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Cost accounting is the process of tracking, recording and analyzing costs associated with the products or activities of an organization, where cost is defined as 'required time or resources'. Costs are measured in units of Currency by convention. Cost accounting could also be defined as a kind of Management Accounting that translates the Supply Chain (the physical movement of products) into financial value to support decision making to improve Cost s and Cash Flow s. There are at least four approaches:
ORIGINS Costs were originally considered fixed. ("Cost" comes from a Latin root meaning "to stand".) In larger organizations, some costs tend to remain the same even during busy periods, while others rise and fall with volume of work. A more convenient way of categorizing these costs is to define them as either fixed or variable. Fixed Cost s were associated with the business administration, and did not change during quiet or busy times. Variable Cost s were associated with productive work, and naturally rose and fell with business activity. In the early twentieth century, as organizations began getting more complex, managers needed a simple way to make decisions about products and pricing. Since most costs at the time were variable, managers could simply total the variable costs for a product and use this as a rough guide for decision-making. :For example: In order to make a railway coach a company needed to buy $60 in raw materials and components, and pay 6 laborers $40 each: total average variable costs of $300. Knowing that making a coach required spending $300, managers therefore couldn't sell below that price without losing money on each coach. Any price above $300 became a contribution to the fixed costs of the company. If the fixed costs were, say, $1000 per month for rent, insurance and owner's salary, the company could therefore sell 5 coaches per month for a total of $3000 (priced at $600 each), or 10 coaches for a total of $4500 (priced at $450 each), and make a profit of $500 in both cases. STANDARD COSTING Standard costing took the idea further, by dividing the fixed costs by the number of items produced, and treating the result as if it were a variable cost. This enabled managers to effectively ignore the fixed costs, simplifying the decision process even more. :For example: if the railway coach company produced 40 coaches per month, and the fixed costs were still $1000/month, then each coach could be said to incur an Overhead of $25 ($1000/40). Adding this to the variable costs of $300 per coach produced a unit cost of $325 per coach. This method tended to slightly distort the resulting unit cost, but in mass-production industries that made one product line, and where the fixed costs were relatively low, the distortion was very minor. :For example: if the railway coach company made 100 coaches one month, then the unit cost would become $310 per coach ($300 + ($1000/100)). If the next month the company made 50 coaches, then the unit cost = $320 per coach ($300 + ($1000/50)), a relatively minor difference. i.e. unit cost is inversely proportional to no. of variables. Evolution of standard costing
As a result, the terms "direct costs" and "indirect costs" often replace the variable/fixed terminology, to better reflect the way allocation of overhead is actually calculated. Indirect costs (often large) are usually allocated in proportion to either direct costs, or some physical resource utilization. One effect of the above is that the practice of allocating fixed costs has a far more distorting impact on unit cost figures than it ever used to have. :For example: say the railway coach company paid its workforce a fixed monthly rate of $8000 (total) and its other fixed costs had risen to $2600/month making the total fixed costs = $10600/month. The unit cost to make 40 coaches per month is still $325 per coach ($60 material + (10600/40)), while 100 coaches would have a unit cost of $166 per coach ($60 + ($10600/100)), and 10 coaches would "cost" $1120 each. Managers using the unit cost figure based on 20 coaches per month ($60 + ($10600/20) or $590) would likely reject an order for 100 coaches (to be produced in one month) if the selling price was only $300 per unit. If they used the original fixed/variable cost distinction, they would see clearly that this order contributes to the fixed costs by $240 per coach ($300 - $60 materials) and would result in a net profit of $13,400 (($240 x 100) - 10600). ACTIVITY-BASED COSTING Activity-based Costing (ABC) is costing by activities. In this case, activities are those regular actions performed inside a company. "Talking with customer regarding invoice questions" is an example of an activity performed inside most companies. Accountants assign 100% of each employee's time to the different activities performed inside a company (many will use surveys to have the workers themselves assign their time to the different activities). The accountant then can determine the total cost spent on each activity by summing up the percentage of each worker's salary spent on that activity. Each product or service is produced and delivered via the activities performed in the company. The accountant can then assign the different activities to the different products using an appropriate allocation method. A company can use the resulting activity cost data to determine where to focus their operational improvement efforts. For example, a job based manufacturer may find that a high percentage of their workers are spending their time trying to figure out a hastily written customer order. Via ABC, the accountants now have a currency amount that will be associated with the activity of "Researching Customer Work Order Specifications". Senior management can now decide how much focus or money to budget for the resolutions of this process deficiency. Activity-based Management includes (but is not restricted to) the use of activity-based costing to manage a business. MARGINAL COSTING This method is used particularly for short-term decision-making. Its principal tenets are:
Thus it does not attempt to allocate fixed costs in an arbitrary manner to different products. The short-term objective is to maximise contribution per unit. If constraints exist on resources then under marginal costing, these resources to maximise contribution per unit of the constrained resource. OTHER COSTING METHODS More varieties of costing methods have been proposed in order to tailor for different aspects of the business. Some of the uprising ones include Inventory Costing method, Process Costing method, Average Costing method, Target Costing method. Still the standard methods and normal costing methods are the best established methods in the accounting world. SEE ALSO EXTERNAL LINKS |
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