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Question 1. What Is Cost Accounting?
Cost accounting involves the techniques for:
determining the costs of products, processes, projects, etc. in order to report the correct amounts on the financial statements, and
assisting management in making decisions and in the planning and control of an organization.
For example, cost accounting is used to compute the unit cost of a manufacturer’s products in order to report the cost of inventory on its balance sheet and the cost of goods sold on its income statement. This is achieved with techniques such as the allocation of manufacturing overhead costs and through the use of process costing, operations costing, and job-order costing systems.
Cost accounting assists management by providing analysis of cost behavior, cost-volume-profit relationships, operational and capital budgeting, standard costing, variance analyses for costs and revenues, transfer pricing, activity-based costing, and more.
Cost accounting had its roots in manufacturing businesses, but today it extends to service businesses. For example, a bank will use cost accounting to determine the cost of processing a customer’s check and/or a deposit. This in turn may provide management with guidance in the pricing of these services.
Question 2. What Is Cost Allocation?
Cost allocation is the assigning of a common cost to several cost objects. For example, a company might allocate or assign the cost of an expensive computer system to the three main areas of the company that use the system. A company with only one electric meter might allocate the electricity bill to several departments in the company.
Allocation implies that the assigning of the cost is somewhat arbitrary. Some people describe the allocation as the spreading of cost, because of the arbitrary nature of the allocation. Efforts have been made over the years to improve the bases for allocation. In manufacturing, the overhead allocations have moved from plant-wide rates to departmental rates, from direct labor hours to machine hours to activity based costing. The goal is to allocate or assign the costs based on the root causes of the common costs instead of merely spreading the costs.
Question 3. What Is A Cost Driver?
Ideally, a cost driver is an activity that is the root cause of why a cost occurs.
In the past century, the root cause of indirect manufacturing costs has changed from a single cost driver (such as direct labor hours) to several cost drivers. Due to sophisticated manufacturing and increased demands from customers, direct labor is no longer the main cost driver of indirect manufacturing overhead.
In addition to direct labor, today’s drivers of indirect manufacturing costs include the number of machine setups required, the number of engineering change orders, the demands from customers for special inspections, handling and storage, the number of components in the units produced, and the number of production machine hours.
Manufacturers that want to know the true costs of their products need to know what is driving their indirect manufacturing costs. For these companies it is not sufficient to merely spread overhead costs to products by using a single factor such as direct labor hours or production machine hours.
Question 4. What Is The Traditional Method Used In Cost Accounting?
The traditional method of cost accounting refers to the allocation of manufacturing overhead costs to the products manufactured. The traditional method (also known as the conventional method) assigns or allocates the factory’s indirect costs to the items manufactured on the basis of volume such as the number of units produced, the direct labor hours, or the production machine hours. We will use machine hours in our discussion.
By using only machine hours to allocate the manufacturing overhead to products, it is implying that the machine hours are the underlying cause of the factory overhead. Traditionally, that may have been reasonable or at least sufficient for the company’s external financial statements. However, in recent decades the manufacturing overhead has been driven or caused by many other factors. For example, some customers are likely to demand additional manufacturing operations for their diverse products. Other customers simply want great quantities of uniform products.
If a manufacturer wants to know the true cost to produce specific products for specific customers, the traditional method of cost accounting is inadequate. Activity based costing (ABC) was developed to overcome the shortcomings of the traditional method. Instead of just one cost driver such as machine hours, ABC will use many cost drivers to allocate a manufacturer’s indirect costs. A few of the cost drivers that would be used under ABC include the number of machine setups, the pounds of material purchased or used, the number of engineering change orders, the number of machine hours, and so on.
Question 5. What Is A Plant-wide Overhead Rate?
A plant-wide overhead rate is a single rate used to assign or allocate all of a company’s manufacturing overhead costs to its production output. (Manufacturing overhead costs are the indirect costs of production such as repairs, maintenance, depreciation, electricity, supervision, etc.) Often the plant-wide rate is an amount per machine hour, an amount per labor hour, or a percentage of a product’s direct costs.
Using a plant-wide rate is logical when there is one root cause of the indirect production costs and the company manufactures similar products. For example, a company with a simple manufacturing operation that produces similar products could have a plant-wide overhead rate of $40 per machine hour if it has budgeted $800,000 of total manufacturing overhead costs and it expects to produce 20,000 machine hours of good output.
On the other hand, if the company manufactures diverse products, some of which use expensive equipment while some use only inexpensive equipment, a plant-wide rate is not appropriate. In response to this situation, manufacturers have developed departmental overhead rates. Thus, only the products that use the expensive equipment in a specific department will be assigned a higher overhead rate of perhaps $70 per departmental machine hour. The products requiring a simpler operation such as assembling may be assigned overhead at a rate of perhaps $20 per direct labor hour.
Some companies have moved beyond both the plant-wide rate and the departmental rates because they want to consider all of the activities that are driving up manufacturing overhead costs. These companies are attempting to find the root causes of the indirect manufacturing costs so they can assign the costs to products in a more logical manner (instead of merely spreading the costs arbitrarily via plant-wide or departmental production hours). This effort is known as activity based costing.
Question 6. What Is Elastic Demand?
Elastic demand means that demand for a product is sensitive to price changes. For example, if the selling price of a product is increased, there will be fewer units sold. If the selling price of a product decreases, there will be an increase in the number of units sold. Elastic demand is also referred to as the price elasticity of demand.
The term inelastic demand means that the demand for a product is not sensitive to price changes.
Elastic demand is a major concern for a manufacturer that attempts to set product prices based on costs. For instance, if the manufacturer’s production and sales have declined and it fails to cut fixed costs, the manufacturer could be worse off by increasing selling prices.
Use the search box on AccountingCoach.com for our Q&A on death spiral which is pertinent to elastic demand.
Question 7. What Are Indirect Manufacturing Costs?
Indirect manufacturing costs are a manufacturer’s product costs other than direct materials and direct labor. Indirect manufacturing costs are also referred to as manufacturing overhead, factory overhead, factory burden, or burden.
Under traditional cost accounting, the indirect manufacturing costs are allocated (or spread) to the products manufactured based on direct labor hours, direct labor costs, or production machine hours. However, in recent decades the indirect manufacturing costs have increased significantly and are less likely to be caused by the quantity of direct labor or production machine hours. (This may not be a problem for financial reporting if the amount of inventory is consistently small, but it can be a problem for pricing and other decisions.)
Examples of indirect manufacturing costs include:
depreciation, repairs and maintenance, electricity, etc. for the production facilities and equipment
salaries, wages and fringe benefits of the indirect manufacturing personnel such as production supervisors, material handlers, quality assurance, and other factory support personnel
factory supplies, outside services pertaining to manufacturing, and other manufacturing related costs.
Question 8. What Is Setup Cost?
Setup cost is the cost incurred to get equipment ready to process a different batch of goods. Hence, setup cost is regarded as a batch-level cost in activity based costing.
Setup costs include the costs of changing the tools or dies on the equipment, moving materials or components, and testing the initial output to be certain it meets the specifications. In addition to the out-of-pocket costs, such as the labor cost of setting up the equipment, there is a much greater cost. The greater cost of setup is the lost opportunity of manufacturing profitable output while the machine is idled during the setup time.
Setup cost is viewed as a non-value-added cost that should be minimized.
Question 9. What Is The Major Weakness Of The Traditional Method Of Allocating Factory Overhead?
Under the traditional method of allocating factory overhead (manufacturing overhead, burden), most of the factory overhead costs are allocated on the basis of just one factor such as machine hours or direct labor hours. In other words, the traditional method implies there is only one driver of the factory overhead and the driver is machine hours (or direct labor hours, or some other indicator of volume produced).
In reality there are many drivers of the factory overhead: machine setups, unique inspections, special handling, special storage, and so on. The more diversity in products and/or in customer demands, the bigger the problem of allocating all the costs of these various activities via only one activity such as the production machine’s hours.
Under the traditional method, the costs of performing all of the diverse activities will be contained in one cost pool and will be divided by the number of production machine hours. This results is one average rate that is applied to all products regardless of the number of activities and the complexity of those activities. Since the cost of many of the diverse activities do not correlate at all with the number of production machine hours, the resulting allocations are misleading.
Activity-based costing is intended to overcome the weakness of the traditional method by having various pools of costs and then allocating each pool’s costs on the basis of its root cause.
Question 10. What Is The Death Spiral?
In cost accounting and managerial accounting, the term death spiral refers to the repeated elimination of products resulting from spreading costs on the basis of volume instead of their root causes. The death spiral is also known as the downward demand spiral.
To illustrate the death spiral let’s assume that Product X is a simple, high-volume product that requires little manufacturing attention. If the accountant spreads the company’s manufacturing overhead costs based on volume, Product X will appear to have high overhead costs. (In reality, Product X causes very little overhead cost especially when compared to the company’s many complex, low-volume products.) If management responds to Product X’s allocated high overhead costs and 1) seeks a price increase which causes the customer to move the production to a competitor with a lower price, 2) outsources the production, or 3) drops the product, then the company’s manufacturing volume will decrease.
If the company does not reduce its fixed overhead to correspond to the decreased manufacturing volume and the accountant continues to spread the overhead costs—including the cost of excess capacity—on the basis of volume, the remaining products will have to be assigned more of the overhead costs. If management again reacts to the new, higher, allocated costs by seeking price increases which cause a loss of sales, outsources production, or drops the products, the company’s manufacturing volume will again decrease. If fixed costs are not decreased accordingly and the accountant again spreads the overhead on the basis of a new, even smaller volume, the entire company could die from the high fixed costs and a small volume of products being produced and sold.
To avoid the death spiral, some companies attempt to allocate overhead costs based on activities and product complexities rather than simply spreading them on volume. Also, some companies do not allocate the costs of excess capacity to products in order to minimize the death spiral.
Question 11. What Are Semivariable Costs?
Semivariable costs are costs or expenses whose behavior is partially fixed and partially variable. Semivariable costs are also referred to as mixed costs.
A common example of a semivariable cost is the annual cost of operating a vehicle. Some of the vehicle’s operating costs will vary with the number of miles driven while other costs will be the same in total regardless of the miles driven. For example, the vehicle’s fuel costs will be variable. However, the depreciation, insurance and licensing may be fixed. Looking only at the vehicle’s maintenance costs may indicate that some maintenance is done each November (regardless of the number of miles driven) while other maintenance is done every 6,000 miles.
A manufacturer’s electricity cost is another example of a semivariable cost. Part of the monthly electricity bill will include 1) a fixed amount, and 2) a separate amount based on the number of kilowatt hours of electricity actually used by the company.
The manufacturer’s electricity cost is also a semivariable cost in relationship with the company’s machine hours. The portion of the electricity cost used to operate the production equipment is variable, but the portion of the electricity cost used for lighting and air conditioning the manufacturing facility is a fixed cost.
These simple examples illustrate that it can be difficult to understand how costs behave. There are many factors, activities, and drivers that influence the level of costs.
Question 12. What Is The Coefficient Of Correlation?
In simple linear regression analysis, the coefficient of correlation (or correlation coefficient) is a statistic which indicates the relationship between the independent variable and the dependent variable. The coefficient of correlation is represented by r and it has a range of -1.00 to +1.00.
When the coefficient of correlation is a positive amount, such as +0.80, it means an increase in the independent variable will result in an increase in the dependent variable. (Also, a decrease in the independent variable will mean a decrease in the dependent variable.) When the coefficient of correlation is negative, such as -0.80, there is an inverse relationship. (An increase in the independent variable will mean a decrease in the dependent variable. A decrease in the independent variable will mean an increase in the dependent variable.)
A coefficient of correlation of +0.8 or -0.8 indicates a strong correlation between the independent variable and the dependent variable. An r of +0.20 or -0.20 indicates a weak correlation between the variables. When the coefficient of correlation is 0.00 there is no correlation.
When the coefficient of correlation is squared, it becomes the coefficient of determination. This means that an r of +0.80 or -0.80 will result in a coefficient of determination of 0.64 or 64%. (This tells you that 64% of the change in the total of the dependent variable is associated with the change in the independent variable.) An r of +0.20 or -0.20 indicates that only 4% (0.20 x 0.20) of the change in the dependent variable is explained by the change in the independent variable.
It is important to realize that correlation does not guarantee that a cause-and-effect relationship exists between the independent variable and the dependent variable. However, a cause-and-effect relationship will mean there is correlation. It is also important to plot the data/observations used in the regression analysis in order to detect and review any outlier.
Question 13. What Is Simple Linear Regression Analysis?
Simple linear regression analysis is a statistical tool for quantifying the relationship between just one independent variable (hence “simple”) and one dependent variable based on past experience (observations). For example, simple linear regression analysis can be used to express how a company’s electricity cost (the dependent variable) changes as the company’s production machine hours (the independent variable) change.
Fortunately there is software to compute the best fitting straight line (hence “linear”) that expresses the past relationship between the dependent and independent variable. Continuing our example, you will enter 1) the amount of the past monthly electricity bills, and 2) the number of machine hours occurring during the period of each of the bills. Next, the software will likely use the least squares method to produce the formula for the best fitting line. The line will appear in the form y = a + bx. In addition, the software will provide statistics regarding the correlation, confidence, dispersion around the line, and more.
(In all likelihood there are many independent variables causing a change in the amount of the dependent variable. Therefore, you should not expect that only one independent variable will explain a high percentage of the change in the dependent variable. To increase the percentage, you should think of the many independent variables that could cause a change in the dependent variable. Next you should test the effect of the combination of these independent variables or drivers by using multiple regression analysis software.)
Prior to using simple linear regression analysis it is important to follow these preliminary steps:
seek an independent variable that is likely to cause or drive the change in the dependent variable
make certain that the past amounts for the independent variable occur in the exact same period as the amount of the dependent variable
plot the past observations on a graph using the y-axis for the cost (monthly electricity bill) and the x-axis for the activity (machine hours used during the exact period of the electricity bill)
review the plotted observations for a linear pattern and for any outliers
keep in mind that there can be correlation without cause and effect
Question 14. How Can A Manufacturer Determine The Precise Cost Of Its Products?
A manufacturer may never be able to determine the precise cost of its individual products. The reason is that most of the manufacturing costs (other than materials and some labor) are indirect costs. This means that most of the manufacturing costs are not directly traceable to individual products and will need to be allocated to them. Examples of indirect manufacturing costs include the rent, property taxes, depreciation, heat, lighting, indirect production workers pay and benefits, repairs, maintenance, and others that occur in the factory.
In addition to the manufacturing costs, there are selling, general and administrative (SG&A) expenses and perhaps interest expense. Generally, accountants do not consider these expenses to be product costs. As a result these expenses are reported on the income statement when they occur and without any allocation to the products. However, these expenses are associated with some or all of the products.
The manufacturer can attempt to calculate the costs and expenses of each of its products, but I don’t think the result will be the true, precise cost. In addition to the allocations (which are viewed as arbitrary), consider that changes in volume will affect a product’s cost. For example, if a company’s total fixed costs remain constant but its volume of products decreases by 20%, the cost of each product will increase. If volume increases, the cost of each product will decrease.
Activity-based costing (ABC) is an attempt to improve the allocation of costs by identifying more of the root causes of the costs (rather than merely spreading costs to products based on machine hours). Even with ABC there will be arbitrary allocations which will prevent knowing each product’s precise cost.
Question 15. What Is The Weakness Of Traditional Cost Allocations?
Traditional cost allocations are often based on volume such as number of products manufactured, number of direct labor hours, number of production machine hours, number of square feet, etc. Unfortunately, it is becoming more frequent that the common costs or indirect costs that require allocation are not caused by volume. In other words, traditional cost allocations are often based on something other than the root causes of the costs.
It is possible that a significant amount of manufacturing overhead might not be caused by production machine hours, yet the overhead is allocated using those hours. For example, a few of a manufacturer’s low volume products may require significant amounts of engineering changes, additional inspections, frequent machine setups with unusually short production runs, special handling, additional storage, and so on. To allocate these special costs to all products on the basis of the number of production machine hours (instead of allocating those costs based on their root causes) will result in individual product costs that are inaccurate and misleading.
Question 16. What Is The Coefficient Of Determination?
The coefficient of determination is a statistic which indicates the percentage change in the amount of the dependent variable that is “explained by” the changes in the independent variables.
For example, a manufacturer may have found through simple linear regression analysis involving 15 monthly observations that 64% of the change in the total cost of electricity (the dependent variable) was associated with the change in the monthly production machine hours (the independent variable). In this example the coefficient of determination is 0.64 or 64%.
The coefficient of determination is symbolized by r-squared, where r is the coefficient of correlation. Hence, a coefficient of determination of 0.64 or 64% means that the coefficient of correlation was 0.8 or 80%. (The range for the coefficient of correlation is -1 to +1, and therefore the range for the coefficient of determination is 0 to +1.)
It is important to note that a high coefficient of determination does not guarantee that a cause-and-effect relationship exists. However, a cause-and-effect relationship between the independent variable and the dependent variable will result in a high coefficient of determination.
Question 17. What Is An Independent Variable?
In accounting, an independent variable is ideally a factor that causes a change in the total amount of the dependent variable. In other words, an independent variable should be something that drives a mixed cost to increase or decrease.
To illustrate, let’s assume that a manufacturer’s production equipment uses a significant amount of electricity. Hence, the monthly electricity cost (the dependent variable) will increase when there is an increase in the number of production machine hours (the independent variable).
In reality there are likely to be many independent variables that cause a change in the amount of the dependent variable. In the case of the monthly electricity cost, the independent variables could also include the non-production machines using electricity, the physical size of the products, the skill level of the operators, the outside temperature and humidity, etc.
Multiple regression analysis is a statistical tool that can assist in determining the significant independent variables.
Question 18. Why Does A Cost System Developed For Inventory Valuation Distort Product Cost Information?
The cost system for inventory valuation may have been developed to provide a reasonable total cost of inventory and a reasonable total cost of goods sold in order to have reasonably accurate financial statements. If a company has small inventory amounts and significant sales, a simple cost system that spreads manufacturing overhead costs solely on the basis of machine hours can result in a reasonably accurate balance sheet and income statement.
While a simple cost system using just one cost driver (machine hours) may result in accurate financial statements, it often fails to provide the true cost of individual products that vary in complexity. For example, one product might require very few machine hours but will require many hours of special handling. The costs assigned on the basis of machine hours alone will be too low in relationship to the true cost of manufacturing this product. Another product might require many machine hours but no other activities. This product’s cost will be overstated because the rate assigned via the machine hours will include an amount for other activities that generally occur for the other products manufactured.
A cost system developed for inventory valuation is limited to the cost of direct materials, direct labor, and manufacturing overhead. The total cost of providing products to a customer will also include nonmanufacturing expenses. One customer might require a company to incur additional selling, delivering, storing, and administrative expenses. Another customer might not require any of those activities and their related expenses.
Activity based costing attempts to calculate the true cost of a product and customer by assigning costs and expenses based on their root causes. Because there are many root causes, the company will assign costs based on many cost drivers. This results in more accuracy for the cost and expense of a specific product for a specific customer than simply spreading the manufacturing costs on the basis of one cost driver such as machine hours.
Question 19. Are There Two Abc Methods In Accounting?
Some accountants use ABC to mean Activity Based Costing. Under this ABC a manufacturer will use many cost drivers to assign overhead costs to products. The objective of Activity Based Costing is to assign the overhead costs based on their root causes rather than merely spreading the costs on the basis of direct labor hours or production machine hours.
A second use of ABC involves categorizing inventory items into “A” items, “B” items, and “C” items. The “A” items are a relatively small number of items which account for the majority of the inventory’s value. For example, the “A” items might be 20% of the items in inventory which account for 70% of the inventory value. At the other extreme the “C” items might be 60% of the items in inventory but they account for only 10% of the inventory value. The “B” items might be 20% of the items accounting for 20% of the inventory value. Under this system, the “A” items will receive the most attention since they account for 70% of the value. This ABC is sometimes referred to as Pareto analysis or Pareto’s rule and it can be applied to more than inventory. For example, 20% of a company’s customers might account for 70% of the company’s sales.