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cost accounting

Page history last edited by PBworks 11 years, 8 months ago

Table of Contents




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Cost accounting


Provides the details necessary for a manager to determine the sources of their competitive advantage. For example, a cost accountant will provide the managers with data to show the cost and price levels that a company can charge relative to their competitors.


This is direclty related to the companies strategy.


The analysis can be used to decide whether a company can add premium features to a product, and charge premium prices. They also help to determine who are the most important customers, and how sensitive they are to price increases, and to help managers analyze competitors products in the marketplace. They help managers to determine whether or not they have adequate cash to fund the new strategy, or if they need to go through fund raising efforts. This area of cost accounting is often referred to as "strategic cost management".


Strategy is about matching a companies resources and capabilities with the opportunities and threats in the marketplace. turn strategy into action - an "action plan". need input from customers, and estimates about how competitors will react. Chose right managers to implement. Make sure there is enough cash.



Value - Chain Analysis

R&D -> Design of Products -> Production -> Marketing -> Distribution -> Customer Service


How do companies add value? they add value through their R&D, design of products, production, marketing, distribution, and customer service. Managers in all of these value chain departments add value. Each of them are customers of the cost accountant.


What roles do management accountants perform? - multiple roles to implement strategy: problem solving (comparative analysis for decision making and planning), score keeping, and attention directing (focus on problems and opportunities).


In a corporation, the managment accountant is called a "controller", and reports to the CFO.


Breakeven analysis


When looking at a proposed project, it is useful to conduct a breakeven analysis to see how many units must be sold to cover your fixed costs.  This "job order costing" is done to figure out the amount of risk there is in the project.


The first thing you need to do is to make a Variable income statement, and figure out what is the contribution margin (revenues - variable costs).  You then subtract all of your fixed costs to come up with your operating income.  Subtract taxes to get your net income.  The goal is to make sure that you have enough contribution margin from this one project to cover your fixed costs of taking on this project (but please just consider only the relevant fixed costs for this project, and do not include non-relevant cash flows). 


The "indifference point" is where the project breaks even, ie where contribution margin just barely covers the fixed costs.


The risk of the project is determined by the operating leverage (contribution margin / net income).  the higher the operating leverage, the more risk of the project (or firm).  This is because if you take on additional debt (fixed interest costs), then the gap between C.M and N.I will be higher, which will result in a higher operating leverage ratio.  (net income will decrease with additional fixed expenses, but C.M stays high, so the ratio of CM / NI will be larger with added fixed costs).


This ratio is extremely useful when comparing two projects (or two companies).  The one with the higher operating leverage will show much higher returns at higher volumes of sales, but will suffer much larger losses at lower volume of sales.  We call it "leverage" because of the amplification effect.








-All Variable costs:

VMCGS (variable manufacturing COGS) *does not include FFO

VS&A (variable sales and admin costs)


C.M. (contribution margin)

-All Fixed costs

FFO (fixed factory overhead)

FS&A (fixed sales and admin)


Operating Income

- taxes


Net Income


  • This is different than the standard Gross Margin income statement that companies normally use when reporting (based on absorbtion costing). The Gross Profit income statement is different in that it combines all inventoriable costs into the COGS figure at the top (FFO is included in the COGS when the firm sells the products), and it also shows all S&A expenses as period costs at teh bottom of the Income statement, as shown here:




- COGS (includes allocation for FFO)


G.M. (gross profit margin)

- VS&A (Variable Sales and admin)

- FS&A (Fixed Sales and admin)


Operating Income

- taxes


Net Income


  • Since all companies are required to report using "Absorbtion" costing, they normally also report using the standard Gross profit income statement. It is useful, however, to be able to convert the ABS income statement to a Variable Income statement. this will help the analyst to be able to see operating leverage, and contribution margin. Also, it will help for internal company control isses (see discussion below).



Converting Absorbtion Income Statement to Variable I/S





Cost Lessons:


  • Prime costs - DL + DM (Direct labor + Direct materials)
  • Conversion costs - all except direct materials (this measures how much it costs to turn the materials into products).
  • Actual costing- wait until the end of the period, and do the calculation with actual numbers (actual quanitity produced), actual prices, actual costs.
  • Normal costing - use actual costs for DL and DM, but use a budgeted cost for allocating factory overhead. This way, you dont have to wait until the end of the period to know what your factory overhead will be. Using Normal costing makes it easier for you to plan the product price, for example. At the end of the period, however, you might have a difference between FOA (factory overhead applied), and FOC (factory overhead calculated - actual). When doing your T-accounts for inventory (WIP, Finished Goods, COGS), you might then need to make an adjustment to correct for this under / over allocation of factory overhead. Note that under "normal" costing, you only have to adjust for factory overhead, because all other numbers are based on actual.
  • Standard costing - it is similar to "normal" costing, except that you now use a budgeted amount for all DM, DL, and factory overhead. The budgeted amount is based on "STANDARDS" which defines how much of each material that you "should" use. If you ran your factory under ideal conditions, using just the standard amount of materials, and standard amount of labor...how much DL, DM, VFO, FFO would you use? (VFO= variable factory overhead, FFO = fixed factory overhead)
  • Static budget = use a fixed budget that you make before the period starts
  • flexible budget = adjust your initial budget by "flexing" the quantity to the actual quanity of output. For example, if you originally thought you would produce 20,000 units, but you actually produced 25,000 units, then you should "flex" your budget to show what the budget "would have been" had you correcly budgeted for 25,000. Then, under "standard" costing, you would calculate the "flexible budget" based on the actual quantity of units produced times the standard quanitity of materials per unit times the standard price per quantity. You can then compare this versus the actual amount that you spent to make those same 25,000 units, and you can figure out how efficient you were in making those units. You can use this information to set pricing for products, and to make improvements in the manufactuing (control).
  • Unfavorable (U) Variance - has the effect of decreasig operating income relative to budgeted amount.
  • Favorable (F) Variance - has the effect of INCREASING operating income relative to budgeted amount.



  • Variable costing - FFO is expensed - this is better for internal reporting
  • Absorbtion costing - FFO is added to inventory (WIP, FG) and is expensed with COGS only when items sold.
  • ABS costing is required for external reporting, but could cause problems if used for internal controls. There is a strage effect that happens under ABS costing, in which managers can artificially inflate the Operating income by producing more. If there is an increasing gap between production and sales, then the balance goes into inventory, but as inventory decreases, accountants will measure a decrease in the COGS expense. (because COGS is calculated, derived based on the following formula: Beg. Inventory + Purchases - End Inventory = COGS). So, if increase the ending inventory, that has the effect of decreasing COGS. If you decrease COGS expense on the income statement, it will make the Net Income appear higher.
  • the Net Income will be different, based on the following formula: Diff in N.I = change in inventory in units, multiplied by the FFO standard rate. (SP). The variable NI will be lower than the absorbtion NI by this amount (might be substantial if the company added lots of inventory).
  • Recommend: convert Income Statement from ABS to Variable
  • If company is using ABS costing - be careful of increasing inventories, especially if managers salaries or bonuses are tied earnings (or the stock price).
  • Investors need to be careful of companies that increase production at the end of the year in order to boost earnings before reporting season.
  • Variable costing will have no "production volume variance", because Factory overhead is not absorbed, it is not applied to the inventory WIP, and so the Budgeted FFO will = the applied FFO under variable costing.
  • Variable costing would just expense FFO under fixed expenses (a period expense).



Converting from Normal / Standard costing back to Actual costing

  • Using Normal or Standard costing is good for planning purposes (and for control, cost reductions), but in the end, the company needs to adjust their books back to "ACTUAL" to show what the actual values are for COGS, and inventory
  • There will often be a difference between the amount of money spent, than what was budgeted. So, by using standard costing, the company might have over / under applied variances between reality and budgeted amounts.
  • there are two common ways to correct these mistakes: (1) make a one-time adjustment to COGS, or (2) prorate them back to WIP, FG and COGS.
  • Lazy accountants will just apply the variances to COGS
  • Better = prorate
  • Prorating will always get you back to actual (either from Normal, or from Standard costing)



Fixed Factory Overhead & Denominator level



Calculating the Breakeven point



Using T-Accounts for Inventory

  • how to adjust for over / under applied FOA to WIP, FG and COGS



Using variances with DL, DM, VFO, FFO



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