Cost Accounting

Management 122
Michael Williams

What is Accounting?
Accounting is the:
collection,
analysis,
and
reporting
of information used in
economic decision making

Economic decision making

Firms exist to provide goods and services, not to
produce accounting reports.
Accounting must serve the economic needs of its
users.
The first question you should ask in any situation
encountered in this class (as in real world
accounting situations) is what does the
company do?
Awareness of the nature of operations is
necessary to tailor the accounting system to a
business needs.

Reporting
Accountants and journalists do the same
thing.
A newspaper takes all the events that
occur in the world, decides which are of
interest to its readers, and only publishes
stories on those few events.
The purpose is to provide readers a clear
sense of what happened without bogging
them down in minor or arcane details.

Analysis
Always solve the problem given to you.
Different problems in the real world may
be similar, but there are often unique
considerations.
Use a consistent, organized general
approach, but be flexible in the specifics.
Identify and focus on the basic concepts.

Collection
Not a primary focus of the course.
The purpose of this course is to provide
you with skills that will be valuable when
you become managers, entrepreneurs, or
consultants (or even auditors), not
bookkeepers.

Types of Accounting
Tax

User
Investors,
creditors
Government

Report
Financial
statements
Tax return

Managerial

Employees

Various

Financial

Need
Earn a high
return
Progressive
taxation
Operating
decisions

Managerial accounting lacks the conflict of interest present in the

other cases, and has the widest range of needs.

For this reason, it is less rigid than tax or financial accounting.

There are no rules, just guidelines.

Topics in the Course

1. Measurement and assignment of cost flows (3/28-4/6)
How do we develop the right information for the decisions that
need to be made?
2. Operational decision making (4/11-5/4)
What should we do?

3a. Budgeting and variances (5/9-5/18)

Did things happen as we wanted them to?
3b. Controlling large organizations (5/23-6/1)
How do we provide the proper incentives to divisional
managers?

What is a cost?
What is an expense?
A cost is a sacrifice of resources.
An expense is a cost incurred in the process of
generating revenues. Expenses are recorded at
the same time that the associated revenues
occur, regardless of when the sacrifice of
resources occurs. (Matching Principle)
Expenses are relevant for financial accounting;
costs are relevant for management accounting.
The only difference is timing. Expenses are
matched to revenues. Costs are recorded
whenever deemed appropriate by management.

Cost/expense example
A company buys a machine for $10 million. It uses the machine for
4 years to produce memory chips.
Revenues occur for 4 years, so expenses are recorded (as
depreciation) over the 4 years of production at $2.5 million per year.
For the purpose of determining the cost of producing each chip, the
firm spreads the cost over the production life (8 million chips) and
allocates $10 million / 8 million chips = $1.25 per chip.
For the purpose of determining whether to buy the machine in the
first place, the company is interested in net present value of cash
flow revenues and costs, so it records the entire $10 million as a cost
on the date of purchase.

Outlay vs. Opportunity

costs

Outlay cost: involves an actual expenditure of cash

Opportunity cost: involves a sacrifice of potential revenue.
Opportunity costs arise when the firm has scarce resources that can be used
in different productive ways. Using these resources in one way, prevents the
firm from alternative uses, sacrificing alternative revenue streams.
Example
A beer manufacturer owns a bottling machine that can be run 20 hours per
day (4 hours are required for daily maintenance).
This machine can be used to bottle regular or light beer, but not both at the
same time.
If the firm uses the machine for the entire 20 hours to bottle light beer, it
cannot bottle any regular beer. In this case, the firm loses potential regular
beer sales, generating an opportunity cost.
Similarly, if the firm uses the machine to bottle regular beer, it incurs an
opportunity cost on lost sales of light beer.

Differential vs. Sunk Cost

Differential cost: a cost that changes if you change some decision.
Sunk cost: a cost that remains constant if you change some decision.
Differential and sunk costs depend on the particular decision under
consideration. A differential cost in one context could be a sunk cost
in another context.
Only differential costs are relevant to decision making.
Example
A firm has a branch office in Missouri. The firm is thinking about
closing the office. If it does, then it can lay off its employees in the
office, but it must continue to pay rent under a long-term lease.
The employee salaries are differential costs.
The rent on the office is a sunk cost.

Fixed/Variable/Mixed/Step
Costs

Fixed cost: a cost that does not change when production volume changes.
Variable cost: a cost that changes in proportion to production volume.
Mixed cost: a combination of a fixed and a variable cost. Cost is a linear
function of production volume with a positive slope and intercept.
Step cost: a cost that increases in steps as production volume changes.

Examples
Fixed cost: CEO salary
Variable cost: wages of assembly line workers
Mixed cost: electricity bill
Step cost: cost of a machine that can produce 10,000 units of output per
day.

Step costs are in between fixed and variable costs. At low volumes, they
act as fixed costs. At high volumes, they act as variable costs.

Direct/Indirect/Overhead
Costs

Cost object: something that generates costs in a firm, such as

a product or a department.
Direct cost: a cost that can be directly attributed to a specific
cost object.
Indirect cost: a cost that cannot be directly attributed to a
specific cost object.
Overhead: all costs except direct labor and materials.
Note that whether or not a cost is direct depends on the
accounting system. A detailed accounting system can trace
more costs than a simple accounting system, but at greater
administration cost.
Indirect costs must be allocated to cost objects in some
arbitrary manner. Direct costs need not be allocated since they
can be directly attributed to cost objects.

Product/Period Costs
Product costs: costs that can be associated with products.
Period costs: costs that can be associated with time periods.
Full absorption cost: a measure of product costs that includes
any cost associated with manufacturing and excludes any cost
associated with marketing or general administration.
Full absorption cost is required for financial reporting. It is
used to value inventory and to determine cost of goods sold.
Any measure of product/period cost is permissible for
management accounting. For example, a firm could measure
product costs as only those manufacturing costs that vary with
the level of production. Thus, only variable manufacturing
costs (and possibly some step costs) would be included.

Margin
Margin is the excess of revenue over some measure of costs.
Some important margins include:

Profit margin: Revenue total cost

Operating margin: Revenue operating cost
Gross margin: Revenue cost of goods sold (GAAP)
Contribution margin: Revenue variable cost

Contribution margin is important in many management

accounting applications. It is relevant to decision making when
changing the level of production/sales. It is also relevant to
budgeting and variance calculations.
We are often interested in contribution margin per unit which
equals price minus variable cost per unit.

Inventory Flows
Product costs are tracked through inventory accounts until products are
completed and sold. Common inventory accounts include raw materials, work in
process, and finished goods.
BB + TI TO = EB

BB = beginning balance
TI = transfers in
TO = transfers out
EB = ending balance

Inventory accounts are chained together. Transfers out of one account are
transfers into another account, until products are sold. E.g., as raw materials are
used, their costs are transferred out of raw materials inventory and into work in
process. Direct labor and manufacturing overhead are also transferred into work
in process.
Transfers into finished goods are known as cost of goods manufactured.
Transfers out of finished goods are known as cost of goods sold.