Cost Accounting Fundamentals
What is Management?
Key Functions:
- Leading
- Organizing
- Controlling
- Coordinating
- Decision Making
Management involves bringing people together to achieve organizational goals.
What is Accounting?
Accounting measures and reports financial and non-financial information related to costs.
What is Cost?
Cost is the resource sacrificed or forgone to achieve a specific objective. There are two main types of costs:
- Actual Cost: A cost that has already been incurred.
- Budgeting Cost: A projected cost that is expected to occur in the future.
What is a Cost Objective?
A cost objective is anything for which a separate measurement of cost is desired, such as a product, service, department, or project.
Relationship Between Cost Accumulation and Assignment
Cost accumulation is the process of collecting cost data, such as materials, advertising, or shipping expenses.
Cost assignment involves:
- Tracing direct costs to a specific cost objective.
- Allocating indirect costs to a cost objective.
For example, the cost of materials used in a specific product can be directly traced to that product, while the cost of rent for a factory might be allocated to multiple products based on their usage of the facility.
Distinguishing Between Direct and Indirect Costs
Direct costs are directly related to a specific cost object and can be easily traced to it. Examples include direct materials and direct labor.
Indirect costs are related to the cost object but cannot be easily traced. Examples include rent, utilities, and administrative salaries.
Cost Drivers and Cost Management
A cost driver is any factor that causes a change in the total cost of an activity. Examples include the number of units produced, the number of machine hours used, or the number of customer orders processed.
Cost management involves the actions managers take to control and reduce costs while satisfying customer needs.
Variable and Fixed Costs
Variable costs change in direct proportion to changes in the level of activity or volume. Examples include direct materials and direct labor.
Fixed costs remain constant in total for a given time period, regardless of changes in activity or volume. Examples include rent and salaries.
Relevant Range
The relevant range is the level of activity within which the assumed relationship between the level of activity or volume and the cost in question holds true.
Total Cost and Unit Cost
Total cost includes all fixed and variable costs incurred to produce a specific product or service.
Unit cost is the cost per unit of a product or service, calculated by dividing the total cost by the number of units produced.
Financial Statements and Cost Terminology
Revenue costs are expenses incurred in the current accounting period and are recorded on the income statement. Examples include salaries and utilities.
Capitalized costs are initially recorded as assets on the balance sheet and are then depreciated or amortized over time. Examples include the cost of acquiring equipment or buildings.
Logical Steps in Cost Allocation
- Identify the indirect costs to be allocated.
- Quantify the costs per unit or in total.
- Identify a suitable cost allocation base.
- Create cost pools whenever possible.
- Quantify the underlying cost driver.
- Calculate the allocation rate.
- Multiply the initial indirect cost by the respective allocation rate.
Guiding Principles of Cost Allocation
- Cause and Effect: Allocate costs based on the factors that drive resource consumption.
- Benefits Received: Allocate costs based on the beneficiaries of the cost object’s output.
- Fairness: Ensure the allocation is reasonable and equitable.
- Ability to Bear: Allocate costs based on the cost object’s ability to absorb them.
Cost Pools
Cost pools group together costs that have the same or similar cause-and-effect or benefits-received relationships. This simplifies the allocation process.
Single-Rate vs. Dual-Rate Cost Allocation Methods
Single-rate cost allocation uses a single cost pool and a single allocation rate for all cost objects.
Dual-rate cost allocation uses separate cost pools for variable and fixed costs, each with its own allocation base and rate.
Support Department Cost Allocation Methods
- Direct Method: Allocates support department costs only to operating departments.
- Step-Down Method: Allocates support department costs to other support departments and then to operating departments.
- Reciprocal Method: Considers the mutual services provided among all support departments.
Undercosting and Overcosting
Overcosting occurs when a product consumes a low level of resources but is allocated a high cost per unit.
Undercosting occurs when a product consumes a high level of resources but is allocated a low cost per unit.
Cross-Subsidization
Cross-subsidization is the result of overcosting one product and undercosting another. This can lead to incorrect pricing decisions and distort product profitability.
Consequences of Undercosting and Overcosting
- Misleading product profitability information.
- Incorrect pricing decisions.
- Cross-subsidization.
Refining Costing Systems
- Direct cost tracing.
- Indirect cost pools.
- Cost allocation basis.
Activity-Based Costing (ABC)
ABC is a costing method that focuses on individual activities and assigns costs based on the resources consumed by each activity. It provides a more accurate picture of product and service costs compared to traditional costing methods.
Major Drivers of Customer Profitability
- Revenue
- Cost
- Volume
Influences on Pricing Decisions
- Customer demand
- Competitor actions
- Costs
Short-Run vs. Long-Run Pricing
Short-run pricing involves temporary adjustments to prices, such as discounts or promotions.
Long-run pricing focuses on the normal list price that covers all costs and generates a profit.
Target Costing and Target Pricing
Target costing starts with the target price customers are willing to pay and then determines the allowable cost to achieve the desired profit.
Target pricing sets a price based on market research and competitor analysis, and then adjusts costs to achieve the desired profit margin.
Value Chain
The value chain is the sequence of business functions in which value is added to a product or service. It includes activities such as research and development, design, production, marketing, sales, and customer service.
Value Engineering
Value engineering is a systematic approach to evaluating and improving the value chain to reduce costs while maintaining or enhancing customer satisfaction.
Cost-Plus Pricing
Cost-plus pricing involves adding a markup to the cost base to determine the selling price.
Sensitivity Analysis
Sensitivity analysis examines how changes in key variables, such as sales volume or costs, affect profits.
Cost-Volume-Profit (CVP) Analysis
CVP analysis examines the relationship between costs, volume, and profit and helps answer “what-if” questions about the impact of changes in these variables.
Strategic Planning and Budgeting
The master budget is a comprehensive plan that includes various individual budgets, such as the sales budget, operational budgets, and the budgeted financial statements.
Variance Analysis
Variance analysis compares actual results to budgeted amounts to identify and understand deviations from the plan.
Benchmarking
Benchmarking is the process of comparing a company’s performance against industry best practices to identify areas for improvement.