Imagine you run your own company. Thanks to financial accounting, you know how well your company performed last year. But how do you know which products to manufacture next year? How do you know how many units of each product your company should make? And how do you know how to price your products? To figure this out, managers rely on an important aspect of managerial accounting: “COST ACCOUNTING”. This post describes the cost accounting simply with light and easy examples. I do realize [though everyone agrees too] that cost accounting is an intricate endeavor. My intent isn’t to teach you how to be a cost accountant, but rather to provide basic clues on some of the things cost accountants look for.
What Is Cost Accounting?
If financial accounting is the process by which companies determine their results-sales and earnings, cost accounting is the system by which they determine the cause of those results. For instance: let’s say you work for the Lie Dharma Shoe Co. The company makes and sells two different styles of men’s shoes: loafers and boots. Thanks to financial accounting, we know that the Lie Dharma Shoe Co. generated $1 million in profit last year. That’s 50 percent worse than it did the previous year, when profits topped $2 million. What happened?
One way to determine what happened is to study the company’s costs. Obviously, a company should know how much it costs to make each product before it manufactures these goods. This information helps it to:
- determine how much to sell its product for;
- decide if a product is worth making;
- decide how many units of each product it will make; and
- determine if it can make the product cheaper, or if it can get a better deal buying it already made from an-other company.
In our example, one explanation for the Lie Dharma Shoe Co.’s falling profits could be that the cost of manufacturing boots rose last year. Let’s assume that this occurred. Without proper cost accounting, the company would not have known this fact. If the company did not know this, it wouldn’t have known to raise its prices to keep pace. And that may be the very reason that the company’s profits fell.
What if the problem wasn’t the boots? Maybe a competitor came along and, through mass production, undercut Lie Dharma’s prices for loafers by 50 percent. If this was the case, Lie Dharma probably needed to slash its prices just to keep up, forcing the company to sell its loafers at cost or below.
How could cost accounting have helped Lie Dharma in this scenario? Here’s one way: What if, through proper cost accounting, Lie Dharma realized that it could buy loafers cheaper than it could make them in-house? If this were the case, the company could have protected its profit margins by purchasing rather than making its own products.
As you can see, cost accounting is a critical tool for managers. By letting a company know how much it costs to make a single unit of a single product, it helps the firm know whether making that additional product is worthwhile.
It also helps a company determine its proper sales mix. Sales mix refers to how many units of each product a company sells. In our example, Lie Dharma may decide to go with a sales mix that favors boots over loafers based on costs and demand. Or, it could choose to make two loafers for every one boot it manufactures. Poor cost accounting could lead to shortages in profitable products, and stockpiles of unprofitable ones.
Cost accounting, like financial accounting, demands consistency. After all, just as investors must feel confident that a company’s financial accounting methods are sound, a firm’s managers must be absolutely sure that the information they are receiving about costs is consistent throughout different product lines. It does a manager no good if Lie Dharma Shoe uses one accounting method to cost its boots and another to cost loafers.
What Are Product Costs?
Product costs are all those costs associated with manufacturing a product. [For those companies that don’t make the products they sell such as retailers product costs are limited to the cost of purchasing inventory]. They include the cost of:
- Raw Materials
- Variable Overhead (such as electricity)
- Fixed Overhead (such as rent)
So how do companies determine how much it costs to make a product? For starters, they take the actual amount of money required to manufacture a product and divide that figure by the number of units they produce. Seems simple enough:
Unit Costs = Total Manufacturing Costs / Numbers of Units Produced
For instance, in our example, Lie Dharma Shoe spent $365,000 making loafers last year, as shown in the table below:
Raw materials $200,000 $300,000
Labor 100,000 100,000
Overhead variable 25,000 35,000
Overhead fixed 40,000 40,000
Total manufacturing costs: $365,000 $475,000
Units made 14,000 15,500
With that money, it made 14,000 loafers. That means each loafer it made cost the company $26.07. Lie Dharma Shoe spent $475,000 making 15,500 boots. That means each boot cost the company $30.65.
What do these numbers tell us? They tell us that Lie Dharma Shoe must sell loafers for more than $26.07 a pair and boots for at least $30.65 a pair to clear a profit.
Should competition drive the price of loafers below $26.07, for instance, the company would know, based on its cost structure that it may no longer be worthwhile to continue selling loafers. Or, this could be a sign that the company may want to outsource the production of loafers [that’s if they can find a manufacturer with cheaper unit costs]. Or, it could be a sign that the firm must not only outsource the production of its shoes but also find cheaper ways to store, sell, market, and distribute its products.
But taking the total manufacturing cost for a product line and dividing it by the number of units produced isn’t the most accurate gauge of costs. For instance: when we calculated that Lie Dharma Shoe’s unit cost for making loafers was $26.07 a pair, what we really calculated was the average cost for manufacturing loafers. Some loafers may have cost more. And some may have cost less, depending on when they were produced [and the cost of raw materials, labor, and overhead at that time].
To find a more accurate number, financial managers break down actual unit costs into two broad categories: JOB COSTING and PROCESS COSTING.
Before going to the next clue of cost accounting [Job Costing], let’s figure out…
What’s a Cost, What’s an Expense, and What’s the Difference?
We’ve been using the word cost throughout this previous sectionS. Isn’t cost the same thing as a expense? After all, if it costs a company $25 to make a shoe, don’t those costs count as expenses on its P&L statement? Eventually. But according to the rules of GAAP, a company cannot record a cost as an expense until a transaction has been recorded.
What does this mean? It means that in any given year, your company’s costs and expenses will differ. For instance: it could cost your company $2,500 to make 100 shoes. But it may only incur $1,500 of expenses. How? Let’s say your company purchased $2,500 worth of leather to make 100 shoes, or $25 of leather per pair of shoes. But let’s say your company only made 60 shoes this year. The cost of the leather used to make those 60 shoes$1,500would be counted as an expense on its income statement for the year. However, the remaining $1,000 worth of leather would be treated as a part of inventory, considered an asset on your company’s balance sheet.
The unit cost method we described above may be appropriate for a company that mass produces its goods. But it’s of little use to manufacturers that custom-make products. Consider an airplane manufacturer. Unlike a carmaker that mass-assembles automobiles, airplane makers build planes to the exact specifications of their customers. For instance, American Airlines may want a slightly different seat configuration than the one United wants for the exact same model plane. Or Delta may want a slightly different audiovisual system installed for its First Class section than the one that Continental Airlines ordered. Therefore, taking the total manufacturing cost of planes and dividing by the number of planes produced would lump in the additional costs of building a plane for American Airlines with the baseline costs of building a plane for a no-frills carrier.
To come up with a more accurate number, cost accountants turn to something called JOB COSTING.
JOB COSTING simply refers to the act of taking the actual costs of producing a specific order of products and dividing that figure by the number of specific products made.
If United Airlines, for instance, orders ten jumbo jets identical model planes with the exact same specifications then the airplane maker could calculate the unit costs of making those planes by taking the total costs of making that batch of planes and dividing by ten.
Job Order Sheet Example
Manufactured For: Strauss Department Store
Product: Men’s Black Dress Loafers
Date Started: 1/1/2008
Order No. B-17
Date Due: 2/1/2008
Raw materials Date Type Quantity Cost Total
Labor Date Type Hours Cost Total
Attributable overhead Date Type Units Cost Total
Total manufacturing costs:
Generally, companies keep track of job costs on a job order sheet, like the one shown in our example above. Obviously, job costing takes more time, effort, and money than simply dividing total costs by the total number of products made.
Given the added time and money required for job costing, some companies find that it’s not worth the effort. For instance: consider the case of a company that bottles spring water. Whether that company sells its spring water to a small chain of health food stores or to large offices, the cost of obtaining and filtering that water remains the same. Therefore, this company does not need to cost its products on a contract-by-contract basis. Let’s say you work for a spring water company that bottles water for the first two weeks of every month. That water goes to all its customers small and large. So, the company would take the total cost of filtering and bottling its water for January and divide that by the number of bottles of water it produced during that time. That would give the firm its process unit cost.
Variable Costs vs. Fixed Costs
Let’s say you work for an automaker. And either through job costing or process costing, you figure out that your company actually spends $6,000 per car it makes. Does that mean that each new car the company makes will cost $6,000? Not necessarily.
To figure out how much each additional car will cost, you need more information: You need to know how much of your total manufacturing costs are fixed costs and how much are variable. You’ll recall that fixed costs are those that don’t fluctuate based on the number of units of product a company makes. For instance: no matter how many cars your company manufactures, its factory rent will remain constant. On the other hand, variable costs are those costs that do fluctuate based on volume.
The cost of raw materials, for instance, will change based on the amount of materials the company consumes. Let’s assume that your company spent $6,000,000 making 1,000 cars (that’s how it came up with a unit cost of $6,000). And let’s further assume that $4,000,000 of that $6,000,000 were variable costs and $2,000,000 were fixed. The company wants to know how much it will cost to make 2,000 cars. Is the answer $12,000,000 [=$6,000 unit cost x 2,000 units] ? No.
Here’s why. Whether the company makes 1,000 or 2,000 cars, its fixed costs will still be $2,000,000. So that’s our starting point. Now, we add the variable costs. When the company made 1,000 cars, the company incurred $4,000,000 in variable costs-meaning its variable unit cost is $4,000. So, at $4,000 a car, 2,000 cars would equal $8,000,000 in variable costs. Add $8,000,000 to $2,000,000, and the cost of building 2,000 cars is actually $10,000,000not the $12,000,000 we assumed from the start.
Tips: How to Cut Costs
How does a company with disproportionately high fixed costs reduce costs? Simple by increasing production!
Here’s how it works:
Imagine that your company owns a factory designed to produce 1,000 shoes per day. And let’s further assume the fixed cost of keeping the factory running is $10,000 a day. That means that whether the factory makes one shoe or 1,000 shoes, it still costs $10,000 to operate the factory.
Now, imagine your company normally makes 750 shoes. Its fixed costs per unit would be $13.33 per shoe. So to produce 250 more shoes, it wouldn’t incur any additional fixed costs. That’s because the factory has idle capacity. Most factories have some unused capacity.
Assuming that you have a decent contribution margin [a contribution margin equals sales minus variable costs], your company could reduce its overall unit cost by utilizing the plant’s idle capacity and making 1,000 shoes. Throughout the day, workers who assemble sweaters may also be responsible for making shirts, or even pants.
How do you know exactly how much of your labor costs went into sweaters versus shirts versus pants? As a result, companies also rely on standard costing to help fill these gaps. Let’s talk about standard costing in brief. Read on…
What is standard costing? Think of standard costs as an estimate that the company comes up with, based on experience. The company establishes these estimates for costs throughout each stage of the manufacturing process:
- the purchase of raw materials;
- the work in progress stage; and
- the finished goods stage.
As products flow through each of these stages, the company examines the actual cost of production to see how close the standard cost allowances are. The differences are recorded as variances, and these variances go a long way toward helping the company identify why certain products are more expensive to produce than they should be.
Whether your firm relies on job costing or process costing, the use of actual numbers to calculate unit cost has its shortcomings.
For instance: gathering actual costs:
Can be expensive, as we just mentioned.
Takes time. In our example, Lie Dharma Shoe would have to wait until the end of a month, a quarter, a year or at the end of a job order to find out what its actual unit costs were. While the data may be accurate, it might not be available to managers in time for them to make quick decisions about future production and pricing.
May be difficult to calculate. This is especially true for companies which manufacture multiple products in a single factory. Imagine you work for a clothing manufacturer, which makes sweaters, shirts, and pants.
FYI: Idle Capacity
According to the Federal Reserve, the nation’s factories ran at 84 percent of capacity in October 1997. If a company determined, based on demand, that it could run its factories at 100 percent capacity, the additional 16 percent of output would be free of the fixed costs associated with running the factory. That’s why we often refer to idle capacity as underutilization of costs.
Distributing Shared Costs
It’s easy to determine how much a product costs if the company you work for only makes one type of product. Similarly, it’s simple to figure out how much raw materials cost your firm. You just calculate the amount of raw materials required to make a batch of products, and divide by the units produced.
But… what about labor? And what about overhead?
Figuring out how to apportion shared costs is one of the most difficult tasks for a cost accountant. At the same time, it’s one of the most important. Go back to our example. Like most companies in the real world, Lie Dharma Shoe manufactures more than one type of product. Let’s assume, however, that it makes both loafers and boots in the same factory. Let’s also assume that workers in that factory are responsible for making both loafers and boots.
When assigning the cost of labor for loafers, how do you know what portion of the labor costs are attributable to loafers, and what portion should go to boots?
One way is through something called “activity-based costing [ABC]“. It works like this. Let’s say that Lie Dharma Shoe makes 60 boots and 40 loafers on any given day. And let’s say that it takes the same number of labor hours to make each shoe. That means on any given day, 60 percent of the company’s labor hours are devoted to boots and 40 percent are devoted to shoes.
Assuming that total labor costs for a day total $10,000, the company can assign $6,000 in labor costs to boots and $4,000 to loafers.
The same is true for overhead. The rules of ABC simply state that you assign costs on the basis of usage-to the extent that usage pattern