Two distinct set of financial reports are used in managing a company, one made by Financial Accountants and the other by Managerial Accountants. These reports are aimed at the company’s external stakeholders such as investors and creditors and are prepared for each quarter and at the end of the financial year and. The format and content of these reports are laid down in laws such as the SOX (Sarbanes- Oxley) Act and in accounting regulations such as the GAAP (Generally Accepted Accounting Principles) and the IFRS (International Financial Reporting Standards). Financial reports become comparable across companies.
Managerial accounting reports are prepared for the company managers to help them in their day-to-day decision making. These reports have no prescribed format or periodicity. They are tailored to needs of each manager and would differ by function – a sales manager’s report would be different from that for a manufacturing manager. These reports contain data both for the past period and predictions for the future period.
Both types of reports depend on the data and analysis provided by the Cost Accounting function as shown in Fig 1 (from D Con e-books, n.d.). As author W.B Lawrence has pointed out in his paper Teaching Cost Accounting, the three principles that cost accounting has contributed to the science of accounting are the use of departmental accounts, expenses appearing as changes in sets of values and the operating statement being used to manage business (Lawrence, 2002).
This paper examines why cost accounting is so important to the success of the firm and how various methods of cost accounting are used to ensure business success.
Why Cost Accounting is Important to a Firm’s Success
Any commercial firm exists to make a profit for its owners, the shareholders. Company managers incur costs on materials, labor and overheads to produce a product that the company can sell to generate revenues. The company also needs land, buildings, plant and machinery and utilities and each of these has a cost. The product also requires spending on R&D and marketing. The selling price of the product has to be fixed such that the company generates a profit after meeting all of these costs, but must remain in the range of its competitors. The cost accounting system provides managers with an accurate picture of each of these elements of cost so that they can apply their minds to minimizing the product costs and maximizing profits for the owners. For example, cost accounting information help managers decide on issues such as making a component in-house or buying it, investing in R&D to develop cheaper or better products, expanding the factory or outsourcing part of the manufacturing or investing in automation to lower wage costs. Each of these decisions impacts costs and profits and relies on data from the cost accounting system (Kwan, 2011).
As Prof. Charles Horngren puts it in his celebrated textbook Cost Accounting - A Managerial Emphasis, “All businesses are concerned about revenues and costs. Whether their products are automobiles, fast food or the latest designer fashions, managers must understand how revenues and costs behave or risk losing control” (Horngren, et al, 2012).
Companies now operate in a global environment where they can not only sell their products worldwide but also source raw materials and components from all around the world. This statement is dramatically illustrated in Fig 2 which shows the global sources for Apple’s iPhone (Hessman, 2014).
Demand uncertainty – Many firms face the problem of uncertain demand for their products or services. Managers are faced with the problem of balancing the sunk cost of idle capacity against the higher cost of procuring resources at short notice and depend upon cost accounting signals to make the right decision (Krishnan, 2015)
Cost structure – Companies with a higher proportion of fixed costs are exposed to the risk of incurring losses when there is a demand downturn. Managers therefore aim for increased cost elasticity through outsourcing, use of leased equipment and contract labor. The cost accounting system provides the signals for managers to think in these terms (Krishnan, 2015).
Cost asymmetry – Various studies have shown that certain elements of cost that go up with increasing volumes do not come down in the same proportion when volumes go down. This phenomenon has been labeled “cost stickiness”. The cost accounting system provides indicators of such sticky costs that help the managers to devise solutions to improve earnings in periods of downturn (Krishnan, 2015).
One major role an effective cost accounting system can play is in the motivation of managers. The Expectancy Theory of Motivation by Edward Tolman and Victor Vroom says is illustrated by Fig 3 below (from Redmond & Nemati, 2016).
The cost accounting system in a company can help in showcasing improvements that result from managerial efforts to his bosses and peers and this recognition can be a great source of motivation.
Methods of Cost Accounting and Their Use
The methods of cost accounting in use in companies has been undergoing change in response to the new demands in the past decade of global competition and increasing use of technology. This evolution is shown in Fig 4 (from Sharaf-Addin, et al, 2014).
The traditional cost accounting techniques of Standard Costing, Absorption Costing and Marginal Costing (Stage 1 in Fig 4) still form the foundation of most cost accounting systems. The Standard Costing system lays down each year the standard cost for each cost element. Actual costs incurred in each period are compared with the Standard Cost and variances are analyzed to determine corrective actions. In Absorption Costing, all costs, whether fixed or variable, are treated as product costs and the selling price of the product is fixed using the absorption cost. In Marginal Costing, the fixed and variable costs are presented separately. This method is useful for short-term decisions such as make-or-buy, accepting a special order or dropping a product line (Tabitha & Ogungbade, 2016).
Some of the limitations of traditional cost accounting systems were sought to be overcome by the development of some new methods. One major advance in the mid-1980s was the concept of Activity Based Costing (ABC) for the allocation of overheads. The ABC method identifies various cost pools. For example, in a machine shop, machine set-up time could be identified as a separate cost pool from actual machining time. Components that are produced in small batch quantities would require larger machine set-up time and would therefore bear greater cost allocation than components that are machined in large batch quantities. ABC was not used just for cost allocation but as a tool to focus the managers’ attention on activities that did not add value to the product or process and was part of the larger movement towards value engineering in all aspects of a company’s operations (Stage 2 in Fig 4).
Most manufacturing companies around the world use the Standard Costing system include its variants of Job Costing (in custom made products, where each job is costed individually rather than over a period) and Process Costing (where manufacturing is a conversion process such as in the chemical industry). Some have adopted ABC for allocation of overheads. In a study of manufacturing companies in Istanbul, Turkey, 31 firms used Job Costing, 7 companies mainly in the chemicals and plastics industry used Process Costing. 19 companies used ABC. Smaller companies tend to adopt simpler systems to avoid complexity and cost (Uyar, 2010).
The Target Costing approach was developed in the Japanese manufacturing industry in the 1970s as a multidisciplinary approach to search for lower costs from the earliest stages of product design and through techniques such as process-reengineering and total quality management (TQM). The cost target was set as the competitive market price less the desired profit margin and the company managers were set the goal of developing a product and manufacturing it within the set cost target. This approach was quickly adopted by the services industry. Target costing also spawned the concept of Life Cycle costing where the focus was not just on ex-factory cost of the product but also costs of spares and service during the customer’s ownership of the product and the costs of disposal at the end of the product life. Another concept that was developed was Throughput Accounting where the focus was on maximizing throughput through a factory or a functional team in the company by improving throughput and thereby lowering costs (Tabitha & Ogungbade, 2016). This is represented as Stage 3 in Fig 4 above.
The Japanese concept of Kaizen which means continuous improvement became widely popular in all parts of the world. Kaizen techniques were useful in raising overall productivity and improving business performance. In the Target Cost method, if the target cost is met there is no further incentive for the managers to continue efforts to achieve further savings. The Kaizen cost approach changes that mindset and it is possible for an organization to set itself goals for continuous small improvements. Companies therefore set Target Costs for new products and once these are in production and in the market, and adopt Kaizen costing goals for continuous small improvements. This is shown as Stage 4 in Fig 4 above.
One criticism of all cost accounting systems is that they only report on the past and do not provide any help to the managers in dealing with the future. The concept of Predictive Cost Accounting seeks to address that criticism. A conceptual diagram is shown in Fig 5 (from Cokins, 2015).
In this approach, data from actual past performance is combined with information such as forecasts and planned changes in products, processes and sourcing to provide a decision support system. The Predictive Cost system will new the emerging field of data analytics and the quality of the system would evolve over time with experience of applying these and evaluating the outcomes (Cokins, 2015).
Summary and Conclusions
Companies generate Financial Accounting Reports for its external stakeholders and Managerial Accounting Reports for its managers, both using data collected and analyzed by the cost accounting function. Cost accounting reports tailored to the needs of specific functional roles helps company managers fulfill their assigned task of maximizing profits for the company shareholders. The cost accounting system helps managers with key decisions such as the price of a product, whether to make a component in-house or to buy it, whether to spend money on R&D or marketing and whether to expand factory capacity.
Globalization where the company’s products can source raw materials and components from anywhere in the world and sell its products in any country add to the need for managers to be supported by reliable information. For many companies the demand for their products can fluctuate which requires managers to make important decisions related to capacity expansion, building cost elasticity through reduction of fixed costs and taking steps to ensure that variable costs go down in proportion to the production volumes. All these decisions have to be based on reliable cost accounting information. The cost accounting system is also an important tool in manager motivation.
Cost accounting systems originated with Standard Cost systems and Activity Based Cost systems that collect and analyze historical costs. Over 80% of companies worldwide, especially the smaller companies continue to rely on historical cost systems. Newer cost accounting systems have emerged. The Target Cost Accounting system sets a target cost for a new product or activity and the Kaizen Cost Accounting system aims to make continuous small improvements to save on costs. The new approach of Predictive Cost Accounting is expected to gain acceptance using the emerging field of data analytics.
References
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