Introduction of Cost Accounting

The importance of cost accounting information to the successful

operation of a business has long been recognized. However, in the current
global economic environment, such information is more crucial than ever. Cost
accounting provides the detailed cost information that management needs to
control current operations and plan for the future.
 All types of business entities—manufacturing, merchandising, and service
businesses—require cost accounting information systems to track their
activities. Manufacturers convert purchased raw materials into finished
goods by using labor, technology, and facilities. Merchandisers purchase
finished goods for resale.
They may be retailers, who sell products to individuals for consumption,
or wholesalers, who purchase goods from manufacturers and sell to
retailers. For-profit service businesses, such as health clubs, accounting
firms, and NBA basketball teams,sell services rather than products. Not-
for-profit service agencies, such as charities, governmental agencies, and
some health care facilities, provide services at little or no cost to the user.
The nature of the manufacturing process requires that the accounting
information systems of manufacturers be designed to accumulate
detailed cost data relating to the production process. It is common
today for manufacturers of all sizes to have cost accounting systems
that track the costs incurred to produce and sell their diverse product
lines.

While the cost accounting principles and procedures discussed in the

text mostly emphasize manufacturers, many of the same principles
apply to merchandising and service businesses. Cost accounting is
essential to the efficient operation of fast-food restaurants, athletic
teams, fine arts groups, hospitals, social welfare agencies, and numerous
other entities.
 Determining Product Costs and Pricing
Cost accounting procedures provide the means to determine product costs
that enable the preparation of meaningful financial statements and other
reports needed to manage a business. The cost accounting information
system must be designed to permit the determination of unit costs as well
as total product costs.

Unit cost information is also useful in making a variety of important

marketing decisions such as:
• Determining the selling price of a product
• Meeting competition
• Bidding on contracts
• Analyzing profitability
 Planning and Control
One of the most important aspects of cost accounting is the preparation of
reports that management can use to plan and control operations. Planning is the
process of establishing objectives or goals for the firm and determining the means
by which they will be met. Effective planning is facilitated by the following:
• Clearly defined objectives of the manufacturing operation
• A production plan that will assist and guide the company in reaching its objectives

Cost accounting information enhances the planning process by providing historical

costs that serve as a basis for future projections. Management can analyze the
data to estimate future costs and operating results and to make decisions
regarding the acquisition of additional facilities, any changes in marketing
strategies, and the availability of capital.
 The word ‘‘control’’ is used in many different ways, but from the viewpoint of
the manufacturing concern, control is the process of monitoring the company’s
operations and determining whether the objectives identified in the planning
process are being accomplished. Effective control is achieved as follows:
1. Assigning Responsibility
Responsibility should be assigned for each detail of the production plan. The
key to proper control involves the use of responsibility accounting and cost
centers. The essence of responsibility accounting is the assignment of
accountability for costs or production results to those individuals who have the
most authority to influence them.
A cost center is a unit of activity within the factory to which costs may be
practically and equitably assigned. The criteria for a cost center are (1) a
reasonable basis on which manufacturing costs can be traced or allocated and
(2) a person who has control over and is accountable for many of the costs
charged to that center.
Cost and production reports for a cost center reflect its costs, in dollars,
and its production activity, in units. In a responsibility accounting system,
the specific data for which the manager is responsible would be
highlighted for the purpose of performance evaluation. Quite often, both
a cost and production report and a separate performance report will be
prepared for a cost center. The performance report will include only
those costs and production data that the center’s manager can control.
A variance represents the amount by which the actual result differs from
the budgeted or planned amount. If the actual amount spent is less than
the amount budgeted for, the variance is favorable (F); if more than
budgeted, it is unfavorable (U).
These reports must be furnished at regular intervals (monthly, weekly, or
daily) on a timely basis. To provide the maximum benefit, the reports should
be available as soon as possible after the end of the period being reported.
2. Periodically Measuring and Comparing Results
Actual operating results should be reviewed periodically and compared
to the objectives established in the planning process. This analysis,
which may be made monthly, weekly, daily, or even hourly in the case of
production and scrap reports, is a major part of cost control because it
compares current performance with the overall plan. The actual dollars,
units produced, hours worked, or materials used are compared with the
budget, which is management’s operating plan expressed in quantitative
terms (units and dollars). This comparison is a primary feature of cost
analysis. The number of dollars spent or the quantity of units produced
has little significance until compared with the budgeted amounts.
3. Taking Necessary Corrective Action.
The performance reports may identify problem areas and
deviations from the business plan. Appropriate corrective action
should be implemented where necessary. A significant variance
from the plan is a signal for attention. An investigation may reveal
a weakness to be corrected or a strength to be better utilized.
Based on the variance analysis, management must be prepared to
improve existing conditions by such means as implementing more
economical purchasing methods and standard portion sizes.
Otherwise, the periodic measurement of activity has little value.
 Professional Ethics, CMA Certification, and Corporate
Governance
The Institute of Management Accountants (IMA) is the largest
organization of accountants in industry in the world. Comparable to
the CPA certification for public accountants, the Certified
Management Accountant (CMA) certificate—which is awarded by the
IMA after the candidate completes a four-year college degree, two
years of relevant professional experience in management accounting
and financial management, and a rigorous four-part examination whose
topics include business analysis, management accounting and reporting,
strategic management, and business applications with a strong
emphasis on ethics—evidences a high level of competency in
management accounting.
Corporate governance is the means by which a company is directed and controlled.
Key elements of the act include:
• certification by the CEO and CFO that the financial statements fairly represent
the results of business operations.
• the establishment of the Public Company Accounting Oversight Board (PCAOB) to
provide oversight of the accounting profession.
• prohibiting a public accounting firm from providing many nonauditingservices to a
company that it audits.
• the requirement that a company’s annual report contain an internal control report
that includes management’s opinion on the effectiveness of its internal controls.
• the placement of responsibility for hiring, compensating, and terminating the audit
firm in the hands of the board of directors’ audit committee, not top management.
• severe criminal penalties for the destruction or alteration of business documents
and for retaliation against ‘‘whistleblowers.’’
 Relationship of Cost Accounting to Financial
and Management Accounting
Financial accounting focuses on gathering historical financial
information to be used in preparing financial statements that meet the
needs of investors, creditors, and other external users of financial
information. The statements include a balance sheet, income statement,
retained earnings statement, and statement of cash flows.
Management accounting focuses on both historical and estimated
data that management needs to conduct ongoing operations and do long-
range planning. Cost accounting includes those parts of both financial
and management accounting that collect and analyze cost information.
It provides the product cost data required for special reports to
management (management accounting) and for inventory costing in the
financial statements (financial accounting).
 Cost of Goods Sold
Merchandising concerns compute cost of goods sold as follows (the
amount of purchases represents the cost of goods acquired for resale
during the period):

Because a manufacturer makes, rather than buys, the products it has

available for sale, the term finished goods inventory replaces merchandise
inventory, and the term cost of goods manufactured replaces purchases in
determining the cost of goods sold, as shown below :
 Inventories
If a merchandiser has unsold items on hand at the end of an
accounting period, the cost of the merchandise is reflected in the current
assets section of the balance sheet in the following manner:

On the balance sheet of a manufacturing concern, the current assets

section is expanded as follows:
 Valuation of Inventories. Many procedures used to gather costs are
unique to manufacturers. Manufacturers’ inventories are valued for
external financial reporting purposes by using inventory costing methods—
such as firstin, first-out (FIFO); last-in, first-out (LIFO); and moving
average—that are also used by merchandisers. Most manufacturers
maintain a perpetual inventory system that provides a continuous record
of purchases, issues, and balances of all goods in stock.
Inventory Ledgers. Generally, both merchandisers and manufacturers
maintain various subsidiary ledgers, such as those for accounts receivable
and accounts payable. In addition, manufacturers usually maintain subsidiary
ledgers for the general ledger inventory control accounts: Finished Goods;
Work in Process; and Materials. These subsidiary ledgers are necessary to
track the individual raw materials, jobs in process, and finished jobs on
hand.