Cost accounting - system requirements

Cost accounting - system requirements

by Nigel Coulthurst

01 Apr 1999

Students preparing for the paper 3, Management Information, examination need to be able to demonstrate that they understand, and can apply, the principles relating to the processing of cost accounting transaction data. This is not just a question of posting transactions but of understanding the factors that influence the cost recording process.

In outline, the process involves accounting for input costs, which relate to resources acquired and consumed in the form of materials, labour and various other resources, and then attaching those costs to work done in the form of outputs of final product or service.

Ultimately, measures of profit in relation to final products/services (by group of product/service or in relation to different customers/geographical areas) will be required. However, many activities in an organisation provide product/service at an intermediate stage where performance measurement will also be necessary if resources are to be well managed.

Whilst there are a number of generic principles regarding cost processing, their application will vary depending both upon the nature of the business and also upon each business’ specific information requirements.

This article reviews the principles affecting the establishment of cost accounting information requirements. A subsequent article will illustrate the processing of cost accounting data to meet those information requirements.

System objectives

The broad objectives of a cost accounting system should be:

• score-keeping;

• attention-directing.

As an extension of financial accounting, especially in manufacturing industries where cost allocations to enable stock valuation are likely to be required, cost accounting provides the basis on which business performance, in terms of profit or loss, can be assessed in line with specified practice (score-keeping).

More significantly, cost accounting provides the basis for management accounting via the provision of regular and detailed information to management so that resources may be acquired and used as economically, efficiently and effectively as possible. The objective should be to provide the right stimulus for management decision-making and control action (attention-directing) by ascertaining product costs and profitability, and by reporting the costs of operations in a useful manner.

With this in mind, cost accounting system design should focus attention on exactly what information is useful, to whom and when, which also raises questions about how frequently and how quickly the information should be provided, and to what degree of detail and accuracy.

Otherwise there is a danger that cost accounting systems produce masses of data without satisfying key information requirements. It is necessary to balance the requirements of scorekeeping, which may necessitate detail, with the requirements of attention-directing, where the focus should be on highlighting exceptions.

An organisation structure chart is a useful start point, along with a clear idea of individuals’ responsibilities and their span of control. Costing environment

Businesses may be placed along the following continuum:

What distinguishes a manufacturing organisation from a service organisation is the existence of a manufactured, physical product. Service organisations towards the manufacturing half of the above continuum will have many of the characteristics of a manufacturer. For example, a shoe repairer will have premises and machinery, and will incur significant materials, as well as labour, costs.

Cost accounting systems are appropriate for all businesses, whether large or small, manufacturing or service, and regardless of their ownership structure. However, greater scope for more extensive cost analysis, and thus also for subsequent use of information, is provided by a manufacturing environment. As a result such an environment usually occupies centre stage in cost accounting textbooks and examinations, especially in the area of cost ascertainment.

It is important to recognise changes in the environment within which businesses operate, especially changes in the manufacturing environment, and the impact that such changes may have on information requirements and thus on the cost accounting system.

In order to compete effectively, businesses engaged in manufacturing have been required to produce increasingly sophisticated products of the highest quality and with first class service, but at low cost. They have also had to develop the flexibility to cope with shorter product and equipment life cycles and with demands for greater product variety, the combined effects of increased competition and more discriminating customers.

This has necessitated reduced set-up times, increased machine and workforce flexibility and reduced randomness previously caused by uncertain supply, quality and manufacturing performance. Advances in computer technology applied to manufacturing have helped to both drive, and also facilitate, change.

Cost accounting systems have thus had to adapt to new information requirements. Accounting information provision has also been profoundly influenced by the ongoing revolution in information technology. Such advances have enabled:

• flexibility of information provision, with opportunities to tailor reports to users and use, and thus the provision of more focused information;

• more frequent availability of information;

• greater detail if required;

• faster feedback;

• more exception reporting, with reduced emphasis on routine;

• more user friendly access and presentation.

What has to be avoided is mountains of paper output from computer systems with a resulting information/data overload. It remains the case that the technology is only useful and valuable if information is provided to the right person, in the right form and at the right time.

Single,

low tech

service =====> Multi-product,

high tech

manufacturer

Cost objects, cost units and cost centres

The term ‘cost object’ is used to describe any aspect of business for which a separate measure of cost is required. This could be, for example, a product, an activity, a department, a region, a customer, or a project.

Where the measurement of the profit generated by each of the different final outputs of a business is required, the cost (and revenue) per unit of output will need to be determined. In this case the cost object becomes a ‘cost unit’, which may be defined as a quantitative unit of product or service in relation to which costs are ascertained.

Areas of a business that provide an internal service (i.e., support other areas within the business) are usually measured on cost performance alone as they do not directly generate sales and thus profit. The cost object becomes a ‘cost centre’, which may be defined as a location, person or item of equipment (or grouping of these) in relation to which costs are ascertained. Costs are identified, and analysed, in absolute terms at the level of the cost centre as a whole.

It may, however, be possible and useful to also establish a cost unit for the centre. For example, a distribution cost centre may use a composite cost unit, e.g., cost per kilogramme/kilometre. This can provide the basis for charging for the service and a means of improving cost control. Each separate activity may become a cost centre and the key driver of the costs of each activity may be identified and used to determine unit costs.

It may also be possible, and may be judged useful, to establish a value for the output of intermediate areas of the business that is other than cost, attempting to reflect the true

value of the output. Cost centres may become ‘profit centres’, or even ‘investment centres’. In an investment centre, performance is measured not simply as revenue minus costs (the measurement criteria in a profit centre); in addition, profit is related to the capital required to generate it.

Thus a product or service may pass from one area of a business to another at a transfer price that seeks to reflect market value at that point. Service departments, for example computer operations, may establish a value for their service, and thus a charge for users which is based upon market values rather than simply upon average costs.

Both absolute and relative measures may be useful. Whereas absolute measures provide, for example, a measure of the total cost of each cost centre, relative measures provide comparisons of one variable with another (e.g., cost per hour, profit per unit, profit per £ of sales).

Cost classification

Cost classification is the process of arranging cost items into groups according to their degree of similarity. Cost items can be similar to one another in several different respects, the particular classification depending upon the purpose of grouping costs together.

A particularly important distinction in stock valuation is between product costs and period costs. Product costs are those costs that have been incurred in getting stock to its present location and condition and are thus used to value any stock carried forward to a future period. In a manufacturing organisation all manufacturing costs should be regarded as product costs for external reporting purposes. Period costs are those costs that are not included in the stock valuation and as a result are treated as expenses of the period in which they are incurred.

Other classifications used to sort and separate costs are according to type (e.g., material, labour) and/or function (e.g., manufacturing, administration, selling). Beyond that, costs may be classified according to directness or according to behaviour.

Direct costs are those that can be allocated to a particular cost object. Indirect costs are those that cannot be so allocated but instead need to be apportioned i.e., shared between two or more cost objects. The smaller the cost object the fewer the costs that can be allocated and the greater will be the costs that have to be apportioned. For example, all costs are direct at the total business level; they become increasingly indirect as the organisation is split further and further into separate units. Whether a cost is direct or indirect depends entirely on the particular cost object.

Where the cost unit is a unit of finished product, direct costs will generally be limited to the raw materials used in the product and the labour employed in production departments on product manufacture. All other manufacturing costs will be indirect as they will have to be apportioned amongst the different products manufactured. Indirect costs in relation to final cost units are referred to as overheads. Earlier Newsletter articles (1 and 2) reviewed the processes relating to the accounting for overheads and the issues involved.

An important classification for decision-making and for cost control is according to behavioural characteristics. Some costs tend to vary with the output level of a particular activity; other costs are incurred because of having an activity, but are largely unaffected by its output level. Raw materials used in a manufactured product are an example of the first; rent and rates paid on a factory an example of the second.

Important concepts here are those of time and relevant range of activity. In the long run all costs become to some extent variable. The classification of costs as fixed or variable is on the assumption of its use for short-term analysis for which it provides relevant information. The classification is also only likely to remain valid as a predictor of costs within a specified range of activity.

A behavioural classification may also form the basis for stock valuation for internal (as opposed to external) reporting (i.e., using only variable, rather than total, manufacturing costs). This would be the case where marginal costing principles are employed in a non-integrated system (see later).

Cost coding

A code can be defined as a system of symbols designed to be applied to a classified set of items. Cost coding is symbols applied to sets of cost items (which may be cost elements, products, cost centres), giving a brief, accurate and logical reference, which facilitates entry, collation and analysis of items in the accounts to meet information requirements. Cost accumulation

The bought-in materials (be they raw materials or components for use in product manufacture, finished products, or consumable materials) and the various services (e.g., insurance, heating, telephone) are introduced into the cost accounts through the purchase ledger. The payroll provides the other prime source of cost data.

Once source data has been recorded, via purchase ledger or payroll systems, cost accounting is concerned with placing values on internal transactions, which represent transfers of value throughout an organisation. Internal transactions reflect the conversion of input resources to outputs of goods or services. Outputs include goods and services provided from one area of an organisation to another as well as those provided to the organisation’s external customers.

At each stage the objective should be to highlight not only the costs to be passed on to the next stage but the economy, efficiency and effectiveness of the stage completed. Both relative and absolute measures may be useful and including both financial and non-financial quantitative data.

Economy is the level of input resources applied to a particular task. Efficiency is the relationship between the resources applied to a task and the output of work generated. Effectiveness is the relationship between the output generated and the output desired.

Absorption versus marginal costing

The identification of the profitability and/or cost of different areas of a business is, as previously stated, a prime purpose of any internal accounting system. Without this information management will have little knowledge of the areas from which the business derives its profit and, therefore, will not be in a position to optimise the allocation of production capacity and selling effort. But this begs the question as to what is the correct measure of cost, and thus profit, to use in measuring performance.

Traditionally the measure of cost that has been used has been total cost because profit will only be made once all costs have been recovered. An absorption costing system seeks to determine product/service profitability net of all costs.

In contrast, a marginal costing system focuses on short-term variable costs in order to identify the contribution that a product/service makes towards the total fixed costs of a business. A behavioural classification of costs, as well as classification by element, function and directness, is required in marginal costing.

The contrast between absorption and marginal costing systems, as far as output information is concerned, is highlighted in the illustrations (see Figure 1) of the format and content of product profitability statements (for a manufacturing organisation) using the two different approaches. The behavioural classification and the emphasis on contribution in the marginal costing statement can be contrasted with the functional classification and total cost apportionment of the absorption format. In a service organisation the cost of sales would include those costs closely related to each service provided.

Figure 1: Product performance measurement: contrasting absorption and marginal costing

ABSORPTION COSTING

Trading and Profit and Loss Account

Product 1 Product 2 Total

Sales x x x

Less: Manufacturing cost of sales x x x

Gross Profit x x x

Less: Selling and administrative overhead x x x

Net Profit x x x

MARGINAL COSTING

Income Statement

Product 1 Product 2 Total

Sales x x x

Less: Variable Cost of Sales x x x

Contribution x x x

Less: Fixed Overhead x

Net Profit x

The contrasting absorption and marginal approaches will determine different transaction processing requirements. With absorption costing, all costs are attached to final cost units, including a share (for a manufacturing organisation) of all manufacturing costs being included in the valuation of finished goods stock. In a marginal costing system, only variable costs are attached to cost units, fixed costs being treated as period (non-product) costs.

The contrasting processing requirements are illustrated in Figures 2 and 3. In a service organisation there would not be a finished stock account; the costs of services are charged to Trading and Profit and Loss Account when complete.

Relationship with financial accounts

When setting up a cost accounting system a final issue to resolve is the relationship that the system will have with the financial accounts. Cost accounting systems vary from, at one extreme having a cost accounting system as an internal accounting system that is completely independent of the financial accounts, through having linked systems (interlocking accounts), to at the other extreme having the cost accounting system fully integrated with the financial accounts as a single comprehensive system. Separation enables independence but results in duplication of source transaction recording.

Refer again to Figures 2 and 3. The diagrams show only one aspect of source transactions (e.g., materials bought rather than creditors; sales rather than debtors). The other aspect of each transaction in the cost accounts (the end of the dashes in the top corners of the diagrams) will depend upon the relationship with the financial accounts.

Interlocking accounts is a system in which the cost accounts are distinct from the financial accounts, the two sets of accounts being kept continuously in agreement by the use of control accounts or reconciled by other means.

The interlocking of the two systems is generally carried out by the use of control accounts in each of the separate cost and financial accounts. However, both practice and textbook treatment vary. One common approach is where the financial accounting system has the normal debit and credit entries within itself and in addition has a memorandum Cost Ledger Account. This account will have posted to it all items that are transferred to the cost accounting system.

In the cost ledger there will be the necessary accounts for costing purposes e.g., Raw Material Stock Control Account, Work-in-Progress Control Account, and in addition an account which is equal and opposite to the memorandum Cost Ledger Account in the financial (general) ledger. This control account in the cost ledger may be termed the Financial (general) Ledger Control Account. Other titles for the account that are sometimes used are Cost Ledger Control Account, Cost Ledger Contra Account, and Financial (General) Ledger Adjustment Account.

This reconciling control account in the cost ledger is an essential element of the ledger because it forms part of the double entry system, as well as enabling the financial and cost ledgers to be interlocked and avoiding duplication of those accounts that are not

required for cost accounting purposes. For example, in the cost accounts the purchase of raw materials on credit would be debited to the raw material stock account: a credit to the financial ledger control account avoids duplication of the creditors’ accounts.

At one time, integration was commonly viewed as a desirable aim. A single system would be expected to reduce costs and obviate the need for any reconciliation. However, the conventions of financial accounting will tend to take precedence in such a system. This may restrict the usefulness of information, in any case restricted by its historic transaction basis, for management purposes. Only a completely separate cost accounting system would be completely free from such restrictions, but the requirement in a manufacturing organisation, for stock valuation in line with accepted reporting principles, would remain.

Summary

This article has sought to review the requirements, and issues, relating to the establishment of a cost accounting system. A subsequent article will provide illustrations of the processing of transaction data within such a system.

References

1 Coulthurst N., ‘Overheads: the traditional whys and wherefores’, ACCA Students’ Newsletter, September 1998.

2 Coulthurst N., ‘The ABC of overheads’, ACCA Students’Newsletter, February 1999.

Figure 1: Product performance measurement: contrasting absorption and marginal costing

ABSORPTION COSTING

Trading and Profit and Loss Account

Product 1 Product 2 Total

Sales x x x

Less: Manufacturing cost of sales x x x

Gross Profit x x x

Less: Selling and administrative overhead x x x

Net Profit x x x

MARGINAL COSTING

Income Statement

Product 1 Product 2 Total

Sales x x x

Less: Variable Cost of Sales x x x

Contribution x x x

Less: Fixed Overhead x

Net Profit x