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Cost Accounting

The cost engineer must be familiar with cost accounting since it is the accountant who keeps the cost records. Moreover the cost engineer should be part of a team in the allocation of overhead and other indirect costs. The first part of this chapter discusses the basic concepts of cost accounting and how they are used on a project. The second part discusses various classifications of accounts. Although the presentation in the first part of this chapter favors work associated with engineering and construction for the oil and chemical industries, the principles are general. Readers interested in a more detailed discussion of the subject are referred to Humphreys (1991). This book, written under the sponsorship of the AACE International, the Association for the Advancement of Cost Engineering, gives an extensive treatment of the subject. 2.1 PROJECT COST ACCOUNTING An understanding of the terms total cost and profit is essential to gain an understanding of cost accounting. For a business to be successful, it must earn a profit. Several terms for sales are employed by accountants, including selling price, contract value, or billable value. They represent the total expected income from the customer. Considered next are the estimated costs of producing the product, be it a manufactured item or a service. Many firms use the term total base cost and commonly have a standard list that defines all the elements that account for the cost of the work. Subtracting the total base cost from the estimated project sales or income gives what is commonly termed gross profit or total overhead and profit. Another term used is gross margin. Considered also are the costs involved in selling the product or service. The most common terms used are overhead cost or selling and general administration expenses. These elements of overhead costs are discussed in

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more detail below. After deduction of the overhead costs there remains the profit or loss before taxes. (Taxes were discussed in Chapter 1). 2.2 ROLE OF COST ACCOUNTING Cost accounting, the principal subject of this chapter, expands the techniques of financial accounting and is part of managerial accounting, as opposed to historical or audit functions. A general definition of accounting is: Accounting is the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character, and interpreting the results thereof (Grady, 1965). All accounting systems include three basic steps: recording, classifying, and summarizing economic data, all three in terms of money. Classification of accounts is based on a listing called the chart of accounts, which plays a major role in all accounting systems. It is employed extensively in computer applications in the form of management information systems. A good chart of accounts structure provides the following: A standard method by which a business prepares cost estimates in a consistent manner A means for recording and classifying cost to permit direct comparison with estimates and budgets Facilities for creation of cost centers such as department or sections Means for dividing cost centers into smaller segments for ease of control and for obtaining unit return cost data The opportunity for cost engineers to follow the chart of accounts in trending the project costs and in preparing cost forecasts and management cost reports.

Cost engineers should be completely familiar with their company s chart of accounts. Table 2.1 is an illustration of a general chart of accounts. 2.2.1 Accounting Terms Before we can consider various classifications of cost, some cost definitions and a few additional accounting terms need to be examined briefly. The definition for cost is: the amount measured in money, cash expended or liability incurred, in consideration of goods and/or services received(AACE, 2003). The most commonly used terms are listed in Table 2.2; these are all defined either in the text of this chapter or as noted in Appendix B.
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These are summary-level accounts, sometimes called control accounts. More detail can be provided by using subaccounts as required. Source: K.K.Humphreys, Jelens Cost and Optimization Engineering, 3rd ed., 1991, McGraw-Hill, Inc., New York, p. 535. Reprinted by permission.

Accounting uses a double-entry system for every transaction with valuation always in terms of money. By way of example, in engineering with no accumulation, Input=Output and similarly in accounting Credit=Debit The terms debit and credit are conventional and have no particular significance as such. The distinction between the terms can always be resolved by reducing a
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AACE Standard definition in Appendix B. See Burden in Appendix B.

transaction to a transfer of money between accounts with the accountant acting as an intermediate who transfers the value from one account to another. Suppose that a company pays a supplier $500 cash that is owed to the supplier. The account for the company records a balance transaction as follows:

Here the suppliers account is a debit since $500 was put into the suppliers account. Similarly the cash account is a credit since $500 was obtained from the cash account. Two basic classes of accounts must be distinguished: Real accounts: Real accounts are allowed to accumulate indefinitely and are not closed out at the end of the year. Revenue and expense, or nominal accounts: These are cleared into capital at the end of the year. Real accounts are of two types. If they are owned by the business, they are called assets. Conversely those owed by the business are called liabilities. In accordance with the double-entry equation, Debits=credits Assets=liabilities and ownership where ownership represents the owners equity in the business. The meaning of terms used in cost accounting varies from company to company. Hence it is necessary to know exact meaning of terms as used by the cost engineers company as well as the general meaning. For example, to some accountants the term manufacturing expense does not include factory overhead since factory overhead is part of product cost and will funnel into the expense stream only when the product costs are released as cost of goods sold. Cost of goods sold is a widely used term that is somewhat misleading in connection with the meaning of cost (see next section). Cost of goods sold is
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an expense because it is an expired cost and is as much an expense as are sales commissions. Cost of goods sold is often called cost of sales. The distinction between direct costs and indirect costs can cause confusion. The topic is discussed more fully below. 2.3 CLASSIFICATION OF COSTS Costs can be classified as unexpired and expired, as summarized in Table 2.3. Unexpired costs (assets) are those which are applicable to the production of future revenues. Expired costs are those which are not applicable to the production of future revenues and for that reason are treated as deductions from current revenues or are charged against retained earnings. Some examples are: 1. Equipment and machinery. This could be automobiles, trucks, desks, computers, or machines in a machine shop. All are assigned an estimated useful life, and they are written off or depreciated over a given period of time. The useful life of any piece of equipment is determined by government regulation or by guidelines set by historical data. The guidelines are flexible and may be changed from time to time by modern technology. When the writeoff is made, the cost becomes an expired cost. The writeoff or depreciation, depending on what it is for, can be classified as direct, indirect, or overhead cost. 2. Raw materials inventory. An accumulation of unused items or components (raw materials) related to producing a product is called an inventory. Items in the inventory may have been acquired at different times and at different prices. In such cases a rule or guideline is required to determine the value at which
Table 2.3 Unexpired and Expired Costs

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these units shall be transferred out of inventory and into expired costs. The rule applies to pricing and has nothing to do with which unit is removed physically from the inventory. A common method of inventory costing is FIFO, or first in, first out. The cost of the oldest unit in inventory is used. Under conditions of increasing prices or inflation, lower acquisition prices are matched with higher selling prices, resulting in higher accounting profit figures and higher income taxes. To avoid these effects, a method of evaluation can be used known as LIFO, or last in, first out, which matches current costs with current revenues. However the lower-cost items remain in inventory. The use of an average valuation represents an effort to find a compromise between the two methods. 3. Prepaid costs. These are costs for which cash has been expended for a service or benefit that extends over more than one production cycle, or 1 year. For example, a 3-year $300 insurance premium may be charged originally to an asset account, Prepaid Insurance. Subsequent accounting for the cost will hinge on (a) the amount applicable to the current period, say $100 for the first year, and (b) the purpose of the insurance coverage. Insurance on factory machinery is inventorial and is therefore transferred from Prepaid Insurance to an inventory account. Insurance on a sales office is not inventorial and is therefore transferred from Prepaid Insurance to an outright expense account. The same determination has to be made for local taxes and rent. 4. Salaries. These can be an unexpired cost. Work on a particular product could be done perhaps months before the final assembly of the items is completed. Also a portion of the product could be fabricated outside and returned for final assembly. The salary is written off to the job or to products in the end. Unexpired costs are found in balance sheets, and expired costs are found in the profit and loss (income) section of the final statements. Cost data found in conventional financial statements, however, are for the specific purpose of reporting to interested outsiders and are not necessarily useful for other applications. The requirement of selecting the appropriate cost type for individual objectives is important. No general rules are possible because of the wide variety of circumstances. Table 2.4 provides a summary.

Table 2.4 Classification of Costs

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2.3.1 Direct Costs Direct costs are also called prime costs and are traceable directly to the product being manufactured or fabricated, such as the fabric in clothing. For an engineering and construction firm one of the prime costs on a project is the design department workhours or salary. In a manufacturing operation, costs are accumulated through three separate accounts: 1. Direct material. Cost of materials, assemblies, and parts which are used for the completion of the project 2. Direct labor. Wages of workers who are participating in the completion of the product 3. Overhead. The costs of all other factors contributing to the completion of the product (see Appendix B) Material cost consists of the basic purchase price and all other expenses required to transfer the materials to the purchasers premises, such as transportation, insurance, and tariff duties. Labor cost is made up of many different factors. It includes the basic hourly rate for hours worked, overtime pay, social security taxes, vacation pay, holidays, sick leave, and so on. 2.3.2 Indirect Costs Indirect costs are all the costs of manufacturing that cannot be classified as direct costs because it is either impractical or impossible. Each classification is initially accumulated in a separate account and at the end of the accounting period is allocated to individual benefiting activities, such as a cost center or project. It is a two-step procedure: accumulation and allocation. Supervisory services, for example, benefit many units of profit and the cost accumulates in a separate account. At the end of the accounting period the cost is allocated to individual products as part of the overhead. Modern technology tends to increase the share of indirect costs while the share of direct labor cost is declining. This is really the purpose of automation to replace direct labor cost with the indirect cost of machines. All businesses are organized by departments or cost centers, but the two are not necessarily synonymous. Costs are accumulated by cost centers, which may or may not coincide with operating departments. Cost centers are located where costs can be measured and recorded as conveniently and accurately as possible. The advantages of having departments and cost centers are: 1. A more accurate selling price can be gained for a product. 2. Cost can be controlled more easily. 3. Long-range forecasting can be more exact.

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Cost engineers should maintain a close liaison with the cost accountants and those who design and apply the cost accumulation system. Cost engineers need to make the requirements known so that all work can be accomplished within appropriate cost and practicality limitations. 2.3.3 Overhead Costs The classification includes all product costs that are not considered prime costs (direct material and direct labor). There is no limit to the possible number of overhead classifications; however, principal groups are: Indirect materials (also known as supplies): materials, such as lubricants, that do not become a part of the finished product. Indirect labor: the wages and salaries of employees who are not directly connected with the manufacture of a product, such as supervisors, maintenance workers, and internal transportation workers. Frequently the cost of fringe benefits is included in this classification. Facilities costs: both short-term cost of the current year and the depreciated part of long-term costs for the current year. The former includes building and equipment maintenance, local real estate taxes, and other periodic items; the latter includes buildings and equipment. Service department costs: for facilities that support productionfor example, accounting, laboratories, stores, cafeteria, and first-aid stations. Overhead is considered one of the most tedious problems of cost accounting. Accumulated overhead costs are allocated in stages. First the overhead costs are allocated to the cost centers and in turn are allocated to job order costs and process costs. With a large number of indirect cost classifications and a large number of cost centers, the computations can be voluminous. Cost engineers must recognize that the cost data that emerge from these calculations are affected significantly by the measures used for allocation, and they should understand fully the techniques used for the allocation. A basis must be selected to allocate the costs fairly. Consider building maintenance as an example. Measurement can be made on the basis of square feet and allocated on the basis of floor space occupied by each cost center. In turn, cost centers must have a measure to allocate this overhead, which might be labor hours, machine hours, material, and so on.

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A simple illustration will show how overhead is applied to an individual job at a cost center with allocation based on labor dollars. Thus job 504 would be allocated $4000 of the total overhead of $50,000 for cost center A. Allocating overhead based on actual data has two distinct disadvantages: (1) it is complicated, and (2) the information is not timely. Units made at the beginning of a month cannot be priced out until the end of the month when actual data become known, and use of actual overhead cost is subject to fluctuation from period to period for such items as taxes, which may occur only once a year. A shortcut method, called an estimated burden rate, has been devised. Managers predict an amount for the overhead cost for a fixed period, usually a year, and determine the measure or basis for charging a job or product for its appropriate share of the overhead cost. Direct labor has been used most widely for this basis. A rate can be established by dividing total estimated overhead cost by the estimated quantity of the selected basis, which becomes the burden rate. These are estimated amounts and variances will occur. The variances should be reviewed periodically and adjusted accordingly. The advantages of the estimated burden rate method are (1) savings of time, and (2) increased possibility of obtaining better data for determination of operating efficiency. 2.3.4 Standard Costs Standard costs and budgets are not identical. Standard costs usually refer to a unit of production, and budget to a total concept like a department. In a sense the standard is the budget for 1 unit of production. The purposes of standard costs are: To build a budget and feedback system To aid in management predictions To save in bookkeeping cost To aid in cash flow forecasting

Standard costs are determined with scientific techniques and objective quantity measurements. The costs developed do not necessarily represent expected performance but rather, desired objectives. Standard costs are merely references to which actual costs are compared. The variances are used in management reports as a valuable tool to highlight areas of good and poor performance. For example, consider a manufacturer producing 10,000 heavy ashtrays. Standards are developed for direct materials and direct labor. The standards based on historical data are:

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For a budget of 10,000 units, the budget for materials becomes $400,000 and for labor $320,000. After a run of 10,000 units, the following data are compiled:

Budget variances are determined as follows (F indicates favorable; U indicates unfavorable):

The variance for materials is $140,000 unfavorable, and for labor it is $23,200 unfavorable. The variances can be traced in more detail. The $140,000 unfavorable variance for material arose as follows:

The $23,600 unfavorable variance for labor arose as follows:

Note that the unfavorable total labor variance is the sum of an unfavorable workhour overrun and a favorable labor rate. Without the standard cost, analysis is meaningful only if standards are kept current and only if actual data are recorded accurately. Close coordination and cooperation is required between the accountants and the engineers. 2.3.5 Joint Costs The term joint costs applies to two or more kinds of products that are produced simultaneously and are not identifiable as individual types of products until a

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certain stage of production, the split-off point, is reached. A product for which there is little or no demand is called a by-product. Joint costs are combined cost up to the point of separation. Since joint costs cannot be traced directly to units worked, the apportioning of the costs to various units of production has to be arbitrary. Joint cost distribution is limited to purposes of inventory costing and income measurement. There are two basic approaches for distributing the cost to various products: (1) physical measures, and (2) net realizable value (relative sales value method). Example 2.1 Consider the following flowsheet:

Both of these products become finished goods at the split-off point. Let the $900 cost up to the split-off point be allocated on the basis of the physical measure gallons. For $900 to be spread over 1500 gal total, the cost per gallon is $0.60, and the allocation becomes:

The income statement becomes:

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There is a loss for A and a profit for B. Now consider an allocation based on net realizable value.

The income statement becomes:

Now A and B both show the identical margin percentage of 10%. Cost engineers must be aware of the dangers associated with cost allocations for joint products, since the allocation can have a decisive impact on the cost data and on subsequent decision-making.

2.3.6 Job Order and Process Costing The two basic types of accounting techniques for accumulating production costs are (1) job order costing, and (2) process costing. In job order costing the production cycle and the cost cycle are of equal length. Job order costing is used for specialized production jobs for which costs can be recorded accurately, but for which considerable work is involved. Job orders can be issued for individual customers or for stock items. Process costing is used for continuous process industries which operate 24 hours per day, such as chemical, steel, and so forth. The production cycle continues without interruption while the cost cycle is cut off for each accounting period to determine the result of operations. Process costs use averages and are less accurate than job order costs, but they are simpler and cheaper to operate. The method is applicable to mass-production industries as well as to process industries.

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REFERENCES
AACE Standard Cost Engineering Terminology. (2003). AACE Standard No. 10S 90. Morgantown, WV: AACE International. Grady, P. (1965). Inventory of Generally Accepted Principles for Business Enterprises. AICPA Accounting Research Study 7. New York: American Institute of Certified Public Accountants, p. 2. Humphreys, K.K. (Ed.) (1991). Jelens Cost and Optimization Engineering. 3rd ed. New York: McGraw-Hill.

RECOMMENDED READING
Adrian, J.J., Adrian, D.J. (1998). Construction Accounting: Financial, Managerial, Auditing & Tax. 3rd ed. Champaign, IL: Stipes Publishing Co. Cokins, G. (2001). Measuring costs across the supply chain. Cost Eng. 43(10):25 31; Morgantown, WV: AACE International. Delaney, P., Epstein, B.J., Nach, R., Budak, S.W. (2003). Wiley GAAP: Interpretation and Application of Generally Accepted Accounting Principles 2004. New York: John Wiley & Sons. MasterFormat: Master List of Titles and Numbers for the Construction Industry. Current ed. Alexandria, VA: Construction Specifications Institute. Miller, C.A., OConnell, E.F. (1958). A proposed standard cost code. AACE Bull. 1(1):811; Morgantown, WV: AACE International. Palmer, W.J., Coombs, W.E., Smith, M.A. (1995). Construction Accounting and Finan-cial Management. 5th ed. New York: McGraw-Hill. Sillak, G.C. (2002). Project Code of Accounts. Recommended Practice No. 20R 98. Morgantown, WV: AACE International. Sillak, G.C. (2002). Project Code of Accountsas Applied in Engineering, Procurement, and Construction for the Process Industries. Morgantown, WV: AACE International.

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