Chapter 1 INTRODUCTION TO COST ACCOUNTING LEARNING OBJECTIVES Upon completion of this chapter, you should be able to: ¢ Distinguish between financial, managerial, and cost accounting Distinguish between merchandising and manufacturing operations © Identify the uses of cost accounting data © Distinguish between job order costing and process costing The main and primary objective of accounting is to provide financial information about an economic entity to different types of users. First we have internal users — managers for planning, controlling and decision making. Then we have external users — the government, those who provide funds and those who have various interests in the operations of theof the entity. Cost Accounting is an expanded phase of general or financial accounting which informs management promptly with the cost of rendering a particular service, buying and selling a product, and producing a product. It is the field of accounting that measures, records, and reports information about costs. All types of business entities - manufacturing, merchandising, and service businesses - require information systems which provide the necessary financial data. Because of the nature of the manufacturing process, the information systems of manufacturing entities must be designed to accumulate detailed cost data relating to the production process. Thus, it is common today for small, medium, and large manufacturing companies to have structured costs accounting systems. These systems should show what costs were incurred and where and how these costs were utilized. Cost accounting today is recognized as being essential to efficient cooperation of business and industry. In order to. appreciate the importance of an efficient cost system, it is necessary to understand the nature of the manufacturing process. In many ways, the activities of a manufacturing organization are similar to those of a merchandising business. Both are concerned with purchasing, storing, and selling goods; both-must have efficient management and adequate sources of capital; both may employ hundreds or thousatids of workers. In the manufacturing process itself, we see the distinction2 Cost Accou nting between the two: merchandisers, such as SM buy items in marketable form to be resold to their customers; manufacturers, such as PHILACOR, must make the goods they sell. Once the merchandising organization has acquired and stored goods, it is ready to carry out the marketing function. ‘The purchase of materials by manufacturer, however, is only the beginning of a long, and sometimes complex, chain of events that will eventually produce a finished article ready for sale. The manufacturing process involves the conversion of raw materials into finished goods through the application of labor and the inéurrence of various ‘factory expenses. The manufacturer. must make a major investment in physical facilities, such as factory buildings and warehouses, and acquire many specialized types of machinery and equipment. In order to carry out the manufacturing process, the manufacturer must purchase appropriate quantities of raw materials, Supplies and Parts, and build up a work force to convert these resources into finished goods. Once the goods are completed and are ready for sale, the manufacturer performs basically the same functions as the merchandiser in storing and marketing the goods. The methods of accounting for sales, cost of goods sold, and selling and administrative expenses are also similar to those of the merchandising organization, Although cost accounting developed originally in manufacturing business to satisfy management’s need for product cost information, cost accounting information i= useful for all types of activities in all types of organizations. Cost accounting is essential not only for profit-seeking entities but also for not-for-profit organizatiozs. such as governmental agencies, churches, and charities, Comparison of Financial, Managerial , and Cost Accounting There are two major areas of accounting - (1) financial accounting and ¢ managerial accounting. Financial accounting is the use of accounting information for reporting to ext parties, including investors and creditors. Financial accounting is prim: concemed with financial statements for external use by those who supply funds the entity and other persons who may have vested interest in the financial operatic of the firm. The suppliers of funds include stockholders (the owners of. Corporation) partners ( the owners of the partnership) and sole proprietors, Credi who provide debts are also interested on the financial statements of the entity. financial statements are the output from an accounting system. The reports under financial accounting focus on the enterprise as a whole. Financial acco is based on historical transaction data. The information may be histori quantitative, monetary and verifiable. The data are historical and are supported documents (evidence). The information provided by financial accounting is usuallyChapter 1 Introduction to Cost Accounting 3 presented in the form of financial statements, tax returns, and other formal reports distributed to various external users. The same information may also be used internally to provide a basis for financial analysis by management. Financial accounting is required for many firms organized as corporations because of the requirements of the Securities and Exchange Commission. The Bureau of Internal Revenue also requires financial accounting information for compliance with the country’s tax laws. Information based on accounting data is required for all firms without regard to their size. Managerial accounting focuses on the needs of parties within the organization, rather than interested parties outside the organization. Managerial accounting information commonly addresses individual or divisional concerns rather than those of the enterprise as a whole. The information may be current or forecasted, quantitative or qualitative, monetary or non-monetary and most of all timely the data are futuristic and some of the costs are not recorded on the accounting books of the organization Managerial accounting is not separate and distinct from financial accounting. Financial accounting data are used in the managerial accounting system. Management decisions made today will affect the financial statement of future periods. There is no requirement or legislation that mandates the format or use of managerial accounting. Managerial accounting methods are tools that are available for use to management. Financial accounting attempts to present some degree of precision in reporting historical information while at the same time emphasizing verifiability and freedom from bias in the information, relevance to the general user and some degree of timeliness in reporting which is not as critical in managerial accounting. The timing of information and its relevance to the decision on hand has greater significance to the internal decision-maker. Management is more conceed on the timeliness of the information so management cannot wait until tomorrow for information that is required for today’s decision. The measuring based in managerial accounting does not necessarily have to be restricted to pesos. Various bases may be appropriate to report managerial information. Examples include: (1) an economic measure such as pesos; (2) a physical measure such as pounds, gallons, tons, or units; and (3) a relationship measure such as ratios...4 Cost Accounting Cost accounting is the intersection between financial and managerial accounting. Cost accounting information is needed and used by both financial and managerial accounting. Cost accounting provides product cost information to external parties, such as stockholders, creditors and various regulatory boards: for credit and investment decisions. Cost accounting provides product cost information also to internal parties such as managers for planning and controlling, Relationship of Financial, Management, and Cost Accounting Merchandising versus Manufacturing Operations Much of our accounting education has centered on the merchandising organizati Thus, it is important here to explain the difference in accounting for manufacturi firms and merchandising firms. Many types of businesses gather information costs, but doing so is especially important in manufacturing. A merchandising company normally buys a product that is ready for resale when is received. Nothing needs to be done to the product to make it salable possibly to prepare a special package or display. As shown Figure 1-1 total beginning merchandise inventory plus purchases is the basis computing both the cost of goods sold and ending merchandise inventory balances. Costs assigned to unsold items make up the ending inventory bal The difference between the cost of goods available for sale and the ending invent amount is the cost of goods sold during the period. The following example sl the computation. Beginning merchandise inventory P 5,000 Plus: Total purchases 24,000 Cost of goods available for sale 29,000 Less: Ending merchandise inventory 6,500 Cost of goods sold 22,500Chapter 1 Introduction to Cost Accounting 7 Computing the cost of goods sold for a manufacturing company is more complex. As shown in Figure 1-2 instead of one inventory account, a manufacturer maintains three inventory accounts: Materials Inventory, Work in Process Inventory, and Finished Goods Inventory. Purchased materials unused during the production Process makeup the ending Materials Inventory balance. The cost of materials used plus the costs of labor services and factory overhead are transferred to the Work in Process Inventory account when the materials, labor services, and ovethead items are used in the production process. (Factory overhead includes such items as indirect materials, indirect labor, utility costs, depreciation of factory machinery, depreciation of factory building, and supplies). The three types of costs mentioned are often called direct materials, direct labor and factory overhead {abbreviated DM, DL, and FO). These costs are accumulated in the Work in Process Inventory (WP Invty.)Account during an accounting period, When a batch or order is completed, all manufacturing costs assigned to the completed units are moved to the Finished Goods Inventory account. Costs remaining in the Work in Process Inventory account belong to partly completed units. ‘These costs make up the ending balance in the Work in process Inventory account. The Finished Goods Inventory (FG Inventory.)Account is set up in the same way as the Merchandise Inventory account under Merchandising. Costs of completed goods are entered into the Finished Goods Inventory account, Then costs attached to unsold items at year end make up the ending balance in the Finished Goods Inventory account, Al! costs elated to units sold are transferred to the Cost of Goods Sold account and reported on the income statement, USES OF COST ACCOUNTING DATA The information produced by a cost accounting system provides a basis for determining product cost and aids management in planning and controlling operatic Determining Product Costs Cost accounting procedures help management in gathering the data needed to determine product costs and thus generate meaningful financial statements and other Teports. Cost procedures must be designed to permit the computation of unit costs as well as total product costs, For example, if a manufacturer spent P10, 000 for labor in a certain month, the information is insignificant; but if this labor produced 5,000 finished units, the fact that the cost of labor was P2 per unit is significant, because this figure can be compared to the unit labor cost of other periods and the trends amaiyzed8 Cost Accounting Unit cost information is also useful in making 4 variety of important marketing decisions, 1 Determining the selling price of a product, ‘manufacturing a unit of product helps in sett A knowledge of the cost of ing the selling price, whice rendering a service. 2. Meeting competition, Ifa competitor is selling the product at a low price, detailed information regarding unit costs can be used to determine the action to be taken by the company, ‘The fe mPany would know if selling price must be reduced, or manufacturing costs must be reduced, or the Product must be eliminated, determine the amount of Profit that each product eame and possibly eliminate those that are least Profitable, thereby concentrating efforts on Planning and Control One of the most important functions of cost accounting is the development of information which can be used by management in planning and controllingChapter 1 Introduction to Cost Accounting 9 operations. Planning is the process Of establishing objectives or goals for the firmi and determining the means by which the fre will attain them, Planning is essential i Sood management because it provides means of coordinating all of the erations of firm. Cost accounting helps in the development of plans by providing historical costs that serve as basis fer Projecting data for planning. Management can Planning can be divided into three (3) components: 1. Strategic planning — concemed with setting long range goals and objectives to determine the overall direction of the company. 2. Tactical planning ~ concerned with Plans for a shorter range (or tine Period) and emphasizes plans to achieve the strategic goals, 3. Operations Planning ~ relates to the day to day implementation of tactical Plans. It emphasizes the coordination of the major factors of Production (materials, labor and facilities) Control is the process of snenitoring the company’s operations and determining Whether the objectives identified in the Planning process are being accomplished. RECENT DEVELOPMENTS IN COST ACCOUNTING Cost accounting is experiencing dramatic changes, Manual bookkeeping has been reduced because of the use of coat ters: Changes in production methods have made traditional applications of cost accounting obsolete in some cases. Increasing emphasis on cost control is seen now in hospitals, in industries facing stiff foreign competition and in many organizations that have traditionally not focused on cost control.10 Cost Accounting marketing. Cost accounting is also related to motivation and behavior because it used in planning and performance evaluation. - Finally, tools from statistics mathematics, and computer sciences are used to perform cost analysis, TWO BASIC PRODUCT-COSTING SYSTEMS 1. Job order costing - a system for allocating costs to groups of unique product, is applicable to the production of customer specified products such. as manufacture of special machines, Each job becomes a cost center for which Costs are accumulated. A subsidiary record (job cost sheet) is needed to k track of all unfinished jobs (work in Process) and finished jobs (finished goods). 2. Process costing - a system applicable to a continuous process of production the same or similar goods, e.g., oil refining and chemical production, . i there is no need to determine the costs of different groups of products beca the product is uniform, each processing department becomes a cost center. Job Order versus Process Costing Job order costing and process costing are the two traditional basis approaches product cost accounting systems. Actual cost accounting systems may differ wi However, all are based on one of these two product costing concepts. Once the of system is selected, it is then adjusted to fit a particular industry, company, Operating department. The objective of the two systems is the same. They provide product unit cost information for Pricing, cost control, inventory valuati and income statement preparation, End-of-period values for the Cost of Goods S Work in Process Inventory, and Finished Goods Inventory accounts are ‘comp! using product unit cost data, Characteristics of Job Order Costing A job order cost accounting system is a product costing system used by comy making one-of-a-kind or special-order products. In such a system, direct mat direct labor, and factory overhead costs are assi igned to specific job orders or of production, In computing unit costs, the total manufacturing costs for each ji order are divided by the ‘number of good units produced for that order. Ind that use a job order cost accounting system include those that make ships, airpl large machines, and special orders. Job order costing may also be used producing a set quantity of a product for inventory replenishment, such as aexample, costs are assigned to audit engagements, For consulting and architectural firms, costs are assigned to contracts, while for universities it maybe for every research project. The primary characteristics of a job order cost system are as follows: 1) It collects all manufacturing costs and assigns them to specific job or batches of product, ‘The main characteristics of a Process cost accounting system are as follows: 1) Manufacturing costs arg grouped by department or work center, with little concern for specific job’ orders. 2) Itemphasizes a weekly or monthly time Period rather than the time taken to complete a specific order, 3) It uses several Works in Process Inventory accounts — one for each department or work center in the manufacturing process, Many ‘manufacturing firms have production evetam.12 Cost Accounting incorporates ideas from both. This blending of ideas is known as hyb: ‘The continuum below demonstrates the relationship between these costing systems. Job-order. ——_____» Hybrid —_————#rocess Product-costing costing system Product-costing systems systems The costing system an organization selects will mainly depend on its underlying production system. Operation costing is a hybrid costing system often used in Tepetitive manufacturing where finished products have common, as well as distinguishing characteristics. For example, in the manufacture of clothing, basic suits can be assembled in one operation, These suits can then move on to the next operation and have a deluxe lining added. Based on the variations, the products and the related costs are identified by batches or by production runs. A television assembly plant, which produces a basic chassis and component system, but which varies options such as remote control and cabinetry would be a logical user of operation costing. Some companies process large orders of identical units as a group through the same production sequence. Each of these orders is called a batch. In batch production, costs are allocated to each batch, Whenever a change in the production line is required to continue production, a new batch is created. A furniture manufacturer may produce a batch of chairs, then a batch of tables, then a batch of drawers, and so forth. Generally, job costing concepts are used to account for batch production and each batch is treated as a job for costing purposes. JOR. NCES BET" ESS & JOB ORDER COS’ PROCESS COSTING JOB ORDER COSTING 4. Homogeneous units pass through 1. Unique jobs are worked on during 2 series of similar processes. time period, 2. Costs are accumulated by 2, ~~ Costs are accumulated by individ processing department je job. 3. Unit costs are computed by dividing 3.’ Unit costs are determined by dividi the individual departments’ costs by the total costs on the job cost sheet the equivalent production the number of units on the joo.SS Chapter 1 Introduction to Cost Accounting 13 4. The cost of production report provides 4. The job cost sheet provides the the detail for the Work in Process Details for the work in Process account for ach department account. In job costing, costs are accumulated for each job or batch produced. In process costing, costs are accumulated by department for an accounting period (for example, month) Process costing has less detailed recordkeeping, hence, if a company was choosing between job and process costing, it would generally find that recordkeeping costs are Jower under process costing. Process costing does not provide as much information a3 job costing because records of the cost of each unit -produced are not kept using process costing. The choice of process versus job costing systems involves a comparison of the costs and benefits of each system. ‘As a general rule job systems are usually more costly than process systems. So if managers and accountants must decide whether to use job costing or process costing, recordkeeping costs must be compared with additional benefits that will be derived from knowing the actual cost of each unit. if recordkeeping costs were equal under job and process systems, for the amity in @ product line, then the job costing systems re better because they provide all of the data that process systems do.