Question

Prepare an essay about the tools and analytical methods used in cost accounting. How will they be of value (or not) to managers and decision makers in different types of organizations? Manufacturing company vs service company. Why / why not? Present your discussion in a logical, integrated format.

Answer 1

Tools and analytical methods used in cost accounting:

Cost accounting involves the recordation, analysis, and reporting of costs to management. The intent behind this type of accounting is to provide insights into the cost structure of a business that can be used to better manage it. As opposed to financial accounting, cost accounting is primarily intended for internal operational activities.

There are following tools and methods used in cost accounting-

• Activity based cost analyses
• Breakeven analysis
• Budgeting
• Cost control
• Marginal cost analysis
• Minimum pricing analysis
• Standard cost development
• Target costing
• Throughput analysis
• Transfer pricing
• Variance analysis

Activity based cost analysis:

Activity-based costing (ABC) is a methodology for more precisely allocating overhead to those items that actually use it. The system can be used for the targeted reduction of overhead costs. ABC works best in complex environments, where there are many machines and products, and tangled processes that are not easy to sort out. Conversely, it is of less use in a streamlined environment where production processes are abbreviated.

The Activity Based Costing Process Flow

Activity-based costing is best explained by walking through its various steps. They are:

Identify costs. The first step in ABC is to identify those costs that we want to allocate. This is the most critical step in the entire process, since we do not want to waste time with an excessively broad project scope. For example, if we want to determine the full cost of a distribution channel, we will identify advertising and warehousing costs related to that channel, but will ignore research costs, since they are related to products, not channels.

Load secondary cost pools. Create cost pools for those costs incurred to provide services to other parts of the company, rather than directly supporting a company’s products or services. The contents of secondary cost pools typically include computer services and administrative salaries, and similar costs. These costs are later allocated to other cost pools that more directly relate to products and services. There may be several of these secondary cost pools, depending upon the nature of the costs and how they will be allocated.

Load primary cost pools. Create a set of cost pools for those costs more closely aligned with the production of goods or services. It is very common to have separate cost pools for each product line, since costs tend to occur at this level. Such costs can include research and development, advertising, procurement, and distribution. Similarly, you might consider creating cost pools for each distribution channel, or for each facility. If production batches are of greatly varying lengths, then consider creating cost pools at the batch level, so that you can adequately assign costs based on batch size.

Measure activity drivers. Use a data collection system to collect information about the activity drivers that are used to allocate the costs in secondary cost pools to primary cost pools, as well as to allocate the costs in primary cost pools to cost objects. It can be expensive to accumulate activity driver information, so use activity drivers for which information is already being collected, where possible.

1. Allocate costs in secondary pools to primary pools. Use activity drivers to apportion the costs in the secondary cost pools to the primary cost pools.
2. Charge costs to cost objects. Use an activity driver to allocate the contents of each primary cost pool to cost objects. There will be a separate activity driver for each cost pool. To allocate the costs, divide the total cost in each cost pool by the total amount of activity in the activity driver, to establish the cost per unit of activity. Then allocate the cost per unit to the cost objects, based on their use of the activity driver.
3. Formulate reports. Convert the results of the ABC system into reports for management consumption. For example, if the system was originally designed to accumulate overhead information by geographical sales region, then report on revenues earned in each region, all direct costs, and the overhead derived from the ABC system. This gives management a full cost view of the results generated by each region.
4. Act on the information. The most common management reaction to an ABC report is to reduce the quantity of activity drivers used by each cost object. Doing so should reduce the amount of overhead cost being used. Breakeven ananlysis: Breakeven analysis is used to locate the sales volume at which a business earns exactly no money, where all contribution margin earned is needed to pay for the company’s fixed costs. Contribution margin is the margin that results when all variable expenses are subtracted from revenue. In essence, once the contribution margin on each sale cumulatively matches the total amount of fixed costs incurred for a period, the breakeven point has been reached. All sales above that level directly contribute to profits. Breakeven analysis is useful for the following reasons: Determining the amount of remaining capacity after the breakeven point is reached, which reveals the maximum amount of profit that can be generated. Determining the impact on profit if automation (a fixed cost) replaces labor (a variable cost). Determining the change in profits if product prices are altered. Determining the amount of losses that could be sustained if the business suffers a sales downturn. In addition, breakeven analysis is useful for establishing the overall ability of a company to generate a profit. When the breakeven point is near the maximum sales level of a business, this means it is nearly impossible for the company to earn a profit even under the best of circumstances. Management should constantly monitor the breakeven point, particularly in regard to the last item noted, in order to reduce the breakeven point whenever possible. Ways to do this include: Cost analysis. Continually review all fixed costs, to see if any can be eliminated. Also review variable costs to see if they can be eliminated, since doing so increases margins and reduces the breakeven point. Margin analysis. Pay close attention to product margins, and push sales of the highest-margin items, thereby reducing the breakeven point. Outsourcing. If an activity involves a fixed cost, consider outsourcing it in order to turn it into a per-unit variable cost, which reduces the breakeven point. Pricing. Reduce or eliminate the use of coupons or other price reductions, since they increase the breakeven point. Technologies. Implement any technologies that can improve the efficiency of the business, thereby increasing capacity with no increase in cost. To calculate the breakeven point, divide total fixed expenses by the contribution margin. The formula is:   Total fixed expenses ÷ Contribution margin percentage A more refined approach is to eliminate all non-cash expenses (such as depreciation) from the numerator, so that the calculation focuses on the breakeven cash flow level. The formula is: (Total fixed expenses – Depreciation – Amortization) ÷ Contribution margin percentage Another variation on the formula is to focus instead on the number of units that must be sold in order to break even, rather than the sales level in dollars. This formula is: Total fixed expenses ÷ Average contribution margin per unit   Budgeting: A budget forecasts the financial results and financial position of a company for one or more future periods. A budget is used for planning and performance measurement purposes, which can involve spending for fixed assets, rolling out new products, training employees, setting up bonus plans, controlling operations, and so forth. At the most minimal level, a budget contains an estimated income statement for future periods. A more complex budget contains a sales forecast, the cost of goods sold and expenditures needed to support the projected sales, estimates of working capital requirements, fixed asset purchases, a cash flow forecast, and an estimate of financing needs. This should be constructed in a top-down format, so a master budget contains a summary of the entire budget document, while separate documents containing supporting budgets roll up into the master budget and provide additional detail to users. Cost control: Cost control is a series of steps that a business uses to maintain proper control over its costs. Implementing this level of control can have a profound positive impact on profits over the long term. The following four steps are associated with cost control:   Create a baseline. Establish a standard or baseline against which actual costs are to be compared. These standards may be based on historical results, a reasonable improvement on historical results, or the theoretically best attainable cost performance. The middle alternative is generally considered to yield the best results, since it sets an achievable standard. Calculate a variance. Calculate the variance between actual results and the standard or baseline noted in the first step. Particular emphasis is placed on the detection of unfavorable variances, which are those actual costs that are higher than expected. If a variance is immaterial, it may not be worthwhile to report the item to management.Investigate variances. Conduct a detailed drill-down into the actual cost information to ascertain the reason for an unfavorable variance. Take action. Based on the information found in the preceding step, recommend to management whatever corrective actions are needed to reduce the risk of continued unfavorable cost variances. Marginal cost analysis: Marginal cost is the cost of one additional unit of output. The concept is used to determine the optimum production quantity for a company, where it costs the least amount to produce additional units. If a company operates within this "sweet spot," it can maximize its profits. The concept is also used to determine product pricing when customers request the lowest possible price for certain orders.For example, a production line currently creates 10,000 widgets at a cost of $30,000, so that the average cost per unit is $3.00. However, if the production line creates 10,001 units, the total cost is $30,002, so that the marginal cost of the one additional unit is only $2. This is a common effect, because there is rarely any additional overhead cost associated with a single unit of output, resulting in a lower marginal cost.    Standard cost:

5. A standard cost is a planned or budgeted cost. It is commonly used to derive cost variances, particularly in regard to production and inventory costs. The variances indicate which costs need to be addressed by management.

   A standard cost is based on engineering designs and production methodologies, which can be attained under normal operating conditions.

   Target costing: Target costing is a system under which a company plans in advance for the price points, product costs, and margins that it wants to achieve for a new product. If it cannot manufacture a product at these planned levels, then it cancels the design project entirely. With target costing, a management team has a powerful tool for continually monitoring products from the moment they enter the design phase and onward throughout their product life cycles. It is considered one of the most important tools for achieving consistent profitability in a manufacturing environment. Throughput analysis: The primary concept underpinning throughput analysis is that you should look at investment decisions in terms of their impact on the entire system, rather than on the specific area in which an investment is contemplated. The system view is based on the fact that most production costs do not vary at the level of the individual unit produced. When a unit is manufactured, only the associated cost of materials is incurred. All other costs are associated with the production process, and so will be incurred even in the absence of any unit-level production. Transfer Pricing:   

   Transfer pricing is the method used to sell a product from one subsidiary to another within a company. It impacts the purchasing behavior of the subsidiaries, and may have income tax implications for the company as a whole.

   Here are the key issues: Revenue basis. The manager of a subsidiary treats it in the same manner that he would the price of a product sold outside of the company. It forms part of the revenue of his subsidiary, and is therefore crucial to the financial performance on which he is judged. Preferred customers. If the manager of a subsidiary is given the choice of selling either to a downstream subsidiary or to outside customers, then an excessively low transfer price will lead the manager to sell exclusively to outside customers, and to refuse orders originating from the downstream subsidiary. Preferred suppliers. If the manager of a downstream subsidiary is given the choice of buying either from an upstream subsidiary or an outside supplier, then an excessively high transfer price will cause the manager to buy exclusively from outside suppliers. As a result, the upstream subsidiary may have too much unused capacity, and will have to cut back on its expenses in order to remain profitable. Variance analysis:   

   Variance analysis is the quantitative investigation of the difference between actual and planned behavior. This analysis is used to maintain control over a business. For example, if you budget for sales to be $10,000 and actual sales are $8,000, variance analysis yields a difference of $2,000. Variance analysis is especially effective when you review the amount of a variance on a trend line, so that sudden changes in the variance level from month to month are more readily apparent. Variance analysis also involves the investigation of these differences, so that the outcome is a statement of the difference from expectations, and an interpretation of why the variance occurred. To continue with the example, a complete analysis of the sales variance would be:

   "Sales during the month were $2,000 lower than the budget of $10,000. This variance was primarily caused by the loss of ABC customer at the end of the preceding month, which usually buys $1,800 per month from the company. We lost ABC customer because we had several instances of late deliveries to it over the past few months."