The need for cost facts

Entrepreneurs undertake business activities with the expectation of making profits. Profits in case of an identified project are revenues minus costs. Economic theory tells us that if you want to sell more, marginal revenue decreases. Marginal cost may decrease or increase. Entrepreneurs make profits due to innovations and risk taking. Innovations are new methods or techniques or designs that give lower costs in doing an existing activity or they may offer new products that make new ways of consumption possible. In this article we focus on cost reduction innovations.

If we have to plan to reduce costs, we need to know what are our current costs. After we implement new methods ot reduce costs we once again have to measure costs to confirm that we actually had lower costs due to introduction of modified methods.

 

Thus to think, plan, and confirm we need cost facts.

 

Cost facts are produced by accounting persons, and now the specialists in this field are called cost accountants. Many companies have separate cost accounting departments.

 

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Overhead Costs

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Index of articles on Cost Accounting, Costing and Cost Management

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Activity based costing - ABC

In traditional costing, direct material, direct labor and direct expenses are identified with the jobs and all other expenses are accumulated under the head “overheads” and are charged to the jobs on the basis of one or two measurements such as direct labor cost or direct material cost of the jobs.

Proponents of activity based costing first brought out the fact that product costs derived by using traditional costing techniques are giving wrong information. The actual product cost of certain jobs is high but traditional costing system is reporting a low cost for them. If the selling price is determined on the basis of such wrong low cost, at the end of the year, companies find that they have not earned the anticipated profits.

In activity based costing, all the costs which are classified as overheads in traditional costing system are accumulated under various activities which are carried out in the organization. From the activity cost for a period, and the number of times the activity is carried out in the period, cost for doing the activity once is ascertained. Then an account is maintained each time the activity is carried and the job responsible for performing the activity is recorded. Therefore the activity cost can be charged to the job.

Thus the job cost, now comprises of direct material cost, direct labor costs, direct expenses and costs of each of the activities consumed by the job.

Activity based costing provides a more realistic estimate of costs of products.

Normally compared to traditional costing system, ABC system provides lower cost figures for standard products and higher cost figures for nonstandard orders. 

The logic of ABC systems is that more finely structured activity-cost pools with activity-specific cost-allocation bases, which are cost drivers for the cost pool, lead to more accurate cost-allocation systems

Hierarchy of Cost Pools

ABC systems commonly use a four-part cost hierarchy or hierarchy of cost pools  -  output unit-level costs, batch-level costs, product-sustaining costs, and facility sustaining costs - to identify cost-allocation bases that are preferably cost drivers of costs in activity cost pools.

Implementing Activity-Based Costing

1. Identify the chosen cost objects

2. Identify the direct costs of the products

3. Select the cost-allocation bases to use for allocating indirect costs

4. Identify the indirect costs associated with each cost-allocation base

5. Compute the rate per unit of each cost-allocation base used to allocate indirect costs to the products

6. Compute the indirect costs allocated to the products

7. Compute the total costs of the products by adding all direct and indirect costs assigned to them.

Use of ABC Systems

Pricing and Product-mix decisions

Cost Reduction and Process Improvement Decisions

Design Decisions

Planning and Managing Activities

Based on

Horngren et al. Cost Accounting Chapter 5. Activity Based Costing and Activity-Based Management, 10th Edition

Cost Accounting - Horngren et al., Book Information and Review

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Cost objectives

Concept

Cost Object: Cost object is anything for which a separate measurement of cost is desired.

 

Product cost and department cost are two main cost objects or cost objectives. But as a concept cost object can be anyting for which a measurement of cost is desired.

 

Managers can ask the cost accounting department for cost information that is required for their decision models. Ordering cost, inventory carrying cost, shortage cost etc. are cost information for decision making in  inventory area. Inventory managers or materials managers are justified in asking for these pieces of cost information from the cost accounting department.

 

Similarly, production management decisions, equipment replacement decisions require cost information for decision making.

 

There is a possibility that cost accountants do not understand the concepts, that operating managers are using for cost information. But cost accounting texts do use many of these concepts. So basically a coordination is required between the operating department and the cost accounting department to arrive at proper cost information.

 

A cost system accumulates costs and the assigns them to various cost objects. Information regarding cost objects requires that there is a cost accumulation system designed for providing the required cost information is in place. Activity based costing system can give much more information compared to traditional cost accumulation systems. But operating departments have to provide more information also in Activity based costing system when they are preparing their expense vouchers or material issue slips and similar other documents.

A List of Cost Objectives in Different Disciplines of Management

Materials Management (Inventory Control)

    Ordering Cost

    Inventory Carrying Cost

    Shortage Cost

Production Management

    Set Up cost

    Cost of Quality

Maintenance Management

    Breakdown cost

Human Resources Management

    Cost Absenteeism

    Cost of Ignorance 

Index of articles on Cost Accounting, Costing and Cost Management

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Absorption cost

Introduction

 

 

In this method of costing, in which total overhead costs are apportioned to the products using a base such as labor hours, direct cost or conversion cost.

In contrast in marginal costing, only variable overheads are allotted or charged to products. Fixed overheads of periods are charged to profit and loss account.

 

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Index of articles on Cost Accounting, Costing and Cost Management

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Overhead cost

Variable overhead costs are related to the production volumes of products and services but their usage is not measured with respect to the specific products. The cost incurred on these heads of expenditure is pooled together and allocated to the products periodically.

Fixed overhead costs are facility maintenance costs and are not related to the production volume. Fixed overhead costs include factory building maintenance, Factory or plant manager's salary, reception department for the factory, Hospital expenditure etc.

Planning Variable Overhead Costs

Horngren et al. bring in the concept of nonvalue added activities and specify that a firm has to undertake only those variable overhead activities that add value for consumers using the related product or service. So this prescription suggests that a firm has to question each of its variable overhead costs and justify its incurrence.

Planning Fixed Overhead Cost

In the case of fixed overhead costs also, each head has to be justified and the activity has to be done efficiently. The important decision issue in the case fixed overhead is the capacity decision. Fixed cost is mostly a top management decision, while variable cost is an operating decision.

Developing Budgeted Variable Overhead Cost-Allocation Rates

As the overhead costs are allocated to cost objects (products), and in job costing, the allocation is to be done immediately after a job is finished, cost allocation rates are calculated.

The steps involved are:
1. The time period to compute the budget is decided. Variable over costs are budgeted.
2. Selection of the cost-allocation base to use in allocating variable overhead costs to the cost objects.
3. Identify the variable over costs associated with each cost allocation base and create the cost pool
4. Computer the rate per unit of each cost allocation base used by dividing the cost pool/budgeted allocation base.

Flexible Budget Analysis of Overhead Variance

Variable Overhead                          =  Actual cost  - Flexible budget amount
flexible budget variance

Variable overhead efficiency variance     =  (Actual units of CAB consumed - Budgeted units of CAB)*
(For each allocation base (CAB) )              Budgeted variable overhead rate for the CAB unit

Variable Overhead Spending Variance

VOSV = (Act. Var. over head cost per unit of CAB - Budgeted Var. overhead cost per unit of CAB)*
              Actual quantity of Var. overhead CAB used for the actual output.

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