Bookkeeping – Cost Accounting (Lesson 77)

Lesson 77

The science of calculating the actual costs of manufacturing is known as cost accounting, a.k.a managerial accounting.  Unlike traditional accounting which records economic transactions after they occur, cost accounting identifies all underlying costs associated with the production of a single unit.   These costs include the unit’s allocated share of fixed, variable, mixed and overhead costs.  The goal is to create a standard of performance and devise methods to measure actual results against the developed standard.

This form of accounting is traditionally used in manufacturing whereby thousands or millions of similar  products are produced over a single  accounting period.  The best examples are consumer goods.  It is uncommon to find this form of accounting in small business.   First off, it is a separate accounting method used  in conjunction with traditional  accounting.  Therefore the small business will need an additional accountant to perform this task.  Secondly,  the cost to implement and monitor exceeds $70,000 to $80,000 per year and in small business this isn’t really cost effective.  Finally, the implementation and utilization of this tool requires formal education of management.  This doesn’t mean it isn’t used in small business; it means it requires some expertise to carry out and this gets expensive.  Given this, the reader still needs to be  familiar with the underlying principles of cost accounting so if the need arises, the accountant can guide management towards solutions.  To help the reader understand cost accounting this lesson first covers cost accounting terminology then the basic concepts.  The last section explains how cost accounting is implemented and used in small business.

Cost Accounting Terminology

For new or inexperienced accountants cost accounting will seem odd.  The terms used are often used with traditional accounting but the difference between traditional and cost accounting is the level of precision cost accounting demands.   Management wants to know the exact cost to produce a single product given a certain volume.   So some terms used with cost accounting relate to volume.  Other terms are directly related to costs to produce a group or production run of the same item.  This  includes fixed, variable and mixed costs.  Finally I’ll explain how overhead costs (expenses and capital) are applied to the cost of the unit produced.  The  following sections cover these terms in more detail.

Range of Production

Every piece of equipment, human being, facility and transportation system has limits to its capacity.  Think of a cargo ship, it may be limited to so many tons or cargo containers without capsizing.  The same is true with production lines, they have a maximum capacity for production.

What is interesting is that in most cases, there is a maximum, optimum and minimum volume of production.  Often human labor is the most restrictive constraint in production.  So the volume of capacity is referred to as the range of production.   As an example, a simple truck will generally go upwards of 180,000 miles without a major repair, i.e. a breakdown.  Think of a palletizer in manufacturing, it may be capable of handling 7,000 cases every 24 hours.  If the plant produces 7,001cases in one day, the palletizer is unable to handle that last case.  The business either

A) doesn’t produce this additional case,
B) buys another palletizer to handle the volume or
C) uses another tool to augment the existing palletizer.

This is what is referred to as ‘Range of Production’.

Fixed Costs

What is fascinating about accounting is that there are multiple definitions for some terms.  The proper definition is often based on the accounting method used.  I know I scratched my head too when I first realized this.  In financial accounting (traditional bookkeeping), fixed costs refers to cash costs that must be paid no matter the level of output or sales.  Examples include rent, insurance and management salaries.

With cost accounting, they are defined as those costs paid or have to be paid no matter the level of production.   As an example, to start production the plant must incur a cost to place the equipment online.   These costs are spread over the estimated production run of that equipment.  If the equipment only produces 10 units, then 1/10th of the total fixed costs is assigned to each unit; if 200 units, then the cost assigned is significantly less.

There are a couple of interesting differences between fixed costs for financial accounting and fixed costs for cost accounting.  Review the following:

Financial Accounting                                      

Financial information includes expenses that are fixed in nature such as rent, communications, front and back office expenses etc.

Cost Accounting

Customarily located in cost of sales section of the income statement, cost accounting includes production labor, materials, supplies and a few other raw resources (utilities, equipment utilization, packaging materials and shipping).   Fixed costs for production are mostly equipment related along with contractual obligations for raw resources such as energy, water and waste management.  

Key Business Principle

ONE OF THE KEY DIFFERENCES BETWEEN FINANCIAL AND COST ACCOUNTING IS TIME.  FINANCIAL ACCOUNTING HAS REGULAR CYCLES, COST ACCOUNTING HAS NO ACCOUNTING PERIODS; IT IS STRICTLY PRODUCTION BASED.

 

Another interesting difference between fixed costs for financial and cost accounting purposes is the timing of payment.  With financial accounting, payment is almost monthly and is required (contractually) to be paid.  Whereas with cost accounting, the payment is most often upfront and very similar to a prepaid item that is allocated over the production run.

Variable Costs

Unlike fixed costs, variable costs are very close to instantaneous in timing.  Common examples include materials and labor for the production run.   These costs only occur if a product is produced.  Often a bulk volume of material is purchased to produce X number of units.  This is also true with labor on the production line.   One hour of labor can produce up to X number of units.

Variable costs are always accounted for in the cost of sales section of the income statement.  But remember, cost accounting is performed as a separate system, like a second set of books.  For financial accounting purposes, variable costs are customarily all of the costs typically recorded to cost of sales.  Whereas with cost accounting, the format is restricted to fixed, variable, mixed and overhead application.

Mixed Costs

Mixed costs comprise elements of both fixed and variable costs for production.   Here is an example:

S&S Dairy

S&S Dairy purchases raw milk and via processing pasteurizes the milk and separates the milk into various products.   The entire plant utilizes a massive cooling refrigeration and freezer system.

The utility bill has two components.  The first is a fixed component for a certain consumption and a second variable component is for any consumption in excess.   Excess consumption is expected during the summer months to cool the warmer air.  In addition, the state where the plant is located licenses the plant-based on volume.  The license is composed of a flat price for upwards of 1 million gallons per month and marginal fee for each gallon in excess of 1 million per month.

Notice in the above examples both a fixed and variable component exists.  These variable attributes exist with several different costs including:

* Insurance
* Equipment Utility (think of mileage limits for leased vehicles)
* Utilities
* Supplies(chemicals, gases and tools)
* Communications

Overhead Application

In prior lessons the term ‘Overhead’  refers to general and capital expenses, specifically with financial accounting.  Cost accounting uses overhead in identifying costs related to expenses including capital expenses specifically incurred related to that product.  As an example, suppose a paper manufacturer had overhead of $400,000 related to the manufacturing of standard size copier paper.  The company decides to add a legal size as an additional product.   Overhead costs increased an additional $218,000.   In this case, the additional overhead is clearly tied to the manufacturing of an additional product line. Most often this isn’t the case.

But the concept is straight forward, those costs (administrative expenses) incurred related to the production of the product are considered overhead. They can’t be specifically tied to a single unit, but relate more to the overall production of the entire product line.  These costs include:

* Management and Office Labor
* Administrative Office Space and its Utilities
* Insurance
* Research and Development Costs
* Legal and Contract Costs
* Office Expenses along with Office Technology
* Professional Compliance
* Corresponding Taxes and Licensing
* Capital Costs

Once these costs are identified, they are grouped together and tallied as a single value.

One of the more confusing aspects of this value is that it is time based and not production based.  So this value has to be converted to a production driven value.

Going back to the paper company, suppose the $218,000 of additional overhead is for one year.   During that year, the manufacturer produced 123,000 cases of legal paper.  This means each case costs $1.77 in overhead to produce.

The allocation formula derivative is to allocate (assign) a value to each unit, in this situation a case of paper.  It can be taken down to a ream of paper.   Each case contains 10 reams,  therefore each ream is assigned 17.7 cents of overhead as a part of its cost to produce.  By the way, each ream has 500 sheets, so each sheet is allocated .0354 of a penny as its share of overhead.  This level of minutia is how cost accountants think.

Basic Concepts of Cost Accounting

The primary goal of cost accounting is to determine the actual costs of production by creating a standard cost of producing a single unit.  The idea is to compare actual outcome against the standard.  The difference is called the variance.   Any actual cost in excess of the standard is evaluated to identify the source of the problem.  Even a simple one half of a penny is significant.  Why?  Because actuarial science (law of large numbers) illustrates the impact of an insignificant value over a large volume production run.

As an example, suppose it costs .04 cents (4/10ths of a penny) more than the standard to produce a single roll of toilet paper.  This doesn’t appear to be much.  But the manufacturer produces 18 million rolls per year.   Look at the total excess cost:

Production                             18,000,000 Rolls
Cost Variance                                  .004  4/10ths of one penny
Dollar Cost of Variance             $72,000 Per Year

This is lost potential gross profit.        

Many of the large consumer goods manufacturers such as Proctor & Gamble, Johnson & Johnson, and Kimberly Clarke produce upwards of one billion units per year of a single product.   A simple 4/10ths of a penny per unit per year equates to $4,000,000 of profit.

So now you understand why cost accounting is so important.  It is trying to identify variances in cost of production and resolve the issue.  It goes further by examining possible substitutions or process changes to reduce costs.

A good example of this is when COKE and PEPSI converted to high fructose corn syrup as a substitute for pure cane sugar back in the 80’s.  Both companies saved billions of dollars in costs without really changing the flavor of the product (however I think I can taste the difference).

Each product has elements of fixed, variable, mixed and overhead costs.  Each of the respective costs are analyzed over a given volume to determine a cost per unit of production.   All the costs are added together to reveal actual costs per unit against a pre-established standard.  Variances are analyzed to determine or identify underlying reasons for the difference.

Notice that in cost accounting, the sales price is irrelevant.  This is due to a lack of control over that aspect of the business model.  Cost accounting is about costs of production assuming all units produced will be sold.

Implementing Cost Accounting in Small Business

Most small businesses are not manufacturers.  However there are some that do exist.   For example, many small businesses are involved in the production of food items.  Even a restaurant can apply cost accounting principles to its business model.  This concept is also true with service based industries such as law or medical offices.  The goal is to build a cost per unit of production model.  As an illustration, this is how a technology enterprise evaluated the cost per hour for a field technician.

Our Towne Network Services

Our Towne builds and maintains office networks including servicing clients on a regular basis.  A typical technician will work between 42 and 45 hours per week handling service calls.  There are several groups of costs for the technician.  They are:

1) Labor Costs
2) Transportation (Service Van, Geek Car, Etc.)
3) Technology (Hardware and Software)
4) Communication including Interfacing with the Main Office
5) Share of Overhead

Our Towne’s accountant wants to evaluate the actual cost of the technician (labor only) for one hour of field time.   To do this, the first step is to evaluate actual billable field hours (range of production).  Here is the schedule:

Total time available for year at 44 HRS/Week                        = 52 * 44  =     2,288
Less:
.    – Vacation Time (2 Weeks @ 44/Each)                                                            88
.    – Sick Time (4 Days @ 8.5/Each)                                                                    34
.    – Training Time per Year                                                                                  44
.    – Human Resources Compliance (Performance Reviews, Documentation)     12
.    – Administration and Down Time @ 10% of Total                                         229
.    – Non-Billable Related to Travel, Tooling, Preparation etc.             17%       389
Net Billable Hours                                                                                             1,492

The next step is to calculate the employee’s total labor cost as an employee.   Here is that schedule:

Technician’s Annual Salary                            $64,000
Payroll Taxes (matching) @ 7.65%                    4,896
Payroll Taxes (FUTA)                                              56
Payroll Taxes – SUTA (2.73% on $7,000)              191
SIMPLE Plan – Flat 3% of Salary                        1,920
Health Care Mandate (Family Rate Subsidy)      3,982
Training Costs (3 Courses)                                     610
 Life Insurance Policy                                               78
Total Technician Costs                                     $75,733

Cost per Billable Hour                                       $50.76

This same process is applied to each of the respective cost groups to determine the overall cost per billable hour for a technician.  This final value does not include profit for the company.  Furthermore, up time, or the actual billable hours per year will unlikely hit 100%.   Most companies are fortunate to get 90% or higher uptime which means the cost per hour for labor is even higher.  In the above labor cost group it is $56.40 per hour with a 90% up time.

When developing a formula to evaluate the cost per unit keep in mind the following attributes affecting the final outcome.

Waste Factors – Waste factors include everything from system losses to defects.  Even the customer will bring back and exchange a defective product.  Waste is inherent in all systems, reducing waste is one of the best cost reduction tools for any business.
Human Error – Nobody is perfect; mistakes will happen.  Include adjustments for human errors.
Environment – From acts of God to governmental oversight, outside forces can and will always increase costs of production.
Human Tendencies – Laborers tend towards doing the least amount as possible.  Oversight costs additional dollars per unit.  Any form of monitoring increases cost per unit.
Equipment Downtime – All equipment require maintenance and repairs. This downtime reduces maximum production and increases costs.

My experience has taught me that most small business entrepreneurs woefully underestimate the cost per unit of production due to improper consideration of the above cost attributes.

The key to cost accounting in small business is determining the primary cost drivers.  Here are some examples:

  • Transportation – Fuel is the number one cost which is usually a function of the number of miles driven.  Miles driven also drive maintenance and repair costs.
  • Food Service – The food service industry is driven by two prime costs – food and labor.
  • Service – labor
  • Energy – Cost of raw resources, specifically fuel
  • Real Estate – Cost of capital especially for investors holding property (rentals)
  • Retail – Cost of products (variable) and presentation (fixed) – rent, utilities, display

Once the cost drivers are identified, separate the costs into the four major groups of fixed, variable, mixed and overhead (to create overhead allocation).  Once created, begin to develop a formula that reasonably covers all the costs associated with the particular product or service sold.

Summary

Cost accounting is a tool customarily found in manufacturing and used in parallel with financial accounting.  It is designed to take all costs and break them down into a cost per unit of production.  It traditionally breaks costs into four distinct groups: fixed, variable, mixed and overhead. The goal is to create a standard cost per unit of production and use this standard to determine cost variances.  By improving variances over long production runs the business is able to improve gross profit from production.  In small business, the accountant must first determine the cost drivers (different for each industry) to create a cost model as the standard.  Act on Knowledge.

If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org.  I would love to hear from you.   If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.

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About David J Hoare 427 Articles
I spent 12 Years as a Certified Public Accountant, Over 20 Years of Practice in Accounting and Consulting, Controller in Management of Closely Held Operations, Masters of Science in Accounting, Prepared over 1,000 Business Tax Returns and Hundreds of Individual Returns