the company needed to purchase ;6< of raw materials and components, and pay 6 laborers ;4< each. %herefore, total variable cost for each coach was ;0<<. =nowing that making a coach re8uired spending ;0<<, managers knew they couldn't sell below that price without losing money on each coach. Any price above ;0<< became a contribution to the fi ed costs of the company. If the fi ed costs were, say, ;,<<< per month for rent, insurance and owner's salary, the company could therefore sell 5 coaches per month for a total of ;0<<< #priced at ;6<< each$, or ,< coaches for a total of ;45<< #priced at ;45< each$, and make a profit of ;5<< in both cases.

Standard Cost Accounting

In modern cost accounting, the concept of recording historical costs was taken further, by allocating the company's fi ed costs over a given period of time to the items produced during that period, and recording the result as the total cost of production. %his allowed the full cost of products that were not sold in the period they were produced to be recorded in inventory using a variety of comple accounting methods, which was consistent with the principles of GAAP. It also essentially enabled managers to ignore the fi ed costs, and look at the results of each period in relation to the 7standard cost7 for any given product. :or e ample& if the railway coach company normally produced 4< coaches per month, and the fi ed costs were still ;,<<<)month, then each coach could be said to incur an overhead of ;.5 #;,<<<)4<$. Adding this to the variable costs of ;0<< per coach produced a full cost of ;0.5 per coach.

%his method tended to slightly distort the resulting unit cost, but in mass(production industries that made one product line, and where the fi ed costs were relatively low, the distortion was very minor. :or e ample& if the railway coach company made ,<< coaches one month, then the unit cost would become ;0,< per coach #;0<< > #;,<<<),<<$$. If the ne t month the company made 5< coaches, then the unit cost ? ;0.< per coach #;0<< > #;,<<<)5<$$, a relatively minor difference. An important part of standard cost accounting is a variance analysis which breaks down the variation between actual cost and standard costs into various components #volume variation, material cost variation, labor cost variation, etc.$ so managers can understand why costs were different from what was planned and take appropriate action to correct the situation.

Weaknesses of Standard Cost Accounting for Management Decision Making

As time went on, standard cost accounting lost its usefulness for management decision making due to a variety of reasons&

%he practice of paying workers on a 'set(piece' basis changed in favour of paying on an hourly rate. Modern companies tend to have relatively low truly variable costs #primarily raw material, commissions or casual workers$ and very high fi ed costs #worker salaries, engineering costs, 8uality control, etc.$. +8uipment has become more comple and speciali'ed and may be a very significant proportion of total costs. !hanges in the level of full cost inventory create swings in profitability that are difficult to e plain or understand. An increase in inventory can 7absorb7 costs of production and increase profits, while a decrease in inventory level will decrease profits. 1rgani'ations with a wide range of products or services have processes which are common to several finished items, making cost allocation irrelevant or misleading.

As a result of the above, using standard cost accounting to analy'e management decisions can distort the unit cost figures in ways that can lead managers to make decisions that do not reduce costs or ma imi'e profits. :or this reason, managers often use the terms 7direct costs7 and 7indirect costs7 to replace the standard costing, to better reflect the way allocation of overhead is actually calculated. Indirect costs #often large$ are usually allocated in proportion to either labor cost, other direct costs, or some physical resource utili'ation. :or e ample& If the railway coach company now paid its workforce a fi ed monthly rate of ;@,<<< #total$ and its other fi ed costs had risen to ;.,6<<)month, the total fi ed costs would then be ;,<,6<<)month. %he unit cost to make 4< coaches per month would still be ;0.5 per coach #;6< material > #;,<,6<<)4<$$, but producing ,<< coaches would result in a unit cost of ;,66 per coach #;6< > #;,<, 6<<),<<$$, provided the company had the capacity to increase production to that level.

Managers using the standard cost for 4< coaches per month would likely reAect an order for ,<< coaches #to be produced in one month$ if the selling price was only ;0<< per unit, seeing that it would result in a loss of ;.5 per unit. If they analy'ed the fi ed vs. variable cost distinction, they would see clearly that filling this order would result in a contribution to fi ed costs of ;.4< per coach #;0<< selling price less ;6< materials$ and would result in a net profit for the month of ;,0,4<< ##;.4< ,<<$ ( ,<,6<<$.

The Development of Throughput Accounting

Main article: Throughput accounting As business became more comple and began producing a greater variety of products, the use of cost accounting to make decisions to ma imi'e profitability came under 8uestion. Management circles became increasingly aware of the %heory of !onstraints in the ,B@<s, and began to understand that 7every production process has a limiting factor7 somewhere in the chain of production. As business management learned to identify the constraints, they increasingly adopted throughput accounting to manage them and 7ma imi'e the throughput dollars7 #or other currency$ from each unit of constrained resource. :or e ample& %he railway coach company was offered a contract to make ,5 open( topped streetcars each month, using a design which included ornate brass foundry work, but very little of the metalwork needed to produce a covered rail coach. %he buyer offered to pay ;.@< per streetcar. %he company had a firm order for 4< rail coaches each month for ;05< per unit. %he company accountant determined that the cost of operating the foundry vs. the metalwork shop each month was as follows& Overhead Cost by Department %otal !ost 9ours Available per month !ost per hour :oundry ; C,0<<.<< ,6< ;45.60 Metal shop ; 0,0<<.<< ,6< ;.<.60 %otal ;,<,6<<.<< 0.< ;00.,0 %he company was at full capacity making 4< rail coaches each month. And since the foundry was e pensive to operate, and purchasing brass as a raw material for the streatcars was e pensive, the accountant determined that the company would lose money on any streetcars it built. 9e showed an analysis of the estimated product costs based on standard cost accounting and recommended that the company decline to build any streetcars. Standard Cost Accounting Analysis "treetcars -ail coach Monthly 3emand ,5 4< Price ;.@< ;05< :oundry %ime #hrs$ 0.< ..< Metalwork %ime #hrs$ ,.5 4.< %otal %ime 4.5 6.< :oundry !ost ;,06.@@ ; B,..5 Metalwork !ost ; 0<.B4 ; @..5< -aw Material !ost ;,.<.<< ; 6<.<< %otal !ost ;.@C.@, ;.00.C5 Profit per Dnit ; #C.@,$ ;,,6..5

9owever, the company's operations manager knew that recent investment in automated foundry e8uipment had created idle time for workers in that department. %he constraint on production of the railcoaches was the metalwork shop. "he made an analysis of profit and loss if the company took the contract using throughput accounting to determine the profitability of products by calculating 7throughput7 #revenue less variable cost$ in the metal shop. Throughput Cost Accounting Analysis 3ecline !ontract %ake !ontract !oaches Produced 4< 04 "treetcars Produced < ,5 :oundry 9ours @< ,,0 Metal shop 9ours ,6< ,5B !oach -evenue ;,4,<<< ;,,,B<< "treetcar -evenue ;< ; 4,.<< !oach -aw Material !ost ;#.,4<<$ ;#.,<4<$ "treetcar -aw Material !ost ;< ;#,,@<<$ %hroughput *alue ;,,,6<< ;,.,.6< 1verhead + pense ;#,<,6<<$ ;#,<,6<<$ Profit ;,,<<< ;,,66< After the presentations from the company accountant and the operations manager, the president understood that the metal shop capacity was limiting the company's profitability. %he company could make only 4< rail coaches per month. Eut by taking the contract for the streetcars, the company could make nearly all the railway coaches ordered, and also meet all the demand for streetcars. %he result would increase throughput in the metal shop from ;6..5 to ;,<.0@ per hour of available time, and increase profitability by 66 percent.

Activity-based costing
Activity(based costing #AE!$ is a system for assigning costs to products based on the activities they re8uire. In this case, activities are those regular actions performed inside a company. 7%alking with customer regarding invoice 8uestions7 is an e ample of an activity performed inside most companies. Accountants assign ,<<F of each employee's 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$. %he accountant then can determine the total cost spent on each activity by summing up the percentage of each worker's salary spent on that activity. A company can use the resulting activity cost data to determine where to focus their operational improvement efforts. :or e ample, a Aob based manufacturer may find that a high percentage of their workers are spending their time trying to figure out a hastily written customer order. *ia AE!, the accountants now have a currency amount that will be associated with the activity of 7-esearching !ustomer 2ork 1rder "pecifications7. "enior management can now decide how much focus or money to budget for the resolutions of this process deficiency. Activity(based management includes #but is not restricted to$ the use of activity(based costing to manage a business.

Marginal Costing

%his method is used particularly for short(term decision(making. Its principal tenets are&

-evenue #per product$ ( *ariable !osts #per product$ ? !ontribution #per product$ %otal !ontribution ( %otal :i ed !osts ? %otal Profit or #%otal /oss$

%hus it does not attempt to allocate fi ed costs in an arbitrary manner to different products. %he short(term obAective is to ma imi'e contribution per unit. If constraints e ist on resources, then Managerial Accounting dictates that marginal cost analysis be employed to ma imi'e contribution per unit of the constrained resource #see 3evelopment of %hroughput Accounting, above$.

Management accounting
Management accounting is concerned with the provisions and use of accounting information to managers within organi'ations, to provide them with the basis to make informed business decisions that will allow them to be better e8uipped in their management and control functions. In contrast to financial accountancy information, management accounting information is&

usually confidential and used by management, instead of publicly reportedG forward(looking, instead of historicalG pragmatically computed using e tensive management information systems and internal controls, instead of complying with accounting standards.

This is because of the different emphasis: management accounting information is used within an organization, typically for decision-making.
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Definition
According to the !hartered Institute of Management Accountants #!IMA$, Management Accounting is 7the process of identification, measurement, accumulation, analysis, preparation, interpretation and communication of information used by management to plan, evaluate and control within an entity and to assure appropriate use of and accountability for its resources. Management accounting also comprises the preparation of financial reports for non management groups such as shareholders, creditors, regulatory agencies and ta authorities7 #!IMA 1fficial %erminology$ %he American Institute of !ertified Public Accountants#AI!PA$ states that management accounting practice e tends to the following three areas& H"trategic ManagementIAdvancing the role of the management accountant as a strategic partner in the organi'ation. HPerformance ManagementI3eveloping the practice of business decision(making and managing the performance of the organi'ation.

H-isk ManagementI!ontributing to frameworks and practices for identifying, measuring, managing and reporting risks to the achievement of the obAectives of the organi'ation. %he Institute of !ertified Management Accountants #I!MA$, state 7A management accountant applies his or her professional knowledge and skill in the preparation and presentation of financial and other decision oriented information in such a way as to assist management in the formulation of policies and in the planning and control of the operation of the undertaking. Management Accountants therefore are seen as the 7value(creators7 amongst the accountants. %hey are much more interested in forward looking and taking decisions that will affect the future of the organi'ation, than in the historical recording and compliance #scorekeeping$ aspects of the profession. Management accounting knowledge and e perience can therefore be obtained from varied fields and functions within an organi'ation, such as information management, treasury, efficiency auditing, marketing, valuation, pricing, logistics, etc.7

Aims
1. :ormulating strategies

.. Planning and constructing business activities 0. 9elps in making decision

4. 1ptimal use of resources 5. "upporting financial reports preparation

6. "afeguarding asset

Traditional practices

vs

innovative

management

accounting

In the late ,B@<s, accounting practitioners and educators were heavily critici'ed on the grounds that management accounting practices #and, even more so, the curriculum taught to accounting students$ had changed little over the preceding 6< years, despite radical changes in the business environment. Professional accounting institutes, perhaps fearing that management accountants would increasingly be seen as superfluous in business organi'ations, subse8uently devoted considerable resources to the development of a more innovative skills set for management accountants. %he distinction between JtraditionalK and JinnovativeK management accounting practices can be illustrated by reference to cost control techni8ues. !ost accounting is a central method in management accounting, and traditionally, management accountantsK principal techni8ue was variance analysis, which is a systematic approach to the comparison of the actual and budgeted costs of the raw materials and labor used during a production period. 2hile some form of variance analysis is still used by most manufacturing firms, it nowadays tends to be used in conAunction with innovative techni8ues such as life cycle cost analysis and activity-based costing, which are designed with specific aspects of the modern business

environment in mind. Lifecycle costing recogni'es that managersK ability to influence the cost of manufacturing a product is at its greatest when the product is still at the design stage of its product lifecycle #i.e., before the design has been finalised and production commenced$, since small changes to the product design may lead to significant savings in the cost of manufacturing the product. Activity-based costing #AE!$ recogni'es that, in modern factories, most manufacturing costs are determined by the amount of JactivitiesK #e.g., the number of production runs per month, and the amount of production e8uipment idle time$ and that the key to effective cost control is therefore optimi'ing the efficiency of these activities. Activity(based accounting is also known as Cause and Effect accounting. Eoth lifecycle costing and activity(based costing recogni'e that, in the typical modern factory, the avoidance of disruptive events #such as machine breakdowns and 8uality control failures$ is of far greater importance than #for e ample$ reducing the costs of raw materials. Activity(based costing also deemphasi'es direct labor as a cost driver and concentrates instead on activities that drive costs, such as the provision of a service or the production of a product component.

!ole of Management Accountants "ithin the Corporation

!onsistent with other roles in today's corporation, management accountants have a dual reporting relationship. As a strategic partner and provider of decision based financial and operational information, management accountants are responsible to manage business team at the same time also have reporting relationships and responsibilities to the corporation's finance organi'ation. %he activities management accountants provide inclusive of forecasting and planning, performing variance analysis, reviewing and monitoring costs inherent in the business are ones that have dual accountability to both finance and the business team. + amples of tasks where accountability may be more meaningful to the business management team vs. the corporate finance department are the development of new product costing, operations research, business driver metrics, sales management scorecarding, and client profitability analysis. !onversely, the preparation of certain financial reports, reconciliations of the financial data to source systems, risk and regulatory reporting will be more useful to the corporate finance team as they are charged with aggregating certain financial information from all segments of the corporation. 1ne widely held view of the progression of the accounting and finance career path is that financial accounting is a stepping stone to management accounting. !onsistent with the notion of value creation, management accountants help drive the success of the business while strict financial accounting is more of a compliance and historical endeavor.

An alternative vie" of management accounting

A very rarely e pressed alternative view of management accounting is that it is neither a neutral or benign influence in organi'ations, rather a mechanism for management control through surveillance. %his view locates management accounting specifically in the conte t of management control theory.

Specific Concepts
Throughput accounting
%he most significant, recent direction in managerial accounting is throughput accountingG which recogni'es the interdependencies of modern production processes. :or any given product, customer or supplier, it is a tool to measure the contribution per unit of constrained resource . #:or a detailed description of %hroughput Accounting, see cost accounting$.

#ean accounting $accounting for lean enterprise%

In the mid to late ,BB<s several books were written about accounting in the lean enterprise #companies implementing elements of the %oyota Production "ystem$. %he term lean accounting was coined during that period. %hese books contest that traditional accounting methods are better suited for mass production and do not support or measure good business practices in Aust in time manufacturing and services. %he movement reached a tipping point during the .<<5 /ean Accounting "ummit in 3earborn, MI. 0.< individuals attended and discussed the merits of a new approach to accounting in the lean enterprise. 5.< individuals attended the .nd annual conference in .<<6.

Transfer &ricing
Management accounting is an applied discipline used in various industries. %he specific functions and principles followed can vary based on the industry. Management accounting principles in banking are speciali'ed but do have some common fundamental concepts used whether the industry is manufacturing based or service oriented. :or e ample, transfer pricing is a concept used in manufacturing but is also applied in banking. It is a fundamental principle used in assigning value and revenue attribution to the various business units. +ssentially, transfer pricing in banking is the method of assigning the interest rate risk of the bank to the various funding sources and uses of the enterprise. %hus, the bank's corporate treasury department will assign funding charges to the business units for their use of the bank's resources when they make loans to clients. %he treasury department will also assign funding credit to business units who bring in deposits #resources$ to the bank. Although the funds transfer pricing process is primarily applicable to the loans and deposits of the various banking units, this proactive is applied to all assets and liabilities of the business segment. 1nce transfer pricing is applied and any other management accounting entries or adAustments are posted to the ledger #which are usually memo accounts and are not included in the legal entity results$, the business units are able to produce segment financial results which are used by both internal and e ternal users to evaluate performance.

!esources and Continuous #earning

%here are a variety of ways to keep current and continue to build the knowledge base in the field of management accounting. !ertified Management Accountants are re8uired to achieve continuing education hours every year, similar to a !ertified Public Accountant. A company

may also have research and training materials available for use in a corporate owned library. %his is more common in larger 7:ortune 5<<7 companies who have the resources to fund this type of training medium. %here are also numerous publications and on(line articles and blogs available. %he Institute of Management Accounting #IMA$ site http&))www.imanet.org)publicationsLma8.asp is one such source which includes the Management Accounting Muarterly publication. Indeed, management accounting is needed in an organi'ation.

Management Accounting Tasks' Services &rovided

/isted below are the primary tasks) services performed by management accountants. %he degree of comple ity relative to these activities are dependent on the e perience level and abilities of any one individual.

*ariance Analysis -ate N *olume Analysis Eusiness Metrics 3evelopment Price Modeling Product Profitability Geographic vs. Industry or !lient "egment -eporting "ales Management "corecards !ost Analysis !ost Eenefit Analysis !lient Profitability Analysis !apital Eudgeting Euy vs. /ease Analysis "trategic Planning "trategic Management Advise Internal :inancial Presentation and !ommunication "ales and :inancial :orecasting Annual Eudgeting !ost Allocation -esource Allocation and Dtili'ation

Cost-(olume-&rofit Analysis
In management accounting, Cost-(olume-&rofit Analysis #C(&$ is a form of cost accounting. It is a simplified model, useful for elementary instruction and for short(run decisions. !1"%(*1/DM+(P-1:I% AOA/P"I" !ost(volume(profit #!*P$ analysis e pands the use of information provided by breakeven analysis. A critical part of !*P analysis is the point where total revenues e8ual total costs #both fi ed and variable costs$. At this breakeven point #E+P$, a company will e perience no income or loss. %his E+P can be an initial e amination that precedes more detailed !*P analyses. !ost(volume(profit analysis employs the same basic assumptions as in breakeven analysis. %he assumptions underlying !*P analysis are&
The beha ior of both costs and re enues is linear throughout the rele ant range of acti ity. !This assumption precludes the concept of olume discounts on either purchased materials or sales." #osts can be classified accurately as either fi$ed or ariable. #hanges in acti ity are the only factors that affect costs. %ll units produced are sold !there is no ending finished goods in entory". &hen a company sells more than one type of product, the sales mi$ !the ratio of each product to total sales" will remain constant.

Assumptions
!*P assumes the following&

!onstant sales priceG !onstant variable cost per unitG !onstant total fi ed costG !onstant sales mi G Dnits sold e8ual units produced.

%hese are simplifying, largely lineari'ing assumptions, which are often implicitly assumed in elementary discussions of costs and profits. In more advanced treatments and practice, costs and revenue are nonlinear and the analysis is more complicated, but the intuition afforded by linear !*P remains basic and useful. 1ne of the main Methods of calculating !*P is Profit volume ratio& which is #contribution )sales$H,<< ? this gives us profit volume ratio.

contribution stands for "ales minus variable costs.

Therefore it gives us the profit added per unit of variable costs.

Model
)asic graph

Easic graph of !*P, demonstrating relation of %otal !osts, "ales, and Profit and /oss. %he assumptions of the !*P model yield the following linear e8uations for total costs and total revenue #sales$&

%hese are linear because of the assumptions of constant costs and prices, and there is no distinction between Dnits Produced and Dnits "old, as these are assumed to be e8ual. Oote that when such a chart is drawn, the linear !*P model is assumed, often implicitly. In symbols&

where

TC ? Total Costs T*C ? Total *i+ed Costs ( ? ,nit (ariable Cost #(ariable Cost per ,nit$ - ? .umber of ,nits T! ? S ? Total !evenue ? Sales & ? $,nit% Sales &rice

Profit is computed as %-(%!G it is a profit if positive, a loss if negative.

)reak do"n

!osts and "ales can be broken down, which provide further insight into operations.

3ecomposing %otal !osts as :i ed !osts plus *ariable !osts. 1ne can decompose %otal !osts as :i ed !osts plus *ariable !osts&

3ecomposing "ales as !ontribution plus *ariable !osts. :ollowing a matching principle of matching a portion of sales against variable costs, one can decompose "ales as !ontribution plus *ariable !osts, where contribution is 7what's left after deducting variable costs7. 1ne can think of contribution as 7the marginal contribution of a unit to the profit7, or 7contribution towards offsetting fi ed costs7. In symbols&

where

C ? ,nit Contribution $Margin%

Profit and /oss as !ontribution minus :i ed !osts. "ubtracting *ariable !osts from both !osts and "ales yields the simplified diagram and e8uation for Profit and /oss. In symbols&

3iagram relating all 8uantities in !*P. %hese diagrams can be related by a rather busy diagram, which demonstrates how if one subtracts *ariable !osts, the "ales and %otal !osts lines shift down to become the !ontribution and :i ed !osts lines. Oote that the Profit and /oss for any given number of unit sales is the same, and in particular the break(even point is the same, whether one computes by "ales ? %otal !osts or as !ontribution ? :i ed !osts.Q,R

Applications
!*P simplifies the computation of breakeven in break even analysis, and more generally allows simple computation of %arget Income "ales. It simplifies analysis of short run trade( offs in operational decisions.

#imitations
!*P is a short run, marginal analysis& it assumes that unit variable costs and unit revenues are constant, which is appropriate for small deviations from current production and sales, and assumes a neat division between fi ed costs and variable costs, though in the long run all costs are variable. :or longer(term analysis that considers the entire life(cycle of a product, one therefore often prefers activity(based costing or throughput accounting.Q.R