Cost Accounting For Dummies
Overview
Take control of overhead, budgeting, and profitability with cost accounting
Cost accounting is one of the most important skills in business, and its popularity as a course in undergraduate and graduate business and management programs speaks to its usefulness. But if you’ve ever felt intimidated by the subject’s jargon or concepts, you can stop worrying. Cost accounting is for everyone!
In Cost Accounting For Dummies, you’ll be taken step-by-step through the basic and advanced topics found in a typical cost accounting class, from how to define costs and how to allocate them to products or services. You’ll learn how to determine if a capital expenditure is worth it and how to design a budget model that forecasts changes in costs based on activity levels.
Whether you’re a student in your first cost accounting course or a professional trying to get a grip on your books, you’ll benefit from:
- Simple methods to evaluate business risks and rewards
- Explanations of how to manage and control costs during periods of business change and pivots
- Descriptions of how to use cost accounting to price IT projects
Cost Accounting For Dummies is the gold standard in getting a firm grasp on the challenging and rewarding world of cost accounting.
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About The Author
KENNETH BOYD (ST. LOUIS, MO) is the Co-Founder of Accountinged.com, and owns St. Louis Test Preparation. He prides himself on making accounting interesting and fun, so he opened an online community for people to chat, comment, and give advice about accounting.
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cost accounting for dummies
CHEAT SHEET
Cost accounting is a valuable tool you use to reduce and eliminate costs in a business. You also use cost accounting to determine a price for your product or service that will allow you to earn a reasonable profit.Familiarize yourself with the most important formulas, terms, and principles you need to know to apply cost accounting.
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General Accounting
In cost accounting, a sell or process further decision asks whether to sell a product “as is” at the splitoff point, or to process further. The splitoff point is the point when the costs of two or more products can be separately identified. There are two criteria you use to justify further processing (and more costs):
If the product has a sales value at splitoff, maybe it’s better to sell it.
In cost accounting, an effective budget applies the matching principle. The principle says you should match the timing of the expenses of creating and delivering your product or service with the timing of getting revenue from the sale. This is accrual basis accounting.
Accrual accounting ensures that revenue is better matched with the expenses incurred to generate revenue.
General Accounting
In cost accounting, a price variance is the difference between actual and budgeted price for something you purchase. Here’s the formula for price variance:
Price variance = (Actual price – budgeted price) × (actual quantity)
An efficiency variance is the difference between actual and budgeted quantities you purchased for a specific price.
General Accounting
When cost accounting, you can allocate costs at different levels: unit level, batch level, and so forth. A batch is a group of units, just like a batch of cookies you bake in the oven. You can analyze how you produce batches (for example, batches of a simple, high-volume product compared to batches of a complex, low-volume product) and possibly reduce your costs.
General Accounting
Cost accounting is a great tool to improve the profitability in any business. It’s a critical subject that accounting students need to learn to be successful in their careers. However, some cost accounting concepts are easily misunderstood and therefore difficult to address correctly on exams. These test-taking strategies will help you succeed on a cost accounting exam by clarifying what is truly being asked in each question.
General Accounting
In cost accounting, you need to trace or allocate all of the costs attached to a product to know the full cost of the product. After you know the full cost, you can compute a reasonable profit level and set a sale price for the product. That’s easy to say, but getting it done takes a little work.
To fully price the product, each unit must absorb material, labor, and overhead costs.
General Accounting
When cost accounting, a usage variance occurs when you use more or less of something (material or labor) than you planned. If your budgeted usage is different from your actual usage, you have a variance.
You have some choices about the usage rate (hours) that you use for budgeting cost allocation. For example, you estimate a level of usage in planning a budget.
General Accounting
In cost accounting, product mix refers to the mix of products you produce. Sales mix refers to the mix of products you sell. They are broadly related. Every company deals with limited capacity, so smart decisions about product mix can greatly increase your profit. You just need to work out the most profitable product mix you can.
General Accounting
When cost accounting, cash basis accounting posts revenue and expenses to the financial statements based solely on cash transactions. Nothing happens until you take cash in or send it out. It’s a simple way of doing things — no accounts receivable and no accounts payable.
On a very basic level, your cash budget is a reflection of your checkbook.
General Accounting
When cost accounting, inventory can be a big cost in your business, and inventory issues may be a factor in a decision to outsource. If your company carries inventory, you have to consider the carrying cost of inventory.
Assume you are a retailer buying inventory. Carrying cost of inventory is the cost to hold and store your inventory.
Cost accounting is a valuable tool you use to reduce and eliminate costs in a business. You also use cost accounting to determine a price for your product or service that will allow you to earn a reasonable profit.Familiarize yourself with the most important formulas, terms, and principles you need to know to apply cost accounting.
In a perfect world of cost accounting, there would be no waste in manufacturing and retailing. In the real world, however, some material is flawed, some products are made wrong, and items bought for retail sale get broken. Here’s how to account for the waste in manufacturing, retailing, and craft services.
The inspection point in cost accounting
The inspection point is the stage in production when you inspect the units produced to determine if they meet your standards.
Think about which method you want to use when cost accounting for normal spoilage. You go through the effort of cost accounting to identify areas where you can make improvement. Ideally, you prefer a system where a problem generates a red flag — it gets your attention so you can fix it.
Those spoiled units need to get your attention.
General Accounting
In cost accounting, the last-in, first-out method assumes that you sell the most recent inventory items first. Take a look at this table. Because prices increased during the month, the last items purchased are more expensive than the first items purchased.
Rubber Mallet — Inventory Purchases and Sales
Date
Units Purchased
Price Per Unit
Total
10/1
100
$10
$1,000
10/15
150
$12
$1,800
10/17
75
$15
$1,125
Total Units
325
Total Cost
$3,925
Date
Units Sold
10/25
50
10/31
50
For LIFO, you start at the bottom of the table and work your way up.
General Accounting
When cost accounting in a just-in-time (JIT) purchasing system, total purchasing costs often need to be adjusted. The JIT purchasing system requires that you place smaller orders more often. With JIT purchasing, your supplier ends up sending many more orders. You should plan for some errors in inspection. The more orders you place, the greater chance that some items weren’t inspected carefully.
General Accounting
In cost accounting, scrap is defined as material that’s left over after production. Scrap has a low sales value, if it has any value at all. You sell scrap “as is.” No costs are added to scrap before you sell it to someone. Keep in mind that if you add any costs (by performing more work) on an item, the unit is considered a byproduct.
General Accounting
After you compute the breakeven points on two products, you can decide on target net income for the period. Assume that you sell Pristine and Sturdy wood. Pristine wood sells for $50 per unit and variable costs are $30 per unit; Sturdy wood sells for $25 per unit and variable costs are $18 per unit. Your target net income for both types of wood is $10,000.
In cost accounting, a budget is a financial plan that includes both financial and non-financial information. Its most obvious features are a projection of revenue (how much you anticipate selling) and expenses (how much you anticipate spending). The budget can also contain non-financial information, such as how many employees you think you need.
In cost accounting, you categorize customer costs by cost pools. For example, vehicle costs (repair, maintenance, and insurance costs) are combined into a cost pool. Next, you trace or allocate the cost pool, based on a cost level (unit, batch, or company division). Finally, you consider the activities that lead to costs.
General Accounting
When cost accounting, you need to include customer returns in your just-in-time (JIT) purchasing cost decision. A return happens when a customer buys a product and isn’t satisfied with the product’s performance.
At that point, the customer may check to see whether the product is under warranty. A warranty is a commitment by the seller of a product (well, often the manufacturer, not the retailer) to repair an item at no cost to the buyer.
General Accounting
Here are two methods of cost accounting for normal spoilage. You calculate equivalent units including spoiled units first. Then you look at the results when you exclude spoiled units from equivalent units.
Say you manufacture men’s leather belts. Consider this information for the example:
Material costs enter production at the beginning of the process.
When cost accounting, you might allocate the cost of rework to a specific job or to all jobs. It’s common to find some normal spoilage at job inspections, so it’s good to become familiar with these two types of journal entries.
Cost accounting — rework allocation to a specific job
Say you’re putting up special wallpaper.
General Accounting
To plan your sales and profits in cost accounting, it’s ideal for you to know the breakeven point for every product type you sell. So if you have a store that sells just two product types, compute the breakeven points for both of them.
Say you manage a lumberyard that sells two types of wood to furniture makers: Pristine wood and Sturdy wood.
General Accounting
In cost accounting and management, cost-volume-profit analysis starts with the breakeven point. Breakeven answers this question: “What’s the amount I need to sell to cover all of my costs?” When you open the front door of your business on the first day of a new month, your first concern is likely to be how much you have to sell to at least cover all costs for that month.
General Accounting
The lower the breakeven point, the easier it is to achieve your sales goal. It takes less effort to break even if you can lower the number of units you need to sell. Would you rather have to sell 100 units or 500 units just to break even? There’s a big difference in time, effort, and financial risk between 100 and 500 units.
General Accounting
In cost accounting, capacity refers to how much you can do, based on the assets (equipment, machinery, vehicles, and so forth) you have. In business, determining your true capacity level is a balancing act. You want to avoid investing too much and then find that the capacity isn’t needed. The money you invest in unused production capacity could be better spent elsewhere.
General Accounting
In cost accounting, goal congruence is defined as consistency or agreement of individual goals with company goals. Everyone in the organization needs to be rowing in the same direction. That process gets tough when you start to set up evaluation criteria for employees. Your staff members have different jobs with different levels and kinds of responsibility.
General Accounting
Advertising is a very common line item in cost accounting. When you advertise, you obviously spend company resources. You need to know if the additional cost will generate higher profits.
A marketing executive used to tell potential clients, “If you don’t advertise, nothing happens.” Sure, he was trying to sell advertising, but he had a point.
General Accounting
In cost accounting, job costing assigns costs based on a specific job or customer. You use job costing when each customer sale incurs a different level of costs. People who work in “the trades” (plumbers, carpenters, and roofers, for example) use job costing.
Say you own a plumbing company and work with homeowners and small commercial buildings.
General Accounting
In cost accounting, the cost of goods available for sale represents the product’s total costs. Total costs have two components — joint costs and separable costs.Assume the cost of goods available for sale are $1,751,163 and $1,260,837 for the heavy-duty blower and the yardwork blower. Say the separable costs are $1,200,000 and $912,000.
In cost accounting, you can imagine many products that start off in joint production. If you make three models of blue jeans, you may cut and sew the same type of denim at the beginning of production. For a while, the three types of jeans look the same. You’re in joint production, and you’re incurring joint costs.
General Accounting
Just-in-time purchasing (JIT purchasing) is a cost accounting purchasing strategy. You purchase goods so that they’re delivered just as they’re needed to meet customer demand. With JIT, when you get customer orders, you plan purchases. You purchase the minimum number of items to meet customer demand. JIT purchasing typically results in more smaller orders and frequent deliveries.
General Accounting
Competitive pricing is a cost accounting fundamental. Just about everyone has shopped at the big discount stores that advertise low prices. Competitive pricing is a tool they use to get customers into the store. As a business owner, you can attract more sales by lowering prices, too. At what point would a price cut be too much — the point where you don’t generate a profit?
General Accounting
Normal spoilage needs to be allocated when cost accounting. Specifically you need to decide whether the cost should be assigned to a specific job or to all jobs. Say you own a plumbing company and work with small commercial buildings. You’re reviewing your plumbing supply costs for the week, and you notice that some brackets were defective.
General Accounting
As you look at your production results, when cost accounting, you need to distinguish between normal spoilage and abnormal spoilage. Why? Because not all spoilage is created equal.
Normal spoilage occurs even in the best of production environments. No matter how efficiently you work, you still incur normal spoilage.
The degree of operating leverage is a cost accounting formula that shows how well you’re using your fixed costs to generate a profit. The more profit you can generate from the same amount of fixed cost, the higher your degree of operating leverage.
Here’s the formula:
Degree of operating leverage = contribution margin ÷ profit
Profit = contribution margin – fixed costs
First, calculate the contribution margin.
General Accounting
In cost accounting, process costing assumes that all units produced are identical. When spoilage creates costs in a process-costing environment, you apply the following methods to account for them.
Cost accounting for abnormal spoilage
Accountants post the cost of abnormal spoilage to a “loss for abnormal spoilage” account.
General Accounting
In cost accounting, supply chain management (SCM) is a management tool you can use to improve your ordering, manufacturing, and inventory processes. Supply chain management is the technique of analyzing and monitoring the movement of raw materials, work-in-process, and finished goods — from origin to the final consumer.
General Accounting
Economic order quantity (EOQ) is a decision tool used in cost accounting. It’s a formula that allows you to calculate the ideal quantity of inventory to order for a given product. The calculation is designed to minimize ordering and carrying costs. It goes back to 1913, when Ford W. Harris wrote an article called “How Many Parts to Make at Once.
General Accounting
Just-in-time (JIT) purchasing is a cost accounting strategy where you purchase the minimum amount of goods to meet customer demand. Say you decide to approach your supplier about moving to a JIT purchasing arrangement. The supplier needs to deliver smaller shipments more frequently. You request a price quote based on new, different levels of purchasing activity.
There’s a process to ordering in cost accounting. Here’s a typical example. Say you own a clothing store. You need to order scarves for the upcoming fall season. A supervisor fills out a purchase order (PO). The form lists the amount, style, size, and unit cost of the items requested.
A manager must approve the order.
In cost accounting, the reorder point is the time when you should place your next order. You use reorder point to avoid running out of inventory — a stockout situation. Lots of bad things can happen if there’s a stockout.
To keep life simple, assume that the demand level is known — you know how much product you’re likely to sell.
General Accounting
When cost accounting, you use the weighted average costing method to calculate costs in a process-costing environment. Now incorporate weighted average analysis into calculating spoilage costs.
To get super-psyched for the weighted average method, keep these points in mind:
To keep it simple, you analyze only the material units and material costs for a product.
General Accounting
In cost accounting when you find a prediction error, you need to consider whether or not to take action. If your actual results differ from your plan, it may not be that big of a deal. You need to consider the size of the difference and how you use the data.
Say you manage a large chain of sporting-goods stores that sells a light windbreaker.
In cost accounting, the process of allocating indirect costs to a product involves judgment. Unlike direct costs (which are traced), indirect costs are allocated, and that requires estimates. The process isn’t easy, but it’s vital. You need to allocate indirect costs carefully to understand the cost of an object, such as a product or service.
General Accounting
In cost accounting, a cost object is anything (a product line, a unit, a batch) that’s used to accumulate costs. A customer can also be a cost object. Looking at costs and profit per customer helps you make good decisions about your limited capacity and customer profit.
Technology allows companies to analyze data for many customers.
General Accounting
When your unit sales are less than breakeven, you’re operating at a loss. And that could affect the cash you need to operate each month. You likely will need cash to pay expenses (such as rent, utilities, and salaries) before you collect cash from sales.
Every time you incur a loss, it’s likely your available cash balance will decline.
General Accounting
In cost accounting, the dual rate cost allocation method categorizes cost into two types of cost pools: fixed costs and variable costs. You calculate a different cost allocation rate for each cost pool. A more specific review of costs leads to more precise cost allocations.
Say you manage an online tutoring business.
General Accounting
In cost accounting, if you use actual usage to allocate costs, one division’s change in usage has an impact on another division’s cost. If one division has higher or lower actual usage than budgeted, the cost allocations can change.
As a division manager, when you’re dealing with actual costs, you’re dealing with two unknowns.
General Accounting
When cost accounting, to determine what may be a reasonable and fair price you must consider the cost for the product or service you provide. That’s your starting point: Consider whether or not the costs are fair. After you and the other party agree, you can discuss a fair profit and price.
Many companies generate a majority of their business through government contracts (contracts with federal, state, and local governments).
In cost management, job costing is a method you use when your customers incur unique amounts of costs. Job costing assesses costs by the job and allows you to provide detailed price estimates based on the product constructed or service provided.
For some businesses, nearly every customer job has different costs, and that’s where job costing asserts its value.
General Accounting
Cost pools are used in cost accounting to separate costs into groups. The pools are then used to allocate costs to a cost object. Again, the cost object is the reason you’re incurring costs. A cost object can be a unit of product, a batch, or a department of your company. Notice how similar the terms cost pool, cost hierarchy, and cost allocation base are.
General Accounting
In cost accounting, cost hierarchy is a methodology that allows you to allocate costs more specifically, and that’s good. Think of it this way: you have a “bucket” of costs. When you start taking costs out of the bucket, where do they end up? Maybe they end up attached to a unit.
Or it might be broader. You could attach the costs to a batch (a group of units), and that’s often a more accurate way to allocate.
General Accounting
When cost accounting, the more accurately you allocate fixed overhead costs, the more accurately your product’s total costs are reflected. If total cost is accurate, you can add a profit and calculate an accurate sale price. To more accurately allocate fixed overhead you use cost pools and cost allocations to compute a cost allocation rate.
General Accounting
When conducting cost accounting, each division should probably bear some of the cost of the company’s corporate headquarters. Why? Because without the work done by the divisions, there wouldn’t be a need for the corporate headquarters at all. However, corporate (head-office) costs can be hard to allocate to divisions.
General Accounting
When you budget for indirect costs in cost accounting, you spread those costs to cost objects, based on a cost driver. A cost driver is an item that changes the total costs. Before you spread the indirect cost, you come up with a rate to allocate the costs to the product or service. The indirect cost rate allows you to price your product to produce a reasonable profit.
General Accounting
In cost accounting, equivalent units are the units in production multiplied by the percentage of those units that are complete (100 percent) or those that are in process. That covers everything.
If a unit is completed and transferred out, it’s 100 percent complete. Now, that may seem obvious, but it’s a point that gets lost when accountants start this analysis.
General Accounting
When cost accounting, you put together your budgeting process for indirect costs with a plan for direct costs. Think of the combined process as normal costing. This is an important point: You trace direct costs and allocate indirect costs.
Normal costing combines indirect cost rate with actual production. The process gets you closer to actual total costs for your product.
General Accounting
When cost accounting, as you open the door of your factory on the first day of the month, you may see partially completed goods sitting on the factory floor. Those goods are considered work in process (WIP). The goods are partially completed, so you’ve incurred some costs, but not all costs.
Your finished goods inventory affects process costing.
General Accounting
When cost accounting, if you think investigating a variance is tough, try ignoring one sometime. Yes, following up takes time and may involve phone calls, discussions with your staff, or additional research into supplier relationships. But if the variance is relevant, you gotta do it.
In accounting, you see the term relevance used frequently.
General Accounting
When cost accounting, you need to add costs to complete production on the units. Material costs are generally easy, but a department will add conversion costs. For example, you pay labor costs to an employee, so the worker will operate a sewing machine. That’s labor, and there’s overhead as well.
The goal is to isolate the costs added during the period.
General Accounting
In cost accounting practice, a spending variance occurs when the rate or price you pay different from your budget. An efficiency variance is incurred when you use more or less than you plan.
You implement variance analysis to understand differences between planned and actual costs. You hope to learn from the analysis and reduce your costs moving forward.
General Accounting
In cost accounting, justifying cost allocation decisions is important. Your justification verifies that you’re selecting the method that allocates costs most accurately. If you can defend your choice of an allocation method, it’s likely that you’ve selected the best one.
Consider these four criteria that support your cost allocation decisions.
General Accounting
When cost accounting, after you count the physical units and figuring a method of costing them, put the two together. You use equivalent units to assign real dollar costs to products.
Say you’re a candy manufacturer. You make inexpensive pieces of candy that sell for 20 cents each. So a piece of candy is your product unit.
General Accounting
In cost accounting, fixed overhead costs are costs that stay the same even as the level of activity changes. Your goal is to reduce fixed overhead costs and generate more profit.
The name of the game for overhead is to look at the activities that cause you to incur cost and decide if those activities are necessary for production.
General Accounting
In cost accounting, you plan variable overhead costs using a process similar to planning fixed overhead. Your goal is to plan overhead costs, compare your plan (budgeted) amounts to actual spending (real life), and review any variances. When you understand the variances, you may be able to make changes to reduce costs.
General Accounting
In cost accounting, revenue and production budgets forecast how many units you plan to produce and how many units you plan to sell.
Say you’re budgeting to manufacture garage doors. You need to forecast how many sales you expect. Then you consider how many garage doors you already have in inventory and plan how many you need to manufacture to meet the sales forecast.
General Accounting
In cost accounting, cost-plus pricing is a pricing method that starts with full costs (fixed and variable costs — the entire cost of your product). You then add a percentage markup (that is, a percentage of the costs). Here’s the entire formula for cost-plus pricing:
Proposed selling price = cost base (full costs) + markup
Say you sell vinyl siding for homes.
General Accounting
In cost accounting, opportunity cost is what you give up by making a decision to go in one direction rather than another. Opportunity costs occur because all businesses have limited resources.
For example, you only have so many machine hours you can use to produce goods. At some point, you have to decide how to use those hours to maximize profit.
General Accounting
Many accountants will tell you that cost accounting is the most difficult accounting subject to learn. That's because cost accounting has many terms that are not used in other areas of accounting (financial accounting and management accounting, to name a few). If you're looking for an overview of the most important terms and principles for this subject, you've found it!
General Accounting
In cost accounting, byproducts are produced during the joint production of other products. The byproduct’s sales value is usually less than that of the “real” products in joint production; however, don’t underestimate the value of a byproduct, because the revenue from byproduct sales may be used to reduce total joint costs.
General Accounting
In cost accounting, market-based pricing sets the product price based on customer expectations and demand. You take a look at the customer’s perceived value of the product. Based on the customer view, you estimate how much he or she would be willing to pay.
Companies that face high levels of competition use market-based pricing.
General Accounting
You buy inventory over time, not all at once (except, of course, when you first stock a store). How much you buy depends on customer demand and the amount of inventory you already own. Over time, the price you pay for inventory changes, both up and down. You need to select a method that best recognizes the cost of your inventory.
General Accounting
When cost accounting, you want to select a method to plan and budget for joint costs. Choosing a method helps you know where you stand during joint production. You can assess if your actual joint costs are on track with your budget. If you’re off track, you can make changes.
The splitoff method in cost accounting
The splitoff point is the point when the costs of two or more products can be separately identified.
General Accounting
Every department in your business needs to budget to control costs when cost accounting. That rule applies whether the departments create a product, provide a service, or support other departments.
When it comes to support costs, you should have a goal in mind. Figure out which departments exist to support other departments or divisions.
To reduce and eliminate costs in a business, you need to know the formulas that are most often used in cost accounting. When you understand and use these foundational formulas, you’ll be able to analyze a product’s price and increase profits.
Breakeven Formula
Profit ($0) = sales – variable costs – fixed cost
General Accounting
In cost accounting, practical capacity is the maximum level of capacity you can handle, taking into account unavoidable delays. Unavoidable delays might include the facts that your production staff takes vacation and that you need to schedule repair and maintenance to maintain your equipment. After accounting for those types of production stoppages, you can calculate practical capacity.
General Accounting
A prediction error occurs in cost accounting when actual costs differ from your estimates. This is an example of a variance — a variance being a difference between planned results and actual results.
You calculate the cost of a prediction error in these steps:
Compute the economic order quantity (EOQ).
The EOQ is calculated as the square root of [(2 x demand x ordering costs) ÷ carrying costs].
General Accounting
When cost accounting, a static budget (also referred to as a master budget) is a summary of operating and financial plans. After the budget is created, it doesn’t change with the level of activity (sales, production) in your business.
A static budget is the starting point for determining a reasonable profit for your business.
General Accounting
In cost accounting it’s necessary to connect the relevant cost and relevant revenue to the capacity planning. After all, capacity is limited. Relevant, of course, refers to the cost and revenue that makes a difference when you make decisions.
Here’s an example. A pastry chef creates and delivers specialty desserts to local restaurants and had seven restaurants as clients.
General Accounting
In cost accounting, qualitative factors don’t involve numbers and financial analysis. Call them “people” factors. Decisions based in part on qualitative factors are relevant, even though you can’t tie specific cost or revenue numbers to them. They can have a long-term impact on profitability, so you need to consider them.
General Accounting
In cost accounting, relevant means that you consider future revenue and expenses. Also, relevant means that a cost or revenue will change, depending on a decision you make. Past costs are water under the bridge, and if the costs or revenue remain the same no matter what you decide, they aren’t relevant.
Relevant costs and relevant revenue have an impact on your profit.
General Accounting
In cost accounting, the cost of goods available for sale represents the product’s total costs. Total costs have two components — joint costs and separable costs. When possible, you want to reduce separable costs, but first take a look at your company’s joint costs.Assume you manufacture leaf blowers. Your two products are heavy-duty blowers and yardwork blowers.
In cost accounting, a special order is a one-time customer order, often involving a large quantity and a low price. This is a chance to make money or lose money. Tough choice.
A special order requires you to make decisions using relevant information. You decide which costs and revenue are relevant. Based on your analysis, you make a decision designed to maximize your profit.
General Accounting
In cost accounting, the stand-alone cost allocation method collects information from the users of a common cost. You assess how much of the total common cost is used by each entity and then you make the cost allocation based on how much each party uses. This is relatively simple.
Assume you have a clothing company with two divisions — the department store division and the small shops division.
In cost accounting, stockout costs represent what you lose when an item is out of stock. You need to consider both the short-term and the long-term impacts of a stockout. Assume someone sees a black-and-orange scarf on your shop’s website. When he or she stops by the store, that scarf is out of stock.
Consider the impact on your business.
Target costing is a two-step process to determine the cost of your product when cost accounting. First, you estimate a target price — an estimated price you think your customer is willing to pay based on market conditions. You use the target price information to compute the target cost. You consider
Customer perception of the value of your product
Customer perception of your product compared with your competitors’
Your ability to differentiate your product from the competition
The first point is about the customer’s perception of your product.
General Accounting
In cost accounting, target net income is the profit goal you set. (Net income and profit are used to mean the same thing.)
You compute target net income by plugging the figure into the breakeven formula [Profit ($0) = sales – variable costs – fixed costs] but with one change. The profit changes from $0 to the target net income amount.
Do you consider taxes when you make a spending or cost accounting decision? Does a bear live in the woods? The answer is “yes” to both questions. If you’re considering a major purchase, think about the income you need to earn and the tax bite. There’s going to be an impact on your profit. Cost-volume-profit (CVP) analysis can help you figure everything out.
In cost accounting, a decision model is a process for making important decisions. Most types of organizations (businesses, sports teams, and governments, to name a few) have a formal process for making choices. Some of this, of course, is common sense. Here are the steps in a typical decision model:
Define the problem.
General Accounting
When cost accounting, you increase and decrease account balances using debits and credits. Business owners need to know these terms because they can’t understand your accounting process without them. Here are rules that never change:
Debits: Always posted on the left side of an account
Credits: Always posted on the right side of an account
So all accounts are formatted like this:
Material Control
Debit
Credit
In accounting, debit and credit don’t mean
the same things they do in common talk.
General Accounting
In cost accounting, the direct allocation method allocates support costs directly to each operating department. It’s simple, because you allocate every dollar out of the support department to an operating department. Because all costs are allocated, none of the support costs remain at the head office. Ta-DAH!
Here’s a direct allocation example.
General Accounting
In cost accounting, gross margin is defined as sales less cost of sales. Cost of sales isn’t total cost, but the cost to make the good. Gross margin is the price of the asset less the cost to make it. There are other costs (marketing and sales, for example) that aren’t part of the gross margin calculation.
You can express gross margin as a percentage:
Gross margin percentage = gross margin dollar amount ÷ sales x 100
For example, if your gross margin for a pair of shoes is $10 and your sales price is $80, your gross margin percentage is 12.
General Accounting
In cost accounting, joint costs are production costs incurred in creating two (or more) products. There are several important reasons why you spend time figuring and allocating joint costs:
Financial reporting: Joint costs need to be computed and allocated for inventory and cost of goods sold. Financial accounting is the process of creating financial reports for external users (for example, shareholders, creditors, or regulators).
General Accounting
When cost accounting, separable costs are incurred after you pass the splitoff point. In many cases, the product won’t be sellable at splitoff, because the product isn’t finished yet.
Say you make two types of leather purses. Both purses go through the same production process. Each product incurs a portion of the joint costs of production.
General Accounting
In cost accounting, control accounts are temporary holding places for costs. Managing costs has to start somewhere, and in accounting, that process most often starts out with control accounts.
Labor, materials, and indirect costs start off in control accounts. It may sound strange, but these accounts and their balances don’t appear in the financial statements.
General Accounting
In cost accounting, the single rate cost allocation method uses one cost rate to dictate the dollars that are allocated from a cost pool to a unit, batch, department, or division. In the case of support departments, the rate allocates dollars to another department or division.
The single rate method doesn’t distinguish between fixed and variable costs.
General Accounting
When cost accounting, the step-down allocation method allows support departments to allocate costs to each other — and ultimately to the operating departments. To accomplish this, the support departments are ranked. The ranking is often based on the percentage of costs that a support department incurs to support other support departments.
General Accounting
In cost accounting, two types of capacity focus on production: theoretical capacity and practical capacity. Consider how much you could produce if customer demand was unlimited. Select a capacity method that makes sense to you, and use that as a tool to plan production and spending.Theoretical capacity assumes that nothing in your production ever goes wrong.
General Accounting
In cost accounting, outsourcing is defined as purchasing a good or service from an outside vendor rather than producing the good or service in-house. It’s also referred to as a make versus buy decision.
A decision to outsource certainly considers reducing costs as a goal. If you can get the same (or virtually the same) product or service for less than it costs in-house, why not?
General Accounting
In cost accounting, the matching principle matches revenue with the expenses related to it. You tie the revenue from selling a unit to the cost of making a unit. This concept is also used to allocate joint costs.
You can allocate joint costs based on the revenue the units generate. Accountants refer to this as the market-based approach.
General Accounting
Variable and absorption costing generate different levels of cost and net income in cost accounting, so it’s important to understand the differences so you can select a costing method to use internally for decision-making.
Say your business manufactures handsaws. Here is a summary of production, sales, and costs in Year 1.
General Accounting
As you consider a price for your product when cost accounting, keep in mind how outside influences impact the price. Suppliers affect the cost of your product based on the rate they charge you for materials or component parts.
If you set your price too high, clients might consider buying from one of your competitors.
General Accounting
In cost accounting, when you put together a budget, you determine how you plan to use your resources. Assets are resources; cash is the most famous asset. Other property, like vehicles, for example, are assets, too. The reason you spend cash for materials and labor is to earn money for your business. The reason you buy a truck for use in your business?
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