Cost accounting involves collecting detailed financial data and recording on that data. The data may be extracted from the books, summarised and presented to management. The managers will use the data for planning and control purposes. Managers are generally interested in knowing the profits and loss made by individual products.
At the time of the Industrial Revolution managers were basing their price on costs. Even today, accountants still cost products using this technique and it is known as "absorption costing".
It involves isolating the costs that can be easily identified with a particular product and apportion the non-identifiable costs. Accountants allocate the "direct costs" first and absorbing the "indirect costs".
The aim of this blog is to identify the direct costs.
As managers we cannot simply leave this parts to accountants. By knowing about cost accounting we can gain greater control over the resources which we are responsible for and make better decisions. Knowing the direct costs allows to determine the price for products and services. If managers get the pricing decisions wrong it can have serious consequences to the company.
Responsibility accounting system
Responsibility accounting system generally consists of the following features:
* Segments. The entity is broken down into identifiable segments. These are known as "responsibility centres" and there are 3 main types:
Cost centres. A clearly defined area of responsibility under a control of an individual. There are "production" cost centres and "service" cost centres.
Profit centres. Both costs and revenues associated with the centre are charged to it. It is possible to calculate profit or loss to each cost centre.
Investment centres. Similar to profit centre but also responsible for major investment decisions.
* Boundaries. The boundaries of each segment would be clearly established.
* Control. A manager is put in charge of each segment.
* Authorisation. The managers will be given the independence to run their segments as autonomously as possible.
The costs and revenues of each segment could be easily identified. The managers can be made responsible for planning, budgeting and controlling of its activities.
Cost classification
In practice is is not easy to identify each cost to a cost centre as some costs are general and no one manager has control over them. Costs that are easily identifiable with a particular cost centre are called "direct costs". In a competitive market selling price can rarely be determined on a "cost-plus" basis total cost of sales plus profit loading). When a market largely determine the selling prices it is vital that the entity's costs are largely controlled and monitored strictly. A standard classification of costs is shown in the figure below.
Source: Dyson, J. R., Franklin, E. 2017. Accounting for Non-Accounting students, Chapter 15
The classification shown may not relate to all entities, for example service sector. The method is based on the "total absorption costing". It is then all costs of the entity are charged (absorbed) to a particular product irrespective of their nature.
There is also another method called "marginal costing". It involves classifying costs into its fixed and variable elements.
Direct materials
Materials consist of raw materials and components parts. Raw materials are those basic ingredients incorporated into a product. Even that the materials can be easily identified, it may not be easy to assign the cost of them to a particular product. Materials may have been purchased at different times and different prices and we need to determine the appropriate pricing methods. The prices of materials also affect the value of stock. Generally a reasonable way of valuing stock is the one used for accounting statements. There are four methods:
* Unit cost. The cost of purchase.
* First-in-first-out method - FIFO. Uses the first price at which materials have been purchased. It is sensible to issue the oldest stock to production first thus avoiding obsolescence and deterioration. This is a very common method used and starts with (1) determining the price paid for the oldest stock and charging any issued to production at that price, (2) once all the eldest ones have been issued, we use the next-oldest price materials to use in production. This method requires using a considerable amount of different prices. The method is logical as the closing stock values are more accurate. The disadvantages are that is is a cumbersome calculation and the cost of production may relate to out of date items.
*Average cost. Calculated by dividing the total value of materials in stock by the total quantity - Continuous Weighted Average (CWA) method. This method is generally used in order to avoid detailed calculations of FIFO. This method may require frequent changes to prices depending on the number of purchased items. Provided that the receipts of materials are recorded this method can be simple to apply. The CWA is obtained by dividing the total value of stock at any one time by the total quantity. A new price will be calculated each time when stock is received to stores. The CWA is easy to calculate, prices relating to previous periods are taken into account and the prices can be updated regularly. But the CWA price may lag behind the current economic prices, may not relate to any actual price paid and sometimes it is necessary to write off any adjustments to the profits and loss accounts at the end of the accounting period.
* Standard cost. Estimating the costs that are likely to be in the future.
Direct labour
Labour costs include the costs of employee salaries, wages, bonuses, national insurance paid and pension funds contributions. Generally we aim to charge labour costs to specific units. If this is not possible then they will have to be treated as indirect costs. To determine direct labour we:
Employees working on specific unit are required to keep record on how many hours they spend on each unit.
The total hours worked on each unit is multiplied by the appropriate hourly rate.
A percentage is added to the total to allow other labour costs i.e national insurance, pension funds contributions and holiday pay.
The total amount is then charged directly to the unit.
In practice it is not easy to accurately estimate the direct labour cost to one unit. It depends on keeping accurate records. Managers should stress to employees how important it is to keep accurate records. High costs may indicate that company will hard it hard to secure a contract.
Other direct costs
It can be difficult to identify other expenses, it is still worthwhile to make the effort. Otherwise the indirect charge just becomes bigger and bigger and causing problems when calculating the total cost per unit.
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