How to Convert a Cash Basis Transactions into Accrual Basis

An accountant often meets cash basis transactions which need to be converted to accrual basis for presentation to a banker or audit. The conversion of cash payments for expenses to the accrual basis can be seen as below 

 

#   Receipts in cash basis minus beginning accounts receivable plus ending accounts                                              receivable, to get net sales in accrual basis.

#   Receipts in cash basis plus ending accounts receivable minus beginning accounts receivable                            and ending unearned revenue, to get revenue in accrual basis.

#   Rent receipts in cash basis plus beginning unearned rent minus ending unearned rent and                                  beginning rent receivable, its results plus ending rent receivable to get rent revenue in                                  accrual basis.

#   Payment for goods in cash basis plus beginning inventory minus ending inventory and                                      beginning accounts payable, its results plus ending accounts payable to get cost of                               goods sold in accrual basis.

#   Payment for expenses in cash basis plus beginning prepaid expenses minus ending prepaid                              expenses and beginning accrued expenses, its results plus ending accrued expenses to get                         operating expenses in accrual basis.

#   Payments for property, plant and equipment in cash basis minus cash payments for property,                          plant and equipment plus periodic write off of the asset cost to get depreciation or                             amortization expenses.

How to convert cash receipts from customer to gross sales.

Cash receipts from customer plus cash discount and sales returns and accounts write off and ending accounts receivable. The results minus beginning accounts receivable to get gross sales.

Cash receipts from customers plus increase in accounts receivable or minus decrease in accounts receivable, to get net sales.

Cash payments for goods plus increase in accounts payable or decrease in accounts payable, to get net purchases.

Net purchases plus decrease in inventory or minus increase in inventory, to get cost of goods sold.

Wages paid during the year plus ending accrued wages minus beginning accrued wages, to get wages expense for the year.

Insurance premiums paid during the year minus ending prepaid insurance plus beginning prepaid insurance, to get insurance expense for the year.

Selling on capital stock or paying off long term debt are increases and decreases in cash, they are not revenue or expenses under either cash basis or the accrual basis. They are non-operating items.

To illustrate the use of this topic, assume Mr. Smith collected $160,000 during the year 2000 from his client and paid $60,000 for all operating expenses during the year 2000 in cash basis. According to a cash basis, net income during the year 2000 is $100,000 ($160,000 - $60,000).

On the beginning of the year 2000

                        Accounts receivable $24,000

                        Accrued expenses or liabilities $7,600

                        Prepaid expenses as assets $4,000

At the end of the year 2000

                        Accounts receivable $10,000

                        Unearned revenue $2,000

                        Accrued expenses or liabilities $13,600

                        Prepaid expenses as assets $6,000

To get Mr. Smith’s revenue in accrual basis $144,000 as follow

Collected in cash $160,000 plus ending accounts receivable $10,000 minus beginning accounts receivable $24,000 and ending unearned revenue $2,000

To get operating expenses in accrual basis $64,000 during the year 2000

Payment on all operating expenses $60,000 plus beginning prepaid expenses $4,000 minus ending prepaid expenses $6,000 and beginning accrued expenses $7,600 plus ending accrued expenses $13,600

To get net income in accrual basis $80,000 for the year 2000

Revenue in accrual basis $144,000 minus operating expenses in accrual basis $64,000

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Financial Reporting and Glimpse of Contemporary System

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.

1. Unit level
2. Batch level
3. Production level
4. 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

Output measures for batch level activities called Batch Level Drivers. Number of batches, inspection hours, number of production orders, number of moves are examples of output measurement of batch level activities.

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

The purpose of knowing the behavior of activity costs to be used for budgeting, continuous improvement efforts, tactical decision making and product costing.

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

 

That forced organizations to use Just In Time (JIT) manufacturing approach and implement contemporary technology as well. Organizations need more relevant and accuracy in product costing and timely cost information to build a sustainable long term competitive advantage and improving the value received by their customers while increasing profits.

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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Recording and Adjustment Process Within Accounting System

Although the entries process or recorded with general journal nor special journal have  done, the next step is posting all data from journal into ledger which we called “ POSTING PROCEDURE “ and followed with an UNADJUSTED TRIAL BALANCE at the end of each period.

The principal purposes of the trial balance

                * To prove that debits and credits of an equal amount are in the ledger.

                * It supplies a listing of open accounts and their balances for any adjustments. 

 

One thing that should be remembered that a trial balance does not prove that all transactions have been recorded is correct, numerous errors may still exist even though the trial balance columns agree.

The trial balance may still balance even when a transaction is not journalized or a correct journal entry is not posted or a journal entry is posted twice or incorrect accounts are used in journalizing or posting.

As long as equal debits and credits are posted even to the wrong account or in the wrong amount, the total debits will equal the total credits. A trial balance may not contain up to date because of the following reasons :

                * Consumption of supplies and earning of wages by employees are not journalized daily.

                * The expiration of some costs such as building, equipment, rent and insurance is not journalized                        during the accounting period because these costs expire with the passage of time rather than                            as a result of recurring daily transactions.

                * Some items such as the cost of utility service may be unrecorded because the bill of the service                        has not been received.

Adjusting entries are made at the end of the accounting period to ensure that the revenue recognition and matching principles are followed and to report on the balace sheet with the appropriate assets, liabilities and owners’ equity at the statement date and report on the income statement the proper net income or loss for the period. In short, adjusting entries are required every time financial statement are prepared.

An essential starting point is an analysis of each account in the trial balace to determine whether it is up to date for financial statement purposes. Adjustments are often prepared after the balance sheet date, there are 5 basic adjustments as follow

1.  Prepaid expenses or prepayments

All payments of expenses that give benefit more than one accounting period is prepaid expenses or prepayments. When a cost of prepayments or payments of expenses is incurred, an asset account is debited to show the service or benefit that will be received in the future. Prepayments are made when building and equipment are purchased.

               * Insurance

               * Supplies

               * Advertising  

               * Rent  

Are samples of prepayments or prepaid expenses. Prepaid expenses expire with the passage of time such as rent and insurance or through use and consumption such as supplies. At each statement date, adjusting entries are made to record the expenses applicable to the current accounting period and to show the unexpired costs in the asset accounts.

Purchased insurance $1,500 cash on 2^nd January 2011 for 3 years. The journal entry on 2^nd January 2011 debited asset account called insurance $1,500 and credited asset account called cash $1,500 to pay that insurance.  

At the end of each year, the adjustment amount to be made is $500 ($1,500 : 3 years) and the adjustment journal entry on 31^st Dec 2011 debited prepaid expenses or prepayments called insurance expense $500 and credited asset account called insurance $500

The rest value of asset called insurance on balance sheet date 2^nd January 2012 is $1,000 ($1,500 - $500). The value of $1,000 is unexpired costs in the asset accounts called insurance.    

2.  Unearned revenue

Revenue receives in cash and recorded as liabilities before they are earned. Receipts from the sale of airlines tickets as unearned revenue until the flight service is provided. A landlord will have unearned revenue from rent when a tenant has prepaid rent. Other samples of unearned revenue such as

              * Rent received in advance

              * Interest received in advance on notes receivable

              * Subscriptions and advertising received in advance by publishers

              * Deposits from customers in advance of delivery of merchandise 

When the payment is received for services to be provided in a future accounting period, an unearned revenue called liability account should be credited to recognize the obligation that exists. The recognition of earned revenue is delayed until the adjustment process. An adjusting entry is made to record the revenue that has been earned and to show the liability that remains. The adjusting entry for unearned revenues is a debit to a libility account and a credit to a revenue account.

A business area rented part of a building for 3 years with $120,000 to a tenant who paid in advance on 2^nd January 2011. The entry on 2^nd January 2011 debited asset called cash $120,000 and credited liability called unearned rent revenue $120,000 because this unearned revenue comes from rent.

At the end of each year, the adjustment amount to be made is $40,000 ($120,000 : 3 years) and the adjustment journal entry on 31^st Dec 2011 debited unearned rent revenues $40,000 and credited rent revenue $40,000 to recognize as revenue from rent during the year 2011.

The liability that remains after adjustment on unearned rent revenues on balance sheet date 2^nd January 2012 is $80,000 ($120,000 - $40,000).

3.  Accrued liabilities or expenses

Expenses incurred but unrecorded at the statement date are called accrued expenses or accrued liabilities. An accrued expense on the books of one company is an accrued revenue to another company.

Some examples of accrued expenses

             * Interest

             * Rent

             * Taxes

             * Salaries

Adjustment for accrued expenses are necessary to record the obligations that exist at the balance sheet date and to recognize the expenses to the current accounting period. Adjusting entry for accrued expenses result in a debit to an expense account and credit to a liability account.

When employees are paid on the last day of the month, there are no accrued wages and salaries at the end of the month or year because all employees will have been paid all amounts due to them.

When employees are paid on a weekly or biweekly basis, it is necessary to make an adjusting entry for wages and salaries earned but do not paid at the end of the period since the reporting period’s last day rarely lands on a payday.

A company pays their sales staff every Friday for a five day works in a week, total weekly payroll is $16,000 . Until Thursday 31^st Dec, the employees have worked four-fifths of a week for which they have not been paid.

The adjusting entry on 31^st Dec debit sales salaries expense $12,800 (4/5 x $16,000) and credit salaries payable $12,800

As a result of this entry, the income statement for the year includes the salaries earned by the sales staff during the last four days in the year and the balance sheet shows a liability account called salaries payable of $12,800

4.  Accrued assets or revenues

Revenue earned but unrecorded at the statement date are known as accrued revenues or accrued receivables. As in the case of interest, rent, commissions and fees accrued revenues may accrue or accumulate with the passing of time or they may result from services that have been performed but neither billed nor collected.

They are unrecorded because the earning does not involve daily transactions or only a portion of the total service has been provided. An adjusting entry is required to show the receivable that still exists at the balance sheet date and to record the revenue that has been earned during the period. An adjusting entry for accrued revenues results in a debit to an asset account and a credit to a revenue account.

An office space is rented to a tenant at $1,000 per month and the tenant has paid the rent for the first 11 months of the year but he has paid no rent for Dec. The adjusting entry on 31^st Dec debit rent receivable $1,000 and credit rent revenue $1,000

As a result of this adjusting entry, an asset of $1,000 rent receivable appears on the balance sheet date 31^st Dec and the income statement discloses the $11,000 rent revenue for the first 11 months plus $1,000 for Dec entered by adjusting entry. The total rent revenue for the year in the income statement is $12,000

5.  Estimated items

Estimated items are uncollectible accounts and depreciation of fixed assets because the amounts are not exactly determinable at the time they must be recorded.

Some account receivable arising from credit sales will prove to be uncollectible. To prevent an understatement of expenses and loss of the period, it is necessary to estimate and record the bad debts that are expected to result. This estimated items suitable for unknown future events and developments.

When a long live fixed asset is purchased, it is assumed that it will be scrapped or sold at a price below the purchase price. The difference between an asset’s cost and its scrap value represents an expense depreciation that should be apportioned over the asset’s useful life. By estimating the probable life of the fixed asset and its scrap value we can determine the expense that is charged in each period.

5a.  Uncollectible accounts

Proper matching of revenue and expenses dictates recording bad debts as an expense of the period in which the sale is made not in the accounts or notes are written off. The proper valuation of the receivable balance requires recognition of uncollectible receivables. At the end of each period, an estimate is made of the amount that will be prove to be uncollectible. The estimate is based on the amount of bad debts experienced in past years, economic conditions, age of receivables and other factors of uncollectibility. The estimate using percentage of the sales on account for the period or a certain percent of the account receivable and notes receivable at the end of the period.

If the experience reveals that bad debts usually approximate one-half of one percent of the net sales on account and the net sales on account for the year are $500,000. The adjusting entry for bad debts on 31^st Dec debit debt expense $2,500 ($500,000 x 0.005) and credit allowance for doubtful accounts $2,500

5b.  Depreciation

Depreciation are similar for reducing the prepaid expenses. The principal difference for depreciation, the credit is made to a separate account called accumulated depreciation. In estimating depreciation of the property, we use the original cost of the property, its length of useful life and its estimated salvage value or trade in value.

A bus costing $60,000 estimated life 5 years, estimated trade in value $5,000 at the end of the period. Because the bus is expected to be worth $50,000 less at the time its disposal then it was at the time of its purchase.

The amount of $50,000 represents an expense that is apportioned over the 5 years of operations. If the straight line method of depreciation is used, each year shows as an expense one-fifth of $50,000 or $10,000

Each full year the bus is used, the following adjusting entry is made on 31^st Dec with debit depreciation expense on transport equipment $10,000 and credit accumulated depreciation on transport equipment $10,000

In addition to five basic adjustments above, towards value of inventory that appear on a balance sheet also needs to be adjusted at the end of period however the procedure for doing on inventory account adjustment depend on what inventory system is in use. A PERPETUAL INVENTORY SYSTEM or a PERIODIC INVENTORY SYSTEM.

Perpetual inventory system

With a perpetual inventory system, purchase and issues are recorded directly in the inventory account. Therefore, the balance in the inventory account represent the ending inventory amount and no adjusting entries are needed. To ensure this accuracy, a physical count of the items in the inventory is made annually. No purchase account is used because the purchases are debited to inventory account and credited to cash or liability. Cost of goods sold account is used to accumulate the issuances from inventory so when inventory items are sold, debit cost of goods sold and credit to inventory.

Periodic inventory system

With a periodic inventory system, a purchase account is used and the inventory account is unchanged during the period. The inventory account represents the beginning inventory amount throughout the period. At the end of the accounting period the inventory account must be adjusted by closing out the beginning inventory amount and recording the ending inventory amount.

The ending inventory is determined by physically counting the items on hand to get units amount and valuing them at cost or at the lower of cost or market.

Cost of goods sold is determined by adding the beginning inventory with net purchases and deducting with the ending inventory.

As soon as these adjusting entries have been recorded and posted, another trial balance called ADJUSTED TRIAL BALANCE is prepared and used to prepare the financial statements.

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Nature of Costs to Product Costing

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

 

Of the three methods, direct tracing is the most precise because it relies on physically observable causal relationships. Direct tracing is followed by driver tracing to get cost assignment accuracy.

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

1. Direct materials
2. Direct labor
3. Overhead

and only these three elements can be assigned to products and use for external financial reporting.

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