Chapter 1

Chapter 1
Cost Accounting:
Information for Decision
Making
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• The importance of cost accounting information to the
successful operation of a business has long been recognized.
• In the current global economic environment, such information
is more crucial than ever.
• Automobiles from Korea, clothing from China, electronic
equipment from Japan, and laptop computers from Poland are
just a few examples of foreign-made products that have
provided stiff competition to U.S. manufacturers both at home
and abroad.
• As a result of these pressures, companies today are placing
more emphasis on controlling costs in an attempt to keep their
products competitive.
2
• Cost accounting provides the detailed cost information that
management needs to control current operations and plan for the
future. Figure 1-1 illustrates the production process for goods and
services for which cost accounting provides information. Management
uses this information to decide how to allocate resources to the most
efficient and profitable areas of the business.
• All types of business entities—manufacturing, merchandising, and
service businesses—require cost accounting information systems to
track their activities.
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• The nature of the manufacturing process requires that the accounting
information systems of manufacturers be designed to accumulate
detailed cost data relating to the production process.
• While the cost accounting principles and procedures discussed in the
text mostly emphasize manufacturers, many of the same principles
apply to merchandising and service businesses.
• Cost accounting is essential to the efficient operation of fast-food
restaurants, athletic teams, fine arts groups, hospitals, social welfare
agencies, and numerous other entities.
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• The activities of a manufacturer are similar to those of a
merchandiser. They purchase, store, and sell goods; both must have
efficient management and adequate sources of capital; and they may
employ hundreds or thousands of workers.
• The manufacturing process itself highlights the differences between
the two: merchandisers, such as Target, buy goods in marketable form
to resell to their customers.
• The purchase of raw materials by a manufacturer, however, is only the
beginning of a long and sometimes complex chain of events that
results in a finished product for sale.
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• The manufacturing process requires the conversion of raw materials
into finished goods through the use of labour and various other factory
resources. A manufacturer must make a major investment in physical
assets, such as property, plant, and equipment.
• To produce finished goods, a manufacturer must purchase appropriate
quantities of raw materials and supplies, and develop a workforce.
• In addition to the cost of materials and labour, the manufacturer incurs
other expenses in the production process.
• Many of these costs, such as depreciation, taxes, insurance, and
utilities, are similar to those incurred by a merchandising concern.
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• Costs such as machine maintenance and repair, materials handling,
production setup, production scheduling, and inspection are unique to
manufacturers.
• Costs such as selling and administrative expenses, are similar to those
incurred by merchandisers and service businesses. The methods of
accounting for sales, cost of goods sold, and selling and other
expenses for a manufacturer are similar to those of merchandisers.
• Service businesses, by comparison, have no inventories because the
service is consumed at the time it is provided. Service businesses have
revenue and operating expenses, but no cost of goods sold.
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Uses of Cost Accounting Information
• Principles of cost accounting have been developed to enable
manufacturers to process the many different costs associated with
manufacturing and to provide built-in control features. The
information produced by a cost accounting system provides a basis
for determining product costs and selling prices, and it helps
management to plan and control operations.
1. Determining Product Costs and Pricing
• Cost accounting procedures provide the means to determine
product costs that enable the preparation of meaningful financial
statements and other reports needed to manage a business.
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• The cost accounting information system must be designed to permit
the determination of unit costs as well as total product costs.
• For example, the fact that a manufacturer spent $100,000 for labour
in a certain month is not, in itself, meaningful; but if this labour
produced 5,000 finished units, the fact that the cost of labour
was$20 per unit is significant. This figure can be compared to the
company’s unit labour cost for prior periods and, often, to the
labour cost of major competitors.
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• Unit cost information is also useful in making a variety of important marketing
decisions such as:
A. Determining the selling price of a product. Knowing the manufacturing
cost of a product aids in determining the desired selling price.
B. Meeting competition. If a product is being undersold by a competitor, unit
costs information can be used to determine whether the problem can be resolved
by reducing the selling price, by reducing manufacturing and selling expenses
attributable to the product, or by some combination of the above that will still
result in profitable sales.
C. Bidding on contracts. Knowledge of the unit costs attributable to a particular
product is of great importance in determining the bid price.
D. Analyzing profitability. Unit cost information enables management to
determine the amount of profit that each product earns, thereby allocating the
company’s scarce resources to those that are most profitable. 11
2. Planning and Control
Planning is the process of establishing objectives or goals for the firm and
determining the means by which they will be met. Effective planning is
facilitated by the following:
• Clearly defined objectives of the manufacturing operation. These
objectives may be expressed in terms of the number of units to be
produced, the desired quality, the estimated unit cost, the delivery
schedules, and the desired inventory levels.
• A production plan that will assist and guide the company in reaching its
objectives. This detailed plan includes a description of the
manufacturing operations to be performed, a projection of human
resource needs for the period, and the coordination of the timely
acquisition of materials and facilities.
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• Cost accounting information enhances the planning process by
providing historical costs that serve as a basis for future projections.
Management can analyze the data to estimate future costs and
operating results and to make decisions regarding the acquisition of
additional facilities, any changes in marketing strategies, and the
availability of capital.
• The word ‘‘control’’ is used in many different ways, but from the
viewpoint of the manufacturing concern, control is the process of
monitoring the company’s operations and determining whether the
objectives identified in the planning process are being
accomplished. Effective control is achieved as follows:
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• Assigning Responsibility. Responsibility should be assigned for
each detail of the production plan. All managers should know
precisely what their responsibilities are in terms of efficiency,
operations, production, and costs. The key to proper control
involves the use of responsibility accounting and cost centers.
• The essence of responsibility accounting is the assignment of
accountability for costs or production results to those individuals
who have the most authority to influence them. It requires a cost
information system that traces the data to cost centers and their
managers.
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• A cost center is a unit of activity within the factory to which costs
may be practically and equitably assigned. A cost center may be a
department or a group of workers; it could represent one job, one
process, or one machine. The criteria for a cost center are (1) a
reasonable basis on which manufacturing costs can be traced or
allocated and (2) a person who has control over and is accountable
for many of the costs charged to that center.
• With responsibility accounting, the manager of a cost center is
accountable only for those costs that the manager controls. For
example, labour and materials costs will be charged to the cost
center, but the manager may be responsible only for the quantity of
materials used and the number of labour hours worked.
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• Cost and production reports for a cost center reflect its costs, in
dollars, and its production activity, in units.
• In a responsibility accounting system, the specific data for which
the manager is responsible would be highlighted for the purpose of
performance evaluation. Quite often, both a cost and production
report and a separate performance report will be prepared for a cost
center.
• The performance report will include only those costs and
production data that the center’s manager can control. A variance
represents the amount by which the actual result differs from the
budgeted or planned amount. If the actual amount spent is less than
the amount budgeted for, the variance is favorable (F); if more than
budgeted, it is unfavorable (U). 16
• Periodically Measuring and Comparing Results. Actual
operating results should be reviewed periodically and compared to
the objectives established in the planning process. This analysis,
which may be made monthly, weekly, daily, or even hourly in the
case of production and scrap reports, is a major part of cost control
because it compares current performance with the overall plan. The
actual dollars, units produced, hours worked, or materials used are
compared with the budget, which is management’s operating plan
expressed in quantitative terms (units and dollars). This comparison
is a primary feature of cost analysis. The number of dollars spent or
the quantity of units produced has little significance until compared
with the budgeted amounts.
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• Taking Necessary Corrective Action. The performance reports
may identify problem areas and deviations from the business plan.
Appropriate corrective action should be implemented where
necessary. A significant variance from the plan is a signal for
attention. An investigation may reveal a weakness to be corrected
or a strength to be better utilized. Management wants to know not
only the results of operations, but also how the results—whether
favorable or unfavorable—compare with the plan, why things
happened, and who was responsible.
• The relationship of planning and control is illustrated and
summarized in Figure 1-2 below:
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Value Creation in Organizations
• The main goal of cost accounting is to assist managers in value
creation and the value chain. Measuring the effects of decisions on
the value of the organization is one of the fundamental services of
cost accounting. As providers of information (accountants) or as the
users of information (managers), we have to understand how the
information can and will be used to increase value. We can then
come back to questions about how to design accounting systems
that accomplish this goal.
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Value Chain
• The value chain is the set of activities that transforms raw resources into the
goods and services. It also includes the treatment or disposal of any waste
generated by the end users.
• In much of our discussion about cost accounting, we will be concerned with the
part of the value chain that comprises the activities of a single organization.
However, an important objective of modern cost accounting is to ensure that the
entire value chain is as efficient as possible.
• It is necessary for the firm to coordinate with vendors and suppliers and with
distributors and customers to achieve this objective.
• Table 1.1 identifies the components of the value chain and provides examples of
the activities in each component, along with some of the costs associated with
these activities.
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Table 1: The Value Chain Components, Example Activities, and Example Costs
Component Example Activities Example Costs
Research and The creation and development of ideas related to new products, services, Research personnel
development (R&D) or processes. Patent applications
Laboratory facilities
Design The detailed development and engineering of products, services, or Design center
processes. Engineering facilities used to develop and
test prototypes
Purchasing The acquisition of goods and services needed to produce a good or service. Purchasing department personnel
Vendor certification
Production The collection and assembly of resources to produce a product or deliver a Machines and equipment
service. Factory personnel
Marketing and sales The process of informing potential customers about the attributes of Advertising
products or services that leads to their sale. Focus group travel
Product placement
Distribution The process for delivering products or services to customers. Trucks
Fuel
Web site creation
Customer service The support activities provided to customers for a product or service. Call center personnel
Returns processing
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Warranty repairs
Supply Chain and Distribution Chain
• Firms buy resources from suppliers. These suppliers form the
supply chain for the firm. Firms also sell their products to
distributors and customers. This is the distribution chain of the firm.
• The value chain is important because it creates the value for which
the customer is willing to pay. The customer is not particularly
concerned with how work is divided among firms producing the
product or providing the service. Therefore, one decision firms
must make is where in the value chain a value-added component is
performed most cost effectively.
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Relationship of Cost Accounting to Financial and Management Accounting
• The objective of accounting is to accumulate financial information for
use in making economic decisions.
• Financial accounting focuses on gathering historical financial
information to be used in preparing financial statements that meet the
needs of investors, creditors, and other external users of financial
information.
• The statements include a balance sheet, income statement, retained
earnings statement, and statement of cash flows.
• Although these financial statements are useful to management as well as
to external users, additional reports, schedules, and analyses are
required for management’s use in planning and controlling operations.
• As a result, the external financial statements for the whole company are
of little help to management in making day-to-day operating decisions.
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• Management accounting focuses on both historical and estimated
data that management needs to conduct ongoing operations and do
long-range planning.
• Cost accounting includes those parts of both financial and
management accounting that collect and analyze cost information.
It provides the product cost data required for special reports to
management (management accounting) and for inventory costing in
the financial statements (financial accounting).
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• For example, cost accounting information is needed to determine:
whether to make or buy a product component; whether to accept a
special order at a discounted price; the amount at which cost of
goods sold should be reported on the income statement; and the
valuation of inventories on the balance sheet.
• The various users and uses of cost accounting data are illustrated in
Figure 1-3.
• Figure 1-4 shows how cost accounting intersects both financial and
management accounting. ‘‘What Is Management Accounting?’’
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Cost Data for Managerial Decisions
1. Costs for Decision Making
• One of the most difficult tasks in calculating the financial consequences
of alternatives is estimating how costs (or revenues or assets) among the
alternatives will differ.
• Do we “know” what will be the effect of this decision on the firm? We
do not, of course. These are estimates that require making many
assumptions and forecasts, some of which may not be realized. This is
what makes this type of analysis both fun and challenging. In business,
nobody knows for certain what will happen in the future. In making
decisions, however, managers constantly must try to predict future
events. Cost accounting has more to do with estimating future costs than
recording past costs. For decision making, information about the past is
a means to an end; it helps you predict what will happen in the future.
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2 Costs for Control and Evaluation
• An organization divides responsibility for specific functions among its
employees.
• These functions are grouped into organizational units.
• The units, which may be called departments, divisions, segments, or
subsidiaries, specify the reporting relations within the firm.
• These relations are often shown on an organization chart.
• The organizational units can be based on products, geography, or
business function.
• We use the general term responsibility center to refer to these units.
• The manager assigned to lead the unit is accountable for, that is, has
responsibility for, the unit’s operations and resources. 30
3. Different Data for Different Decisions
• One principle of cost accounting is that different decisions often
require different cost data.
• “One size fits all” does not apply to cost accounting. Each time you
face a cost information problem in your career, you should first
learn how the data will be used.
• Are the data needed to value inventories in financial reports to
shareholders? Are they for managers’ use in evaluating
performance? Are the data to be used for decision making? The
answers to these questions will guide your selection of the most
appropriate accounting data.
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Trends in Cost Accounting throughout the Value Chain
• Cost accounting continues to experience dramatic changes. Developments in
information technology (IT) have nearly eliminated manual bookkeeping.
• Emphasis on cost control is increasing in banks, hospitals, manufacturing
industries, airlines, school districts, and many other organizations that have
traditionally not focused on it.
• Cost accounting has become a necessity in virtually every organization,
including fast-food outlets, professional organizations, and government
agencies.
• One reason for this rapid change is that managers at each stage of the value
chain require information on the performance of products, services, suppliers,
customers, and employees.
• Managers of the activities and cost accountants must work together at each stage
to make decisions that increase firm value. Because these processes themselves
have undergone great change in recent years, cost accountants and cost
accounting methods must continuously adapt to changes in all business areas.
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1. Cost Accounting in Research and Development (R&D)
• Lean manufacturing techniques, in which Toyota Motor Company
is considered a leader, are not simply about production.
• Companies partner with suppliers in the development stage to
ensure cost-effective designs for products.
• Product engineers need cost accounting information to make
decisions about alternative materials. For example, Johnson
Controls, a manufacturer of automobile seats, needs to make trade-
offs between the cost and weight of materials, which is an
important factor in fuel economy and the cost of recycling the
materials at the end of the car’s life.
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2. Cost Accounting in Design
• An important activity in product development is design.
• Product designers must write detailed specifications on a product’s design and
manufacture.
• The design of a product can have a significant impact on the cost to manufacture
it. Designs that are complex might add additional functions, which, while
making a product more desirable, may also require complex and expensive
manufacturing processes.
• Design for manufacturing (DFM) is the concept that manufacturing cost and
complexity need to be considered in the design of the product.
• Cost accountants help designers understand the trade-off by using methods such
as activity-based costing, which considers the activities or processes that will be
required to bring a product to market.
• Hewlett-Packard, for example, uses activity-based costing methods to
communicate to designers the costs of alternative designs of testing equipment.
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• Activity-based costing is a product costing method that has
received a great deal of attention since the 1990s (will be discussed
in detail in a later chapter).
• This costing method is more detailed and complicated than
conventional costing methods, but it can provide more accurate cost
numbers.
• ABC assigns costs to products based on several different activities,
depending on how they drive costs, whereas traditional costing
methods assign costs to products based on only one or two factors,
generally based on volume.
• In general, ABC provides more detailed cost information, enabling
managers to make more informed decisions.
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3. Cost Accounting in Purchasing
• Companies now partner with suppliers to increase the efficiency in
the supply chain. Partnering requires information on the
performance of partners to ensure the relationship adds value.
Performance measures are being used to evaluate the performance
of key suppliers and business partners.
• The use of cost accounting methods such as target costing, activity-
based costing, performance measures, and incentive systems that
support teamwork, helps firms such as Federal Express and Dell
Computers manage their partnerships to keep the supply chain
“lean” and add value throughout the chain.
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• These approaches to managing suppliers allow firms to support
continual improvement throughout the supply chain by facilitating
benchmarking.
• Using benchmarking methods, managers measure a company’s own
products, services, and activities against the best levels of
performance that can be found either inside or outside the
manager’s own organization. Because managers seek continual
improvement, they do not treat benchmarking as a one-time event
but as an ongoing process.
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4. Cost Accounting in Production
• Operations managers and financial accountants use cost information in the
production stage to understand and report the costs of the multiple products
produced.
• One of the most important developments in production, associated with lean
manufacturing, is the use of just-in-time (JIT) methods. Using just-in-time
methods, companies produce or purchase units just in time for use, keeping
inventories at a minimum.
• If inventories are low, accountants can spend less time on inventory valuation
for external reporting and more time on managerial activities. The economic
justification for JIT comes from the trade-off between the costs of setup and
stock-outs as compared with the costs of holding inventory.
• Modern cost accounting systems have helped managers better understand the
relative costs so that appropriate inventory policies can be set and targeted
improvements sought.
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• Firms that use lean manufacturing techniques look to the cost
accounting system to support these techniques by providing useful
measurements at the work cell or process level.
• Lean accounting systems provide these measures. In addition, these
systems are designed to avoid unnecessary transactions, in effect
eliminating “waste” from the accounting processes, just as lean
manufacturing is designed to eliminate waste from the manufacturing
process.
• The production process is not limited to manufacturing. Service firms,
such as banks, insurance companies, and theme parks, produce or
provide services demanded by customers. Efficient use of capacity
(employees) in providing services is critical in increasing value.
Managers look to cost accounting information to help them understand
and plan capacity. 39
5. Cost Accounting in Marketing
• Marketing managers require cost accounting information to
understand the profitability of different customer groups.
• Advances in accounting information systems that capture data at
various levels of detail have made possible customer relationship
management (CRM), which allows firms to target more precisely
those customers who are profitable by assessing the costs to serve a
customer along with the revenues a customer generates.
• For example, Harrah’s Entertainment is able to compete on the
basis of providing complimentary services to customers (typically
called “comping”) based on their expected personal profitability.
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6. Cost Accounting in Distribution
• Earlier, we said that managers use accounting information to determine
where in the supply chain value-added activities will take place.
• Cost accountants work with managers to estimate whether it is more
efficient (less costly) to perform an activity in the firm or to have
another firm produce the product or perform the service.
• This is referred to as outsourcing. Firms frequently consider activities in
the distribution stage for outsourcing. As business becomes more global,
specialized information on markets, regulations, and customs is critical
to the speed of delivery. As a result, cost information often identifies
specialized companies as being more efficient in distributing products,
as opposed to handling distribution internally. 41
7. Cost Accounting in Customer Service
• Many companies have adopted the concept of total quality management
(TQM), which means that the organization is managed to excel on all
dimensions and the customer ultimately defines quality.
• The customers determine the company’s performance standards
according to what is important to them.
• Companies can indicate the high quality to consumers through the
product warranty. Cost accountants help managers make decisions about
quality in two ways. First, cost of quality (COQ) systems identify the
costs associated with producing defective units as well as the lost sales
associated with poor-quality products. Second, they provide information
on the projected warranty claims, which can be compared to the
increase in revenues estimated from offering a longer or more
comprehensive warranty.
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8. Enterprise Resource Planning
• We have seen how cost accounting is used throughout the value chain. It is
important that the information be consistent in all components of the chain.
• As the cost of information technology falls and the value of information
increases, managers have adopted enterprise resource planning (ERP) systems.
• ERP systems are integrated information systems that link various activities in an
organization. Typical systems include modules for production, purchasing,
human resources, and finance.
• By integrating these systems, managers hope to avoid lost orders, duplication of
effort, and costly studies to determine what is the current state of the enterprise.
Because all of the company’s systems are integrated, the potential for ERP to
provide information on costs of products and services is large. Implementation
problems and the scale of the task in large firms (enterprises) have kept many
companies from realizing that potential so far.
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3. Cost Accounting in Purchasing
• Companies now partner with suppliers to increase the efficiency in
the supply chain. Partnering requires information on the
performance of partners to ensure the relationship adds value.
Performance measures are being used to evaluate the performance
of key suppliers and business partners.
• The use of cost accounting methods such as target costing, activity-
based costing, performance measures, and incentive systems that
support teamwork, helps firms such as Federal Express and Dell
Computers manage their partnerships to keep the supply chain
“lean” and add value throughout the chain.
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