To meet financial reporting to external, according to income statement, cost must be classified as production costs, selling and administrative costs. Production costs are viewed as product cost while selling and administrative costs are viewed as period costs. Production costs attached to the products sold are recognized as an expense or cost of sales. Production costs that are attached to products that are not sold are reported as inventory on the balance sheet. Selling and administrative are viewed as cost of period expense or cost of period and would not appear on the balance sheet.
Income statement for a manufacturing firm computed as absorption costing or full costing because all manufacturing costs are fully assigned to the product. Cost of goods sold is the cost of direct material, direct labor and overhead costs attached to the units sold. To compute the cost of goods sold, it is necessary to determine the cost of goods manufactured. The cost of goods manufactured represents the total cost of goods completed during the current period which consists of direct material, direct labor and overhead costs.
If the cost of goods manufactured is for a single product, then the average unit cost can be easily computed by dividing the cost of goods manufactured by the units produced. For example during the period, production of 480,000 bottles of perfume with the cost of goods manufactured $1,200,000. The average unit costs is $2.50 per bottle ($1,200,000 : 480,000 bottles)
Work in process consists of partially completed units in production at a given point in time. Beginning work in process consists of the partially completed unit on hand at the beginning of a period. Ending work in process consists of those on hand at the end of period. The cost of these partially completed units is reported as the cost of beginning work in process and the cost of ending work in process.
The cost of beginning work in process represents the manufacturing costs carried over from the prior period while the cost of ending work in process represents the manufacturing costs that will be carried over to the next period. In both cases, additional manufacturing costs must be incurred to complete the units in work in process.
The cost of services sold of an income statement for a service firm is computed differently from the cost of goods sold in manufacturing firm. Cost of services sold would always correspond to cost of goods manufactured. Although cost of information for external reporting is important, additional objectives to provide cost information for product costing and operational control.
To understand cost behavior, we agree that each activity has inputs and outputs. Activity inputs are the resources consumed by an activity in producing its output and can be classified into materials, energy, labor and capital. Activity output is the result or product of an activity.
If the activity is moving materials, the inputs would be crates as materials, fuel as energy, a forklift operator as labor, a forklift as capital and the output is material movement; So there is always the presence of activity, input and output.
Activity output measure an assessment of the number of times the activity is performed. It is quantifiable measure of the output. Number of moves is an output measure of moving materials, called ACTIVITY DRIVER.
Cost behavior describes the costs of changes in activity inputs such as materials, energy, labor and capital to change on activity into output. Generally cost behavior can be described as fixed, variable and mixed.
There are some requirements to assess cost behavior
1. The activity must be defined.
2. Its inputs and outputs must be identified and measured.
3. The effect on the cost of inputs must be calculated.
The most difficult part of assessing on cost behavior is identifying and measuring activity output. We can simply identify and measure activity output by classifying activities into four general categories since each category or different level respond to different types of activity drivers.
- Unit level
- Batch level
- Production level
- Facility level
Unit level
Unit level activities are those performed each time a unit is produced, such as grinding, polishing and assembly. Those are examples of unit level activities input. Output measures for unit level activities referred to as Unit Level Drivers. Units of product, direct labor hours, machine hours are examples of output measurement of unit level activities.
Batch level
Batch level activities performed each time a batch of goods is produced. The cost of batch level activities vary with the number of batches but are fixed with the number of units in each batch. Some examples of batch level activities input such as
* Setups
* Inspections
* Production scheduling
* Material handling
Product level
Product level activities are those performed as order and number of moves. This action is needed to support various products produced by a company. These activities inputs develop products to be produced and sold and the costs of these activities tend to increase as the number of different products increases. There are examples of product level activities input such as
* Engineering changes
* Developing product testing procedures
* Marketing products
* Engineering processes
* Expediting goods
Output measures for product level activities called Product Level Drivers. Number of changes orders, number of products, number of processes, number of expediting orders are examples of output measurment of product level activities.
Facility level
Facility level activities are those that sustain factory’s general manufacturing processes. Providing facilities, maintaining grounds, providing plant and security are examples of facility level activities input. Output measures for facility level activities called Facility Level Drivers such as
* Plant size in square feet
* Ground maintained
* Number of security personnel
Behavior of fixed cost
Are costs that are constant within a relevant range of an activity output.
A leasing cutting machine $120,000 per year has a max production capacity 240,000 units. The cost of leasing cutting machine is a fixed cost, it remains unchanged within the 0 unit to 240,000 unit range as activity output changes. In other words, the cost of $120,000 remains unchanged as the level of the driver varies.
Behavior of variable cost
Are costs that in total vary in direct proportion to changes in activity output, as units produced increase, the total variable cost also increases.
Power consume for running a cutting machine depends on unit output is produced, more output is produced, more power is consumed. If the rate of power $5 per kilowatt hour and each department only consumes 0.5 kilowatt hour, so to produce 100,000 unit output the cost of using power is $250,000 (0.5 x $5 x 100,000 unit)
If the unit output reach 180,000 the cost of using power become $450,000 (0.5 x $5 x 180,000unit). If the unit output reach to max 240,000 the cost of using power become $600,000 (0.5 x $5 x 240,000)
Behavior of mixed cost
Are costs that have both a fixed and a variable component.
Total salary to be paid to salesmen each year $75,000 plus a sales commission $3 per unit sold. Assume 125,000 units sold in a year, the total selling cost for the year which have to be paid is $450,000 mixed cost. Consist of salesman’s salary as fixed cost $75,000 plus commission as variable cost $375,000 (125,000 x $3 per unit).
The use of contemporary cost management system more widely than a traditional cost management system. A contemporary cost management system faced with
* Product diversity
* Product complexity
* Shorter product life cycles
* Increased quality requirements
* Intense competitive pressures
Traditional management accounting
Traditional management accounting systems focus on production volume based activity output. This approach assumes that costs can be classified as fixed or variable with respect to changes in the units or volume of product produced. Only units of product that are highly correlated with direct labor hours and machine hours are assumed to be of importance. These unit level or volume based drivers are used to assign production costs to products. Since unit based cost drivers are not the only drivers that explain cause and effect relationships, much of the product cost assignment activity must be classified as ALLOCATION.
Therefore in traditional cost management system, cost assignment tends to be allocation intensive. The product costing objective of a traditional cost accounting system is assigning production costs to inventories and cost of goods sold for purposes of external financial reporting. Value chain product costs (consist of research and development, production, marketing, consumer service) and operating product costs (consist of production, marketing, consumer service) are not available for management use.
Performance is measured by comparing actual outcomes with standard or budgeted outcomes however the emphasis is only on financial measures of performance, non financial measures are ignored by traditional management accounting system. Managers are rewarded based on their ability to control costs. The traditional approach traces costs to individuals who are responsible for incurring costs. The traditional emphasis is on managing costs. The reward system is used to motivate these individuals to manage costs. The approach assumes that maximizing the performance of the organizations by maximizing the performance of individual subunits in the organization, this approach is referred to as Responsibility Centers.
Contemporary management accounting
Contemporary management accounting has evolved to significant changes in the competitive business environment. The objective of a contemporary cost management is to improve
* Quality
* Content
* Relevance
* Timing of cost information
Those managerial objectives can be achieved using a contemporary system than using a traditional system because a contemporary management accounting emphasizes on tracing intensive. The role of driver tracing is significantly expanded by identifying drivers unrelated to the volume of product to produced called NON UNIT BASED ACTIVITY drivers, including batch level and product level drivers.
The use of unit and non unit based activity drivers increases the accuracy of cost assignment, quality and relevance of cost information.
The activity of moving raw materials and partially finished goods from one point to another within a factory. The number of moves required for a product is a much better measure of the material handling activity than the number of units produced. A batch of 10 units produced could require as much material handling activity as a batch of 100 units produced, because the number of units produced may have nothing to do with material handling. Product costing in a contemporary management accounting tends to be flexible, it supports a variety of managerial objectives including the financial reporting objective. More comprehensive of product costing with contemporary management accounting are emphasized for better planning, control and decision making process. Different cost for different purposes takes on real meaning in a contemporary management accounting system.
The successful control in the contemporary manufacturing environment is based on the management of activities, not costs. The activity based management is the heart and soul of contemporary control. Activity based management focuses on the management of activities with the objective of improving the value received by the customer and the profit received by providing this value. It includes Process View and Cost View.
Process view
* Why it happens, driver analysis was done to explain why costs are incurred.
* What activities is on processing, what work is done to identify activities.
* How well the activity is performed, performance analysis should take to evaluate the work performed and the results achieved.
Cost view
* Tracing the cost of resources
* Tracing the cost of activities
* Tracing the cost to cost objects (products and customers)
Contemporary management accounting systems requires detailed information on activities, accountability for activities rather than costs and a global approach to control and emphasizes the maximization of systemwide performance instead of individual performance. Financial and non financial performance are measured since they are both important.
By using a contemporary management accounting system you will get significant benefits in
* Product costing accuracy
* Improving on decision making
* Enhanced strategic planning
* Improving ability to manage activities
This contemporary management accounting system is suited for supporting the goal of continuous improvement but this system is costly and more complex because it requires some measurements on activities.
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