Toward Diversified Cost Accounting Systems

By Timian, Karen A.; K. Fleming, Mary M. | The National Public Accountant, February 2000 | Go to article overview

Toward Diversified Cost Accounting Systems


Timian, Karen A., K. Fleming, Mary M., The National Public Accountant


Cost accounting systems usually take the form of job order or process. Each of these two systems can be expanded to include standards and recording of the variances in the accounting records. Variances are written off to Cost of Goods sold or allocated to the various inventory accounts and Cost of Goods sold on a rational basis. Ideally, firms detail their accounts by variable and fixed costs.

NEED FOR A SOUND COST ACCOUNTING SYSTEM

A good cost accounting system allows managers to solve a multitude of accounting problems as well as furnish data for business decisions. For example, defining cost by variable and fixed makes it possible for managers to calculate a contribution margin on a per unit basis or in total. Contribution margins can then be used for cost-volume-profit analysis, including simulation resulting from changing any of the components of the break-even formula. Now the firm can readily determine the impact of these changes on profit or loss, evaluate if it is possible or practical to operate with the revised components, and identify the optimal level of output.

From variable and fixed costs, flexible budgets can be quickly prepared for planning and control. After-the-fact flexible budgeting allows for the removal of the flexible budget variance (budgeting for a different volume than sold). Thus, performance reporting can be limited to whatever variances managers consider to be pertinent. Types and causes detail these variances. If warranted, immediate corrective action should be instituted for unfavorable variances.

Firms must make sound business decisions if they are to survive. These decisions usually require up-to-the-minute data because old accounting numbers lose their information contents rapidly. Many business decisions, such as make/buy, transfer pricing, adding or dropping products/divisions, pricing, special orders, and capital acquisitions, depend on knowing which costs are variable and which are fixed.

Generally, for inventory measurement, the entire cost of manufacturing an item is treated as a product cost, meaning that all manufacturing costs (variable and fixed) are treated as belonging to products. Fixed costs and variable indirect costs estimated for an accounting period (often a year) are allocated to the cost objects by means of a predetermined overhead rate using a rational allocation base. There should be a correlation between the amount of indirect costs charged to the cost objects and the variable(s) driving the costs. The selection of an appropriate cost driver is essential if the allocation to inventory is accurate. Frequently, indirect costs are allocated on either the principle of equality or ability to bear. The principle of equality charges all products a prorated amount using a variable basis, such as direct labor hours or machine hours. The principle of ability to bear allocates a larger share of the indirect cost to products with higher sales or profit margins. Both ignore which variab les are driving the costs. Erroneous allocation of indirect manufacturing cost directly affects the valuation of the inventory, which in turn affects the amount capitalized as an asset, and the timing and amount of profit when inventory is transferred to Cost of Goods Sold. Therefore, net income and earnings per share are directly affected by the appropriateness or inappropriateness of the cost charged to inventory.

Because under generally accepted accounting principles, net income is directly affected by units sold and units produced, managers may be motivated to stockpile inventory to improve their performance. Unfortunately, such a strategy is not always appropriate, as unsold inventory is costly to carry, may suffer from spoilage or obsolescence, and disputes the validity of just-in-time inventory control. If adequate capacity exists to cover future periods' sales and production needs, overstocking is especially unwise, as the firm will be forced to continue this unsound practice indefinitely. …

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