Cost Accounting

The field of accounting is typically divided into two areas, financial accounting and cost (or managerial) accounting. Whereas the purpose of financial accounting is to report the results and position of a business to external parties, cost accounting focuses on internal reporting for the purpose of improving managerial decision making. This means that cost accounting is forward looking, as opposed to the primarily backward-looking financial accounting.

As a further distinction, cost accounts are not required to adhere to GAAP like their financial counterparts are. This is because they are performing analysis primarily to assist management teams, who do not need the same standardized reporting that is the external requirement. This also means that cost accounting involves some different metrics than financial accounting. For example, physical measures like units produced per hour may be utilized in cost accounting that would never be seen on any financial statements.

To see how this is used in the real world, take a look at two basic cost accounting concepts: cost allocation and cost-volume-profit analysis.

Cost Allocation

Simply put, the purpose of cost allocation is to assign costs to separate jobs or divisions within a company. For example, Ford’s ( F cost accountants might want to separate out what costs are going into their car, SUV, and truck segments in order to determine which is the most profitable or which has the potential to become more efficient.

In cost accounting, there are two categories of costs: direct and indirect.

Direct Costs

Direct costs, including direct materials and direct labor, do not require any allocation calculations because they can be applied directly to their job or segment. The cost of metal and components used for an F-150 truck can easily be attributed to the truck segment, as can the worker-hours spent building the truck.

Indirect Costs

However, indirect costs, like the cost to build and maintain factories or manager salaries, are more difficult to allocate. Typically, what a company will do is determine a cost driver for each cost. Cost drivers are activities that cause costs to be incurred—potentially items like machine hours, labor hours, or square footage used. One key task for a cost accountant is to select the cost driver that most accurately predicts actual costs.

Let’s say that we run a bread factory and we have three segments: bread, cookies, and cakes. We have selected machine hours as the cost driver for our indirect costs. In 2017, the factory operates at the following activity level:

SegmentBreadCookiesCakesTotal
Machine Hours2200150013005000

At the end of the year, our company has incurred $180,000 of indirect costs (rent, manager salaries, ect). To determine the amount allocated to the bread segment, we would take 2200 hours (the amount of cost driver used by bread machines) divided by 5000 hours (the total amount of cost driver used by the entire factory) to get 44%. Then, we multiply that value by $180,000 of indirect costs to get $79,200 allocated to the bread department.

2200 bread machine hours/ 5000 total machine hours = 44%

44% *$180,000 indirect costs = $79,200 allocated to bread segment

Through similar calculations, we can allocate 30% of costs to cookies and 26% of costs to cake, reaching allocations of $54,000 and $46,800 respectively.

Analyzing Cost Allocation

In terms of takeaways, this analysis is telling us that the bread segment is responsible for the greatest percentage of our machine hours and accounts for the greatest percentage of costs. Depending on the level of revenue being earned from bread sales, management may look to make bread production more efficient.

Companies usually test multiple cost drivers before making a final decision. For instance, in this example management might look at the square footage of factory space taken up by bread machines vs cake and cookie machines, as space could be a logical predictor of the costs to heat, light, and maintain the factory. This is one of the reasons why Cost Accounting cannot be GAAP compliant – there is an inherent subjectivity that the managerial team needs to make when deciding how they internally allocate their costs, so outside observers will never be able to compare two company’s cost accounts “apples to apples”.

Cost-Volume-Profit

Cost-Volume-Profit (CVP) analysis is a process used to predict future financial performance given various output levels. The basic formula involved in CVP analysis is as follows:

Pre-tax Profit = (Price * Units) – (Variable Cost per Unit * Units) – Fixed Costs

or

Pre-tax Profit = Revenue – Variable Costs – Fixed Costs

This formula is a simplified version of an income statement. Notice that instead of listing each item (cost of goods sold, depreciation, etc), this formula classifies all costs as either fixed or variable. This is extremely helpful in terms of allowing cost accountants to project the degree to which a company will be more or less profitable given a certain change in output level, but is also somewhat simplistic. In a real-world company, it can be difficult to determine whether certain costs are fixed or variable. However, CVP provides a useful theoretical guideline regardless.

Applying CVP

One common use of CVP is to analyze how much an increase in output will impact profits. Let’s say our factory had the following bread data for 2016:

Bread Segment
Units sold100,000
Revenue per unit$4
Variable Cost per unit$2
Fixed Costs$150,000

Using our CVP equation, we can easily determine pre-tax profit:

($4 revenue per unit * 100,000 units) – ($2 VC per unit * 100,000 units) – $150,000 FC = $50,000 pre-tax profit

Since in this example revenue per unit is greater than variable cost per unit, increasing units sold will increase profit and vice versa. Another interesting application of CVP is to find the breakeven point, or output level needed to generate a profit of $0.

To find breakeven, we need to set profit equal to zero in the CVP equation and then solve for units (we use the variable x to represent units here):

$0 = 4x – 2x – $150,000

$150,000 = 2x

x = 75,000 units

Therefore, we need to sell 75,000 units to break even on the bread division. Notice that when we solve for x, we simplify and can take out a more direct formula for breakeven:

Breakeven Units = Fixed Costs / (Revenue per unit – VC per unit)

The final term in this equation (Revenue per unit – VC per unit) is often referred to as the unit contribution margin, as is describes the amount per unit sold that a company has available to contribute to covering fixed costs.

CVP, Margins, and Break-Even Applications

In simple cases, the Variable Costs per Unit are fixed, but in the real world they tend to follow a “U” shape as a company increases production. As the company increases production, the variable costs start to go down.

Imagine if you were running your own bakery – If you only bake 2 loaves of bread per week, you will only need to buy one small bag of flour from the local grocery store. Once you get up to 20 loaves, you will probably be buying flour in 25 pound bags – and if you look at the labels at the grocery store, you will see the bigger bags cost less per pound. Once you start producing 200 loaves per week, you might skip the grocery store entirely and work directly with a wholesaler, lowing your input price even more. This is called “Economies of Scale”.

Diseconomies of Scale

At a certain point, you will also start hitting “Dis-economies of Scale”, where your variable cost per unit starts to increase. One of these is purely the number of man-hours spent baking bread – each employee only works so many hours per week. If all employees are fully utilized, you will need to hire one new employee, lowering the average output per worker. For example, imagine you currently produce 2000 loaves per week, with 5 employees each working as hard as they can. Your employees each earn $20/hour, and work 35 hours per week. To calculate the current variable cost per unit due to labor, you would calculate:

Total Salary Cost = Total Employees * Hours per Week * Hourly Wage

Total Salary Cost = 5 * 35 * $20 = $3500

Current Labor VC per Loaf = Total Labor Cost / Total Loaves Produced

Current Labor VC per Loaf = $3500 / 2000 = $1.75

Now if your company wants to bake 2100 loaves next week, you will need to hire a new employee. This new employee is currently under-utilized, which means it impacts your average cost per loaf.

Total Salary Cost = Total Employees * Hours per Week * Hourly Wage

Total Salary Cost = 6 * 35 * $20 = $4200

Labor VC per Loaf = Total Labor Cost / Total Loaves Produced

Labor VC per Loaf = $4200 / 2100 = $2.00

The other biggest concern that can cause diseconomies of scale include maximizing the machine hours per worker – if you have too many bakers in the bakery, some may be idle waiting for an oven to free up.

Double Break-Even

This means companies have two break-even points: the first is the minimum they need to produce and sell to pay their expenses, and the next is the maximum they can sell before diseconomies of scale eat all of their profits.

Managers use both points every day. The lower break-even point brings up a “shut-down” question – is it more profitable in the long run to continue producing that good at all, or are the current resources it uses able to be better utilized elsewhere. The higher break-even point raises a flag for reinvestment and efficiency evaluation – as variable costs increase, managers decide if more capital (in our example, more or bigger ovens in the bakery so each baker gets plenty of machine time), or different production processes can be implemented to keep profits flowing as business grows.

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