Managers rely on cost accounting to provide an idea of the actual cost of processes, departments, operations or product which is the foundation of their budget, allowing them to analyze fluctuation and the way funds are used socially for profit. Cost accounting is used in management accounting, where managers justify the ability to cut costs for a company in order to increase that company's profit. As a tool for internal use, versus a tool for external users like financial accounting, cost accounting does not need to follow the GAAP standards (Generally Accepted Accounting Principles) because its use is more pragmatic.
Cost accounting creates a financial value out of the production of a product, measuring currency that is nominal into units that are measured by convention. By taking recorded historic costs a bit further, cost accounting allocates a company's fixed costs over a specific time period to what items are actually produced during that period of time, creating a total cost of product production. Products that were not sold during that period of time produced a "full cost" of those products, recording them in a complex inventory system that uses accounting methods of its own that are in compliance with the GAAP standards. Managers are then able to focus on each period's results as it relates to the "standard cost" of any product.
Any distortions in cost that were caused by calculating what the overhead of a product is versus what a unit cost is for companies that specialize in only one specific product are very minor in industries that mass produce that product with a low fixed cost. Understanding why costs vary compared to what was actually planned helps a manager to save company money by taking actions that are appropriate to correct that variation in the future. Variance analysis is a very important part of cost accounting because it breaks down each variance into many different components of standard cost and actual cost. Some of these components are material cost variation, volume variation and labor cost variation.
Cost accounting is a very important part of the management accounting process. In order for managers to determine the best methods to increase a company's profitability, as well as saving company money in the future, cost accounting is a necessary system in the management of a company's budget, providing important data to analyze fluctuation in company production costs.
Pre-production costs can be defined as those costs related to acquisition and retention, exploration and development. The treatment of these three categories of cost varies based on whether one has elected the full cost or successful efforts method of accounting.
METHODS OF COSTING
In the early industrial age, most of the costs incurred by a business were what modern accountants call "variable costs" because they varied directly with the amount of production. Money was spent on labor, raw materials, power to run a factory, etc. in direct proportion to production. Managers could simply total the variable costs for a product and use this as a rough guide for decision-making processes.
Some costs tend to remain the same even during busy periods, unlike variable costs, which rise and fall with volume of work. Over time, the importance of these "fixed costs" has become more important to managers. Examples of fixed costs include the depreciation of plant and equipment, and the cost of departments such as maintenance, tooling, production control, purchasing, quality control, storage and handling, plant supervision and engineering. In the early twentieth century, these costs were of little importance to most businesses. However, in the twenty-first century, these costs are often more important than the variable cost of a product, and allocating them to a broad range of products can lead to bad decision making. Managers must understand fixed costs in order to make decisions about products and pricing.
For example: A company produced railway coaches and had only one product. To make each coach, the company needed to purchase $60 of raw materials and components, and pay 6 laborers $40 each. Therefore, total variable cost for each coach was $300. Knowing that making a coach required spending $300, managers knew they couldn't sell below that price without losing money on each coach. Any price above $300 became a contribution to the fixed costs of the company. If the fixed costs were, say, $1000 per month for rent, insurance and owner's salary, the company could therefore sell 5 coaches per month for a total of $3000 (priced at $600 each), or 10 coaches for a total of $4500 (priced at $450 each), and make a profit of $500 in both cases.
Costing is an important process that many companies engage in to keep track of where their money is being spent in the production and distribution processes. Understanding these costs is the first step in being able to control them. It is very important that a company chooses the appropriate type of costing system for their product type and industry.
One type of costing system that is used in certain industries is process costing. Process costing varies from other types of costing (such as job-order) in some ways, yet is similar in other ways. Process costing is an accounting methodology that traces and accumulates direct costs, and allocates indirect costs of a manufacturing process. Costs are assigned to products, usually in a large batch, which might include an entire month's production. Eventually, costs have to be allocated to individual units of product. It assigns average costs to each unit, and is the opposite extreme of Job costing which attempts to measure individual costs of production of each unit. Process costing is usually a significant chapter.
Process costing is a type of operation costing which is used to ascertain the cost of a product at each process or stage of manufacture. CIMA defines process costing as "The costing method applicable where goods or services result from a sequence of continuous or repetitive operations or processes. Costs are averaged over the units produced during the period". Process costing is suitable for industries producing homogeneous products and where production is a continuous flow. A process can be referred to as the sub-unit of an organization specifically defined for cost collection purpose.
Under the successful efforts method, costs are grouped by some smaller basis, usually fields, and are capitalized by group if the costs directly result in the development of proved reserves. Costs not resulting in proved reserves are expensed as incurred (or as a determination of proven reserves are made). Basically, within a cost group, exploratory dry wells are expensed and exploratory successful wells are capitalized.
Activity-based costing (ABC) is another system for assigning costs to products based on the activities they require. In this case, activities are those regular actions performed inside a company. "Talking with customer regarding invoice questions" is an example of an activity inside most companies.
Accountants assign 100% of each employee's time to the different activities performed inside a company (many will use surveys to have the workers themselves assign their time to the different activities). The accountant then can determine the total cost spent on each activity by summing up the percentage of each worker's salary spent on that activity.
A company can use the resulting activity cost data to determine where to focus their operational improvements. For example, a job-based manufacturer may find that a high percentage of its workers are spending their time trying to figure out a hastily written customer order. Via ABC, the accountants now have a currency amount pegged to the activity of "Researching Customer Work Order Specifications". Senior management can now decide how much focus or money to budget for resolving this process deficiency. Activity-based management includes (but is not restricted to) the use of activity-based costing to manage a business.
While ABC may be able to pinpoint the cost of each activity and resources into the ultimate product, the process could be tedious, costly and subject to errors. As it is a tool for a more accurate way of allocating fixed costs into product, these fixed costs do not vary according to each month's production volume. For example, an elimination of one product would not eliminate the overhead or even direct labor cost assigned to it. ABC better identifies product costing in the long run, but may not be too helpful in day-to-day decision-making.
Under the full cost method, all costs (by country) of exploring and developing wells (whether proven or unproved) are capitalized and then depleted using the units of production method whereby your total proven reserves are considered. Basically, all of the costs of developing wells, whether successful or unsuccessful, are depleted as production units are realized from your proven wells.
Full cost plus pricing seeks to set a price that takes into account all relevant costs of production. This could be calculated as follows:
Total budgeted factory cost + selling / distribution costs + other overheads + MARK UP ON COST
Budgeted sales volumes
An illustration of applying this method is set out below:
Consider a business with the following costs and volumes for a single product:
Factory production costs
Research and development
Fixed selling costs
Administration and other overheads
Total fixed costs
Variable cost per unit
Mark-up % required
Budgeted sale volumes (units)
What should the selling price be on a full cost plus basis?
The total costs of production can be calculated as follows:
Total fixed costs
Total variable costs (8.00 x 500,000 units)
Mark up required on cost (5,625,000 x 35%)
Total costs (including mark up)
Divided by budgeted production (500,000 units)
= Selling price per unit
The advantages of using cost plus pricing are:
Easy to calculate
Price increases can be justified when costs rise
Price stability may arise if competitors take the same approach (and if they have similar costs)
Pricing decisions can be made at a relatively junior level in a business based on formulas
The main disadvantages of cost plus pricing are often considered to be:
This method ignores the concept of price elasticity of demand - it may be possible for the business to charge a higher (or lower) price to maximize profits depending on the responsiveness of customers to a change in price
The business has less incentive to cut or control costs - if costs increase, then selling prices increase. However, this might be making an "inefficient" business uncompetitive relative to competitor pricing;
It requires an estimate and apportionment of business overheads. For example, total factory overheads need to be calculated and then allocated in some way against individual products. This allocation is always arbitrary.
If applied strictly, a full cost plus pricing method may leave a business in a vicious circle. For example, if budgeted costs are over-estimated, selling prices may be set too high. This in turn may lead to lower demand (if the price is set above the level that customers will accept), higher costs (e.g. surplus stock) and lower profits. When the pricing decision is made for the next year, the problem may be exacerbated and repeated.
Amongst the factors that influence the choice of the mark-up percentage are as follows:
Nature of the market - a mark-up should reflect the degree of competition in the market (what do the close competitors do?
Bulk discounts - should volume orders attract a lower mark-up than a single order
Pricing strategy - e.g. skimming, penetration (see more on pricing strategies further below)
Stage of the product in its life cycle; products at the earlier stages of the life cycle may need a lower mark-up percentage to help establish demand.
Last but not least, Lean accounting has developed in recent years to provide the accounting, control, and measurement methods supporting lean manufacturing and other applications of lean thinking such as healthcare, construction, insurance, banking, education, government, and other industries.
There are two main thrusts for Lean Accounting. The first is the application of lean methods to the company's accounting, control, and measurement processes. This is not different from applying lean methods to any other processes. The objective is to eliminate waste, free up capacity, speed up the process, eliminate errors & defects, and make the process clear and understandable. The second (and more important) thrust of Lean Accounting is to fundamentally change the accounting, control, and measurement processes so they motivate lean change & improvement, provide information that is suitable for control and decision-making, provide an understanding of customer value, correctly assess the financial impact of lean improvement, and are themselves simple, visual, and low-waste. Lean Accounting does not require the traditional management accounting methods like standard costing, activity-based costing, variance reporting, cost-plus pricing, complex transactional control systems, and untimely & confusing financial reports. These are replaced by:
lean-focused performance measurements
simple summary direct costing of the value streams
decision-making and reporting using a box score
financial reports that are timely and presented in "plain English" that everyone can understand
radical simplification and elimination of transactional control systems by eliminating the need for them
driving lean changes from a deep understanding of the value created for the customers
eliminating traditional budgeting through monthly sales, operations, and financial planning processes (SOFP)
correct understanding of the financial impact of lean change
As an organization becomes more mature with lean thinking and methods, they recognize that the combined methods of lean accounting in fact creates a lean management system (LMS) designed to provide the planning, the operational and financial reporting, and the motivation for change required to prosper the company's on-going lean transformation.
SETTING SELLING PRICES
Fixing the selling price can be based upon a value basis or a cost plus basis with either basis subject to modification according to market conditions. Not exactly scientific and true in all cases but the most profitable businesses tend to be managed by accountants while the best sales growth companies have a sales oriented manager at the helm.
Value basis is used to set selling prices according to the amount the customer will pay for the product and the value of products or services being provided. A strong influence when using a value basis are the benefits a customer will derive from purchasing the product from each business compared with alternative suppliers and the general market rate for that type of product.
Using a value basis that prices products above the general market level requires support and a marketing strategy to demonstrate to the market place the benefits and advantages a prospective client receives. Pricing a product or service below the accepted market price requires to be supported with ensuring as wide an audience as possible is aware of the bargain prices and the reasons why a lower price is being offered.
To establish the most profitable level at which selling prices should be pitched it is important to conduct market research to determine the general level of pricing within the product area. Also list the benefits and advantages within the context of other competitive products of the specific products being offered to enable the business to use these factors in support of the price structure adopted. To maximum level at which value basis prices can be set is dependent upon the value the target customer places on that product or service taking into consideration the quality, service, availability and benefits provided.
Cost based pricing is a financial accounting calculation based upon fixing a gross profit margin that the business requires given the expected sales volume and fixed overhead or operating costs to produce a net profit. Normally a sales price set using a cost basis would be the amount paid for the product plus an incremental percentage. Cost based pricing usually occurs in areas where competition is often working on the same cost basis and by selling similar products and services the volume of sales is sensitive to competitive prices. Market research should establish the range of competitive prices.
There are a number of influences that impact on setting the selling price of a product in addition to the cost and competition. Sales location, added values, buying policy, operational costs and others all require factoring into the calculation. Business size also has an influence as small business accounting is less sophisticated than accounting and financial control in larger businesses. The tow single most important factors in setting the selling price of a product or service to generate the highest profit margin attainable are the competition and the original cost of the product.
In many cases the existing competition has already set a price for the product. Each business has to decide whether to accept this price according to the expected volume and the gross profit margin generated or charge a higher or lower price with the consequential effect on sales volume. The purchase price paid drives the competitive edge. Larger business have greater opportunities to buy in larger quantities and obtain cheaper prices and many high volume businesses will search to source products from overseas markets to obtain even cheaper products.
If the purchase price paid by competitors is low then that cost must be either matched by adopting similar business practices or the products sold into a niche area of the market where more flexible prices can be obtained at the required volume to generate the gross margin required to cover fixed operating costs and achieve the target net profit.
Different prices can be set for different customers to exploit higher profit margins where possible and achieve higher volumes in market conditions where the price has a major influence on quantities bought. A manufacturer will often set different prices for each customer dependent on volumes purchased and the negotiation skills of the client purchasing function.
Market conditions often determine a range of pricing policies including offering quantity discounts for higher volumes, cash discounts for faster settlement, lower than normal prices to allow a market to be penetrated and established more easily and higher than normal prices in situations where supply may exceed demand. The accounting software or bookkeeping system employed should identify gains and losses due to different pricing structures.
The levels of supply and demand may change over time and a flexible pricing policy to take advantage of these changes is desirable. It is an economic fact that when demand exceeds supply prices will increase and when supply exceeds demand prices go lower. Failure to react quickly has a major impact on the total gross margin attained.
The overriding decision to be taken on setting selling prices is the amount of gross profit generated by the sales volume of those products in relation to current business policy and fixed operating costs and profit requirements that business needs to achieve and demonstrate through the accounting figures produced by the final bookkeeping reckoning.
From an accounting point of view the sales volume and price of each product should be calculated to determine the previous gross profit margin attained and planned for the future. The actual or forecast gross profit margins must cover the fixed operating costs of the business or remedial action taken to ensure the business is profitable. Setting prices is a combined decision of the sales and accounting function.