Concerning with output of organizations, there are two types of organizations output, tangible products and services products. Tangible products are goods produced by converting raw material through the use of labor and capital inputs such as plant, land and machinery. Producers of tangible products need not have direct contact with the buyers of their goods. The buyer of cars never need to have contact with the engineers and assembly line workers that produced those cars. Organizations that produce tangible product are manufacturing organizations.
Services are tasks or activities performed for a customer or an activities performed by a customer using an organization’s product or facilities. Services are also produced using materials, labor and capital inputs such as medical care, dental care, etc. Accounting are examples of service activities performed for customers. Car rental are examples of services where the customer uses an organization’s product or facilities. Organizations that produce intangible products are service organizations.
Managers of both type of organizations need to know how much individual product cost and accurate product costs for profitability analysis and strategic decisions concerning with product design, pricing and product mix.
To achieve competitive advantage, can we rely on our current reported product costs or should we rely on the individual costs for decision making ? We need product costs to use for pricing on our products and services and to to bid on potential jobs, we also can use product costs to improve our product design.
To be honest, we are not confident sometimes with the individual product costs. We have simply assigned to products based on an assumed relationship however this allocation may not reflect on any actual cause and effect relationship. To improve the accuracy of product costing, we must know how much each product is costing. We need to learn more about costs and then make decisions that bear directly on the costs.
Nature of costs
The fundamental of a good management is understanding to the nature of costs, especially if we are going to pursue on continuous improvement. We have to do with some measurements and take some steps to improve accuracy to support our continuous improvement goal. It is necessary to understand the meaning of cost and its terminology. Assigning costs to products and services and other objects is one of the principal objectives of a management accounting information system. Improving the cost assigment process is one of the most important thing to be applied. The goal is increasing the accuracy of assignments and producing higher quality information which can be used to make better decisions. The more accurate in costing will produce better pricing decisions and significant increases in profits.
Before we go on to talk about cost assignment process, we need to define on what “ COST “ is. Cost is the cash or cash equivalent value sacrificed for goods and services to bring a current or future benefit to the organization.
Cash equivalent means non cash resources that can be exchange for the desire goods or services, it may be possible to exchange equipment for material used in production. In striving to produce a current of future benefit, a manager should make every effort to minimize the cost required to achieve this benefit. Reducing the cost means a firm is becoming more efficient. Manager should provide the same or greater customer value for a lower cost than competitors to achieve a competitive advantage. Managers should also understand about “ OPPORTUNITY COST “ .
To understand about opportunity cost, let us think on this example, a firm which has $500 thousand that can be used to replace their manufacturing technology by using some automated equipments instead of using those fund into deposit with the rate of 12% per year. The opportunity cost of the capital tied up in automated equipments is 12% x $500 thousand which we also called as the cost of carrying the automated equipments.
Along with a profit making, cost are incurred to produce future benefits or revenues, As costs are used up in production of revenues, they are called expired costs or expenses.
In the income statement, expenses are deducted on each period from revenues to determine the period’s profit. To remain in business, revenues must exceed expenses or the income earned must satisfy the owners of the firm. Lowering price increases customer value by lowering customer sacrifice is connected to the ability to lower costs. Hence, managers need to know cost and its trends. Assigning costs to determine the object costs is critical in providing this information to managers.
Any item such as products, customers, departments, projects, activities and so on, for which costs are measured and assigned is called “ COST OBJECT “. In recent years, activities such as
- Setting up equipment for production
- Moving materials and goods
- Purchasing parts
- Billing customers
- Paying bills
- Maintaining equipment
- Expediting orders
- Designing products
- Inspecting products
have emerged as cost objects. Because those activities of works are performed within an organization. Activities play a spectacular role in putting costs to other cost objects and these are essential elements of a contemporary management accounting system.
Assigning costs accurately to cost objects is crucial. The objective is to measure and assign as well as possible the cost of the resources consumed by a cost object. It is not difficult to see which cost assignment is more accurate. Distorted cost assignments can produce erroneous decisions and bad evaluations. If a plant manager is trying to decide whether to continue producing a product internally or to buy it from a local company, then an accurate costing will produce and be used to do the analysis because bad cost assignments can prove to be costly.
The relationship of cost to cost objects can be exploited to increase the accuracy of cost assignments. Costs are directly or indirectly associated with cost objects. “ INDIRECT COSTS “ are costs that can not be easily and accurately traced to a cost object. “ DIRECT COSTS “ are those costs that can be easily and accurately traced to a cost object. “ ACCURATELY TRACED “ means that the costs are assigned using a cause and effect relationship. Ability to assign a cost to a cost object by cause and effect relationship called “ TRACEABILITY “. Traceability means that costs can be assigned easily and accurately to a cost object using an observe measure of the resource consumed by the cost object.
The more costs that can be traced to the object, the greater accuracy of the cost assignments. Traceability is a key element in building accurate cost assignments. Management accounting systems deal with many cost objects. It depends on which cost object is the point of reference. If the plant is the cost object, a direct cost is heating and cooling, however if the cost object is a product produced in a plant then utility is indirect cost. It is possible for a particular cost item to be classified as a direct cost and indirect cost. To trace costs to cost objects can occur in one of two ways
I. Direct tracing
The process of identifying and assigning costs that are physically accomplished by physical observation associated with a cost object to that cost object called “ DIRECT TRACING “.
The cost object of maintaining equipment activity is the cost of parts, tool and maintenance equipment that can be easily identified by physical observation with the cost object. Ideally, all costs should be charged to cost objects using direct tracing.
II. Driver tracing
Unfortunately, it is often not possible to physically observe the exact amount of resources being consumed by a cost object. Another approach is to use cause and effect reasoning to identify factors called “ drivers “.
“ DRIVER TRACING “ is the use of drivers to assign costs to cost objects although less precise then direct tracing. Driver tracing use Resource Drivers and Activity Drivers.
II a. Resource Drivers
Measure the demands placed on resources by activities and are used to assign the cost of resources to activities.
Activity of maintaining equipment consumes resources such as parts, equipment, tools, labor and energy or power to run the equipment and tools. Some resources such as materials, equipment and tools are directly traceable to the activity however other resources such as power and labor may not directly traceable. If a resource driver such as “machine hours” (20,000 machine hours) to be used to assign the cost of power (the rate cost of power $0.5 per machine hour), so the cost of power $10,000 (20,000 machine hours x $0.5 per machine hour) would be assigned to the activity.
The total cost of the activity is the sum of direct traceable costs and driver traceable costs.
II b. Activity Drivers
Measure the demands placed on activities by cost objects and are used to assign the cost of activities to cost objects.
Activity of maintaining equipment has “ number of maintenance hours worked “ as activity driver that can be used to assign cost of maintaining equipment to production departments as the cost object. If the cost of maintaining equipment is $20 per maintenance hour and a production department uses 2,000 hours for grinding work then $40,000 (2,000 hours x $20 per maintenance hour) would be assigned for maintaining equipment on that production department.
Some activities with their activity drivers as follow
- Drilling holes number of machine hours
- Inspecting finished goods number of batches produced
- Maintaining equipment number of maintenance hours
- Moving materials number of moves
- Ordering materials number of purchase orders placed
- Packing goods number of boxes
- Paying bills number of invoices
- Providing power number of kilowatt hours
- Redesigning products number of engineering orders
- Scheduling production number of different products
- Setting up equipment number of setups
The driver tracing is the heart of a cost assignment, this approach known as Activity Based Costing (ABC). ABC assigns costs to cost object by
- Tracing costs to activities and then
- Tracing cost to cost objects.
Indirect costs can not be traced to cost objects. No causal relationship exists between the cost and the cost object. Assignment of indirect costs to cost object is called ALLOCATION.
Since no causal relationship exits, allocation indirect costs is based on convenience or some assumed linkage. Suppose we want to consider the utility cost of heating and lighting to five products which is manufactured by a plant. It is difficult to see any causal relationship. A convenient way to allocate this cost is simply to assign it in proportion to the direct labor hours used by each product.
Arbitrarily assigning indirect costs to cost objects will reduce the accuracy of the cost assignments. Even the best costing policy is assigning only direct traceable costs to cost objects, however allocations of indirect costs serve other purposes besides accuracy and the direct cost assignments should be reported separately with indirect cost assignments.
It is possible to assign costs to cost objects through
- Direct tracing
- Resource drivers
- Activity drivers
There are three methods of assigning costs to cost objects through
- Direct tracing
- Driver tracing
- Allocation
Driver tracing relies on causal factors called drivers to assign costs to cost objects. The precision of driver tracing depends on the quality of the causal relationship described by the driver. Identifying drivers and the causal relationship is more costly than either direct tracing or allocation.
One advantage of allocations is its simplicity and low cost of implementation. Allocation is the least accurate cost assignment method and its use should be avoided or minimized where possible.
In many cases, driver tracing is the most benefit and more accurate in costs measurements.
Product Costs
It is a cost assignment that supports managerial objective being served. Suppose that management is interested in strategic profitability analysis. To support this objective, management needs information about all revenues and costs associated with a product.
A value chain or a set of all activities required to design, develop, produce, market, distribute and service, cost is appropriate because it accounts for all the costs to assess strategic profitability. A value chain product cost is obtain by assigning costs to the set of activities that define the value chain and then assigning the cost of these activities to products. Value chain product costs is needed if managerial objectives is pricing decisions, product mix decisions and strategic profitability analysis.
If the managerial objective is short run profitability analysis, the costs of designing and developing may not relevant for existing products. A decision to accept or reject an order for an existing product would depend on the price offered by the potential customer and the cost of producing, marketing, distributing and servicing that order. Only the operating activities within the value chain would be important and defines an operating product cost. Operating product costs consist of production, marketing and customer service is needed if managerial objectives is strategic design decisions and tactical profitability analysis.
Suppose the managerial objective is external financial reporting, traditional product cost in this case are needed.
One of the central objectives of a cost management system is the calculation of product costs for external financing reporting. For this purposes costs are divided into production costs and non-production costs.
Production costs associated with the manufacture of goods or the provision of services while non-production costs associated with the functions of designing, developing, marketing, distribution, customer service and general administration.
The cost of marketing, distribution and customer service are often called selling costs. The cost of designing, developing and general administration are called administrative costs. For tangible goods, production costs are referred to manufacturing costs and non-production costs are referred as non-manufacturing costs. Production costs can be classified as
- Direct materials
- Direct labor
- Overhead
and only these three elements can be assigned to products and use for external financial reporting.
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Good Article ^^
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