Cost Accounting
Category: Financial Control Management
The Cost of Goods Sold account, found on the Income Statement, indicates the costs associated with the quantity of units sold during the period. The Balance Sheet account Inventory represents the costs associated with the quantity of unsold units at the end of a period.
The process of determining the costs of all units that can be sold, and then allocating these costs between the units sold during the period (cost of goods sold) and the units unsold at the end of the period (inventory) is referred to as Product Costing. Only product costs are use in product costing, not period costs.
Product Costs are costs that are closely associated with units produced by the enterprise or purchased for resale by a retailer or wholesaler. Examples: Cost of materials and labour used in production. Thus, Product Costs are inventory costs when incurred and these costs are assets until the units are sold. At the moment of sale, several things happen:
— The economic benefit, sales revenue, is realized;
— The asset expires;
— No longer recognizing the product cost as an asset, it is now recognized as an expense, cost of goods sold;
— The Cost of Goods Sold is matched with the sales revenue on the Income Statement.
Period Costs are costs that are recognized as expenses as soon as they are incurred. They are not assigned to the product; instead, they are immediately assigned to the Income Statement as an expense of that period. The benefits provided by period costs are realized fully when the costs are incurred and are recognized in the current period. Examples: Administrative salaries, Marketing expenses.
It is important to classify product costs and period costs correctly. If these costs are classified incorrectly, they will be expensed at the wrong time, and the financial statements for the period will be inexact.
There is a third group into which costs can be classified when they occur: Non inventoriable unexpired costs. These costs represent assets when they are incurred, but they are not costs that can be assigned to inventory. Example of such costs: Expenditures for prepaid insurance, prepaid rent, machinery, buildings. Each of these costs is an asset, other than inventory. Many of these assets are used up or consumed as time passes. As they expire over time, the amount expired can then be classified as a product cost or a period cost.
Manufacturers must maintain three different inventory accounts:
— Raw materials inventory. Materials purchased from a supplier;
— Work in progress. The unfinished goods in production — the units that are being worked on;
— Finished goods inventory. The completed product awaiting sale.
Categories of Product Cost used in Moldovan National Accounting System:
— Direct materials. Raw materials that become an integral part of the completed product;
— Direct labour. It is the work that directly converts the raw materials into finished goods;
— Manufacturing overhead. The total costs of production department minus direct costs. Examples: indirect materials, indirect labour, rent, property tax, maintenance and repair, utilities, depreciation, idle time.
The Cost Flow of a retailer goes directly from purchase of goods to sale. The Cost Flow for a manufacturer is much longer:
— Purchase and use of raw materials;
— Use of labour;
— Use of manufacturing overhead;
— Transfer of manufacturing overhead to Work in Progress;
— Completion of production;
— Sale of finished goods.
Overhead Allocation between Product Types
Cost allocation is a process of assigning cost to specific products. It rises the issue of what share of costs need to be assigned to a particular product. The answer to this question has the effect on the viability of the business.
Cost allocation is needed in order to determine product costs, which in turn are needed for (1) reporting to external authorities (Statutory Accounting) and for (2) analyzing product line profitability (Managerial Accounting).
In the process of cost allocation, Direct and Indirect Costs must be assigned to specific products. Direct Costs are easy to allocate because they are linked to particular products, based on the internal standards supported by a normative base. The common Direct Costs are:
— Raw materials;
— Energy;
— Production Labour;
— Subcontracted services.
In order to allocate Direct Costs it is enough to match products made and direct expenses incurred, however, even direct cost allocation sometimes causes difficulties if there are many products made in one place and they use the same machinery an the same materials. In this case direct costs are assigned proportionally to standard norms which are developed by the technological and planning departments. Periodically, standard norms must be compared with actual consumption patterns to make adjustments.
Indirect Costs, often called Overheads, are the hardest to allocate because they are not directly traceable to products. The common Indirect Costs are:
— Top management expenses;
— Social assets;
— Depreciation of buildings;
— Repair and maintenance;
— Interest expenses;
— Rent;
— Security;
— Heating and ventilation.
The Overhead Expenses are allocated in a Two-Stage Process. At the first stage the factory overheads (G&A, Marketing, and other overheads) are assigned to Cost Centers (product line A, product line B) and only then they are assigned to particular products, using specific allocation bases. Identifying Cost Centers is important for accurate cost allocation. A Cost Center is a responsibility center where managers are accountable for the expenses which fall under their control. Normally, cost centers are represented by workshops.
Overhead allocation is a very complex calculation process. All allocation methods are subjective and therefore disputable. The more indirect the cost is, the more subjective its allocation is likely to be. The purpose of the allocation is not to be fully accurate, but simply to spread costs in a fair and efficiency-improving manner.
Allocation bases should be chosen according to the following criteria:
— They should be related to the cost considered, i.e. of the resources effectively used;
— They should be representative of the normal operating conditions;
— If possible, they should be a factor of which decision-makers can have an impact;
— In some cases, they can take the special objectives of cost management into account.
The following are commonly used simple allocation bases:
1. Direct Labour. It is acceptable when manufacturing processes are highly Labour-intensive, overhead a small percentage of total costs and low product diversity. It’s not relevant when Labour costs are low (e.g. 10%) and overhead high (e.g. 30%);
2. Depreciation of machines. It is justified in highly capital-intensive industries. It is also relevant for some types of overhead which are often linked to production facilities (interest expenses, chief engineer. It is not relevant in non capital-intensive industries and for overhead caused by the number of staff;
Sales. This method will be «painless», as only best-selling products will be penalized. It is not representative in terms of cost generation and it removes part of the incentives to increase sales;
Energy. Only relevant if other bases related to production processes do not apply (e.g. if some departments are grossly overstaffed, or if machines for different products vary widely), as it then becomes the only possible way to assess resources used.
Management should be aware of the consequences to their business when choosing an allocation base. For example, the common Moldovan practice of splitting overhead by a proportion of direct Labour tends to distort the costs of hand-produced products versus those machine-produced products. Choosing «Sales» as an allocation base often penalizes products that are high revenue generators. A good basis on which to allocate overhead in a Moldovan manufacturing company is often a mix of direct Labour and machines.
Changing the itemization and overhead allocation base usually yields different profitability estimates for individual production lines or individual products. The higher the share of overhead costs, the greater the expected changes in profitability estimates for individual products as a result of overhead reallocation. There is no ideal base for overhead allocation but there are more appropriate bases of allocation for each company. Potential benefits from a more detailed allocation of overhead must exceed the related costs.
Incorrect overhead allocation between product types and production divisions can result in (1) inconsistency between the price ratio for individual products and market demand, (2) unjustified reduction of output for some products, (3) incorrect assessment of divisions operations.
The choice of overhead allocation base is determined by company specifics, industry characteristics, as well as by the relative value of certain costs within the overall structure of company costs.
Cost Drivers
The Cost Driver is a factor which affects the level of a particular cost dramatically: it can have a positive or a negative impact. A cost driver is the element of a cost that exerts great influence over its account, such that a change in the cost driver necessarily results in a change in the cost. Knowing the cost driver of products is vital to understand the elements of cost and to make decisions accordingly. Mastering cost drivers allows enterprises to make operational decisions with some degree of certainty as to their cost impact.
Examples of Cost Drivers:
— Labour — Location, efficiency of work;
— Raw materials — Purchasing sale, wastage, delivery costs;
— Financing costs — Interest rates, inflation, location;
— Repairs cost — Number of machines to be repaired, age of machines;
— Energy cost — Volume of buildings to be heated, efficiency of heating system, waste;
— Sales department — Number of invoices issued, number of customers;
— Accounting department — Number of transactions, average transaction processing time;
— Warehousing costs — Average length of storage, number of pallets handled;
— Distribution costs — Complexity of route structure, number of owned vehicles.
Product engineering has a significant effect on the cost of each product. Beyond the basic product engineering, the detailed product specification such as purity, quality, and finish could add further costs. Design specification can often add significant additional cost that customers may not be prepared to pay or may simply not want. The company must analyze whether what is produced is really expected by the customer at the proposed price.
The areas where cost gains can be obtained:
— Input costs can be reduced;
— Switching from one technology to another;
— Labour productivity improvement;
— Efficient organization of the business process;
— Economy of scale;
— Change of location;
— Distribution costs.