Introduction to Cost Accounting and Inventory Control Systems
Financial and General Accounting
A technique or tool of economics and administration that records the economic activity of a company.
Management Accounting
A technique to identify, collect, prepare, analyze, plan, and evaluate all kinds of economic, financial, and other information to help management make decisions in planning and controlling operations.
Cost Accounting
Concept
Part of a company’s general information system that tracks, analyzes, and interprets the details of the costs associated with producing articles or providing a service.
- Provides information to management accounting and financial accounting.
- Deals with the classification, collection, control, and allocation of costs.
Objectives of Cost Accounting
- Improve operational efficiency
- Support decision-making, planning, and control
- Complete information on financial statements
- Inventory valuation
- Wholesale pricing
- Determining the most profitable items
- Deciding to make or buy
- Reduce or minimize costs
- Planning and controlling operations
- Special decisions and long-term planning
Cost
A sacrifice or loss incurred to achieve a specific objective. It is measured as the monetary amount paid to procure goods and services.
Cost Objects
Anything for which a separate measurement of costs is desired. Examples include a product or a project.
Expenses
An accounting item that reduces the benefit or increases the loss of an entity.
Generally understood as the expense incurred for the purchase of goods or services derived from the normal operation of the organization, and is not expected to generate earnings in the future.
Unlike costs, expenses (e.g., the purchase of raw materials) will likely generate future income when processed and sold as a finished product.
Accounting standards generally require that expenditures are accounted for following the accrual basis. This means that expenditure should be recorded at the time the economic event occurs, regardless of whether it was paid or received, or formalized through a contract or other document.
A fundamental difference between costs and expenses is that costs are born and die in the same accounting period, while expenses can span two or more periods.
Cost Elements
Producing a product or process requires consuming raw materials into goods or services.
A company requires a set of goods and services called elements, which are the parts used to create an article or service.
These elements are:
- Direct Materials (MD) or Commodities (MP)
- Direct Labor (MOD)
- Indirect Manufacturing Costs (CIF)
Cost Schemes
- Prime Costs: The sum of direct material costs and direct labor costs.
- Conversion Costs: The sum of direct labor costs and manufacturing overhead costs.
Cost Classifications
According to Function Where They Are Incurred
- Production Costs
- Selling and Administrative Costs
According to Their Identification with Any Activity
- Direct Costs
- Indirect Costs
As They Relate to the Volume of Activity
- Variable Costs
- Fixed Costs
Inventory Control Systems
Merchandise inventory is a detailed list of:
- Products or items available for sale
- Items in production
- Items that will be used in the manufacture of other products
To address the technical problem posed by fluctuating purchase prices in valuing inventory and determining the cost of sales, three methods are commonly used: FIFO, LIFO, and PMP. All of these methods adhere to the principles of cost accounting and valuation.
These accounting tools are sometimes called methods of inventory recovery, suggesting their usefulness in valuing merchandise stock.
FIFO (First-In, First-Out)
The FIFO method assumes that the first units received are the first to be used. Therefore, the cost of output or cost of sales corresponds to the oldest prices, while remaining units in stock are valued at the latest purchase prices.
LIFO (Last-In, First-Out)
With the LIFO method, the outputs of goods are valued at the last purchase price, and inventory stocks are valued at the first price, the reverse of the FIFO method.
PMP (Weighted Average Price) Method
With the PMP method, outputs and stocks are valued at the same unit price, the average price. The PMP is obtained by dividing the total inventory cost by the total number of units in stock.
Break-Even Point
The break-even point refers to the amount of sales that makes total revenues equal total costs, resulting in zero profit.
Assumptions of Break-Even Analysis
- Fixed costs are constant in total and variable at the unit level.
- Variable costs are constant per unit.
- Selling price is constant.
The break-even point indicates how much production must be sold to avoid losses. Managers are interested in the break-even point because they want to avoid operating losses.
A break-even point is commonly used in businesses or organizations to determine the potential profitability of selling a certain product. To calculate the break-even point, it is necessary to have clearly identified the behavior of costs.
Let:
- IT = Total Revenues
- CT = Total Costs
- P = Unit Price
- Q = Number of Units Produced and Sold
- CF = Fixed Costs
- CV = Variable Costs
Then:
If the product can be sold in quantities greater than the break-even point, the company will generate profits. If sales are below the break-even point, losses will occur.
Uses of Break-Even Analysis
- Allows for a simulation to determine the sales amount needed to begin making a profit.
- Assesses the viability of a project by determining if demand exceeds the break-even point.
- Helps determine the sales level at which it might be beneficial to change a variable cost for a fixed fee or vice versa.
- Determines the number of units or sales needed to achieve a specific profit target.