Cost Accounting For Dummies. Kenneth W. Boyd
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order you take on when you have excess production capacity. A customer approaches you about producing an “extra” order — an order you weren’t expecting. You need to decide what price you will accept for the special order.
Management accounting instructs you to consider only the cost and revenues that change, based on your decision, called differential costs and revenues. That makes sense, because the method is forward-looking. Old, unchanging stuff generally doesn’t count.
Your price for the special order depends on the costs. Reports you generate about costs help you make the decision to accept or reject the special order. If you’re producing cost reporting, that sounds like cost accounting to me. So you see how cost and management accounting can overlap. There’s more on special orders later.
Cost accounting sometimes uses historical information to start the analytical process. For example, when you plan your costs for next year, you take a look at spending in past years. Spending in prior year provides a starting point for planning costs — a baseline. The baseline is adjusted for all the foreseeable changes that might occur in the New Year. That helps you decide whether your budgeted costs should be higher or lower.
Using Cost Accounting to Your Advantage
Cost accounting runs through your entire business process. To begin, you decide whether the cost of obtaining the information is worth the benefit you receive from it. If you decide that it is, you use cost accounting to analyze your costs, make decisions, and look for cost reductions in your business.
Starting with cost-benefit analysis
The cost of obtaining information should be lower than the benefit you receive from your analysis. The cost includes labor hours and technology costs. For example, you need someone to search for the information. You also may need to create new cost reports in using your technology. The benefit of performing the analysis is the cost savings you’re able to implement.
Say you manufacture dining room tables; you make five different models of tables. At one point in production, your staff sands the wooden tabletops by hand.
Until now, you haven’t calculated the time required to sand each type of table. You take the total labor costs for sanding and trace them to each table, regardless of the model. Maybe you should do a cost analysis and assign the sanding cost to each table model.
You incur some costs to do the analysis. Someone on your staff will go through the employee time cards (used for payroll). The workers record the time they spend on all tasks, including sanding. They also record the table models they worked on during production. Your accountant can compute the total sanding time per table model, based on the time cards.
Consider what you might gain. You assign the sanding cost more precisely. As a result, each table model’s total cost is more accurate. Because your profit is the sale price less the total costs, the updated cost allows you to calculate a more precise profit. Sounds like the cost of the analysis might be worth it, especially if the competition is high in your furniture-making industry.
Planning your work: Budgeting
Cost accounting plays a role in your budgeting process. You might think of budgeting as just forecasting sales and planning expenses. If you own a flower shop, you budget by forecasting sales of each type of flower or arrangement. You also plan expenses, such as utility costs for the shop and your lease payment.
Your work with cost accounting takes budgeting to a new level of detail. Until now, you looked at costs by type (utilities, lease expense). Now, you analyze cost by type and by product (for example, those roses need to be kept in a cooler, which requires electricity). Based on the product’s costs and sale price, you can compute a profit.
So start off with an analysis of each product’s cost, price, and profit. Build on that information. You could then put together a budget for each department. Finish up by combining all your smaller budgets into a company-wide budget. That company-wide budget will give you all the company’s costs by type and your revenue total. You build your company-wide budget based on cost accounting by product.
By starting your budget at the product level, your budget is a lot more specific. When you compare your actual results to your budget, you’ll see the differences in more detail. The detail lets you make more precise changes in your business going forward.
Controlling your costs
Cost accounting helps you stay on top of your costs — and make changes along the way. You should analyze costs frequently. Most companies perform this analysis on at least a monthly basis … and sometimes weekly or even daily. The more specific you make your analysis, the better. As always, the benefits you gain from your analysis should outweigh the costs.
If you analyze costs frequently, you find areas where you can reduce costs immediately. There’s nothing worse than discovering a problem after it’s too late to fix, so don’t create a budget and shove it in a drawer. Review your actual results, and compare those results to your budget. If you find large differences, dig deeper. Consider reviewing more detail to find out what caused the difference.
Here are some tools you can use to control costs. Each tool is explained in detail in this book:
Cost-volume profit (CVP) analysis: CVP is a simple tool to analyze costs, sale price, and units sold. There’s a user-friendly formula — the kind of tool you can play around with on a notepad or spreadsheet. Check out Chapter 3 for more on CVP.
Variance analysis: A variance is the difference between your planned costs and actual costs. A large variance is a red flag — a number that gets your attention. You investigate variances to find ways to reduce your costs. Chapter 7 tells you more.
Activity-based costing (ABC): This analysis allows you to assign costs using the activities put into making your product or service. ABC assigns costs to products based on levels of activity: labor hours incurred, machine hours used, and so forth. See Chapter 5 for an in-depth look.
Support costs: Nearly every business incurs support costs. These are areas of your business that support your production and sales efforts. Accounting and legal costs are good examples of support costs.
Joint costing: Your business may use the same process to produce several different products. This situation is called joint production. The products will share common costs of this production, or joint costs. Now, it’s likely that each product has its own unique costs after joint production; however, you need a tool to allocate the joint costs when the products are produced together.
Setting a price
After you’ve nailed down your product’s full cost (all costs, both fixed and variable), you can price your product effectively. The difference between your price and full product cost is your profit (see Chapter 12).
Pricing and competition
Consider how pricing comes into play. Your product’s price may be limited, based on competition. Say you sell baseball gloves. To compete and maintain your current level of sales, you can’t price your glove any higher than $100.
To meet your profit goal, you start at the top and work your way down. The top is your $100 price; you can’t go any higher without losing sales. Your profit is sale price less cost. The only way to increase your profit is to lower your costs.