Chapter 15 Cost Control In a manufacturing concern accounting activities are usually divided into two parts: financial accounting

and cost accounting. Financial accounting deals with the business as a whole, and at the end of a designated accounting period it produces information about the current financial status of the business, as well as the amount of profit or loss incurred during the period in question. Role of Cost Accounting Balance sheets and profit and loss statements do not reveal how profitable one product is versus another, or whether one plant produces more efficiently than another. Although the stockholder or investment analyst may care little about details of efficiency and cost since to them the overall profit of the business is sufficient, management must take a different point of view. Naturally, management is interested in maintaining the overall position of the company. The overall position of a company can include such measures as how successfully it competes, how it is perceived by its customers, competitors, and investors, and its capacity for future growth. In cost accounting the total expenditures in operating a business are broken down on per item or per unit basis, as for example the cost of producing a gallon of gasoline, a ton of coal, a dozen shirts, or a refrigerator. The same idea can be extended to cost per production order, as when a special product is made for a customer, or extended to cost per activity or operation, such as the cost of drilling inch holes, or plating sheet metal of a certain size and quality. Cost accounting provides information for the following purposes: 1. Cost determination The costs and expense of a business are recorded, classified, and allocated to various jobs, departments, products, or services. 2. Costs for pricing Once costs are determined, the information also serves as a guide regarding prices to be quoted to customers. Even though selling prices are governed only partly by the costs of production, in the long run the selling price must atleast equal the costs of production, or there will be serious consequence to the profit and loss statement. 3. Cost for managerial decision In a sense, both cost determination and cost for pricing provide bases for managerial decisions. Although managerial decision making actually becomes much more complex than the statement above implies, cost information may be helpful in making decision that have to do with (a) whether to add a new product, or to drop one that is now being produced (b) Whether to manufacture a certain unit, or buy it on the outside, and (c) whether to add certain sales terrories and drop others.

4. Cost control One of the more essential purposes of cost accounting is control of expenditures. Such control leads to efficiency in the use of labor, materials machines and plants. Although to a large extent selling prices are determined by competition, the profit-making capacity of a business is guided by the efficiency with which costs are controlled. Basic Cost Elements There are three basic cost elements with which we deal in this section direct material cost, direct labor cost, and overhead. Overhead will be further subdivided as to whether it results from factory operation, sales effort, or general administration. Figure 15.1 shows in chart form the derivation of basic cost elements.

Figure 15.1 Derivation of Basic Cost Elements Direct Material cost is the cost of the material that can be identified directly with the product that is delivered to the customer. In practice, any scrap or waste of material is still charged as direct material even though it is not delivered to the customer. Also, one must take a practical point of view when applying this strict definition of direct material and arriving at direct material costs. Some direct material may cost so little that it is not worthwhile to identify and charge it as direct material. Paint is a good example. Indirect material in general may be thought of as those items used in the manufacture of a product that do to not become an integral part of it. Costs of these materials become overhead costs. Good examples of indirect material are light bulbs to light the area, cleaning rags, sandpaper, and hand tools. The concept of direct labor cost is very similar to that just described for direct material costs. The direct labor costs are the costs of the labor that can be identified directly with the manufacture of the product that is delivered to the customer.

When added together for any one product, the direct material and direct labor costs are called prime cost. Prime cost, then, represents the total direct cost of producing a product and is usually a figure relatively easy to determine with reasonable accuracy. Overhead costs present a different kind of problem. Overhead costs are often defined as all manufacturing costs other than direct material and direct labor, or other than primes costs. This may seem like a backward definition, but it turns out to be as useful a definition as one can devise. IN practice, overhead costs are arrived at in essentially this manner. If a cost item is not either direct labor or direct material, it must be overhead. We have mentioned tow common types of overhead: indirect material and indirect labor. Other items that usually fall into the overhead category are heat, light, power, insurance, rent, depreciation, taxes, and telephone. Often it is possible to identify overhead expense with a particular product, as when a special lubricant is used only in the manufacture of one product. In such a case one may be tempted to charge the entire cost of the lubricant to that product, instead of putting it in overhead to be apportioned later among all products, but this is seldom done because the additional accuracy obtained would not be worth the cost of the extra bookkeeping. Exception might be in cases where expensive dies or tools are required for one product or where readily identifiable and separable departments or buildings are used on only one product. Obtaining Unit Costs In the preceding section we have been concerned largely with defining cost elements. Let us consider how these cost figures are obtained, particularly on per unit or per-product basis. Direct material and direct labor present little difficulty. One can generally measure the amount of direct material used per unit of product. Because material costs can be determined from vendors invoices and if product yields are known, the direct material dollars per unit can easily be obtained. Most factories require their employees to keep time records. From these records the number of direct labor hours spent on any product or order can be determined. Knowing hourly rates and units of output, one can easily compute direct labor dollar cost per unit. Common bases for the allocation of overhead costs are 1. Number of employees 2. Direct labor costs 3. Direct labor hours 4. Direct material costs 5. Machine hours 6. Floor area 7. Prime Costs

Past versus Future Costs We have speaking of cost determination and cost allocation strictly in the historical sense. In other words, our discussion so far has looked at cost after the accounting period is over and products have been stored in the warehouse; and we have then tried to determine costs on a per unit basis. Such figures are interesting and helpful to some extent, but they are not completely adequate. In managing operations, we need sufficient information about what future costs should be so that bids may be placed on jobs, selling prices may be estimated ahead of time, and a basis for corrective action may be provided. The use of standard costs is helpful both in predictive work as well as in control. Figure 15.2 Development of the Total cost of a product

Job Order Costs and Process Costs Whether one is developing standard costs or historical costs, the problems involved will vary depending on whether one follows the job-order cost method or the process-cost method. Sometimes it is necessary to combine the two methods, but for the most part the method one uses depends upon the type of manufacture. The job-order cost method collects the cost of jobs that are kept separate during the manufacture or construction period. The cost unit is the job, the order, or the contract and the accounts sow the cost of each order. This method assumes that the jobs can be physically identified and separated from each other. A variation of the job-order cost method is the costing of orders by lots. In many shops it is much more convenient and economical to consider a product in lots of a dozen or a hundred rather than individually. Cost Reduction and Cost Control At some time or other almost every company has had some kind of program of cost reduction. The precise reason for any particular program of cost reduction may vary considerably from time to time and from company to company, but all such programs have in common the basic need to reduce costs of operations below their present level. Specific reasons could be the softening of the economy generally, particularly rough competition in a specific product line, or a wish to reduce the selling price of a particularly product and thereby broaden its market. Budgetary Control In the previous sections we outlined the use of cost standards as a device for controlling manufacturing operations. Cost accounting, although not a control device itself,

provided the necessary information for setting up cost standards. Budgets are also used for cost control purposes and are discussed in that role in the pages that follow. Budgets and Their Use We normally think of budgets in terms of a number of dollars and a list of items on which those dollars will be spent. A business budget differs somewhat from these common concepts in as much as it must be more detailed. It will specify units to be produced, broken down into sizes and styles, as well as costs of production. In fact, a considerable part of the budget comes from the use of the estimated cost breakdown figures discussed earlier. The budget can then be thought of as an overall plan for the operation of the business in terms of sales, production, and expenditures. Fixed and Flexible Budgets The preparation of a budget being with an estimate of sales for the year ahead. Techniques for making such forecasts are discussed from sales forecasts production requirements can be determined, taking into account the inventory situation. The production estimate then becomes the basis for determining material, personnel, plant, and equipment requirements and the costs allied with each. Breakeven Charts Examining the breakdown of costs that appears on a flexible budget, one finds certain costs, such as rent, taxes, and insurance, that is constant event as production varies. Other cost items, such as wages and materials, vary as production costs suggest the construction and use of onces in the basic nature of production costs suggest the construction and use of breakeven charts. A breakeven chart shows the cost of production at various levels of breakeven charts. A breakeven chart shows the cost of production at various levels of output as well as the income from sales at the same output levels. It must be assumed that all goods produced are sold, or else the chart has little meaning. Profit Centers Attempts are often made to apply the breakeven chart technique to the company as a whole. IF the company produces and sells but one product, such an attempt will be relatively successful. On the other hand, of a number of products are produced and sold, summary figures of sales and costs may not have too much meaning. Variation in product mix will cause variations in summary figures, which might in turn lead to erroneous conclusions. It makes much better sense to divide the organization into units or centers and to compute costs and profits for each of the various units. Accounting and Management In this chapter we have discussed the use of accounting, especially cost accounting in the management of a manufacturing enterprise. Before ending the chapter it may be well to emphasize that cost accounting is a means to an end and not an end in itself.

This familiar and overused phrase is particularly applicable in this case, for often we become overawed with the apparent accuracy of cost figures, with the possible result that the company is being operated for the convenience of the cost accounting department. Cost accounting is a tool or an aid to good management, the same as many other functions are aids. All must be kept within the proper framework so that the company as a whole may prosper.