MANAGEMENT FINANCIAR CONTABIL - WHAT KIND OF COST SYSTEM DO YOU NEED IN YOUR COMPANY?

UNIVERSITY 'SPIRU HARET'

FACULTY 'MANAGEMENT FINANCIAR CONTABIL'

 

WHAT KIND OF COST SYSTEM

DO YOU NEED IN YOUR COMPANY?

Although cost accounting is conceptually simple, it is not an all-purpose management tool. In some situations where a detailed cost system would be desirable, the expense of designing, installing and operating it is to high; in other situations where detailed information is readily obtainable, it has little value.

Many managers, failing to recognize the relationship between cost accounting and environment, spend hundreds of thousands of dollars on systems that do not suit their production processes. Fortunately, new computer systems have enlarged the options. The managers can choose a system that works well for their purposes, providing both good control and effective analysis. There are situations where cost control and cost analysis are likely to be crucial to an organization.

The feasibility of a particular cost system and its usefulness to a manager depend on many different factors. In some situations a detailed cost system is desirable, and the expense of designing, installing, and operating it is low. In other cases, although cost information would be of value, obtaining it is too expensive. Elsewhere, even detailed cost information has limited value.

Unfortunately, many managers fail to recognize that numerous factors influence cost accounting, including production method, product type, corporate strategy, and market conditions. Some companies spend several hundred thousand dollars for cost systems that are never implemented because the systems do not suit the production process, and the managers responsible have lost their jobs.

Nonetheless, because of the recent availability of the computer software that can produce accurate and detailed information on basic operations, many managers are renewing their efforts in cost accounting. In addition, with direct costs now constituting a smaller share of total cost, it is more important to separate costs into their fixed and variable elements and to allocate fixed costs in greater detail. This is especially true where costs are crucial for pricing.

Uses of cost information

In principle, cost accounting is a simple management tool. Its objective is to plan and record costs to assist in controlling and analyzing an organization. Managers can facilitate control by comparing the planned cost of some activity with its actual cost. A good cost system raises a reg flag so that management can focus its attention on potential problems. It also provides information for analysis.

Associating cost information with products or product groups makes analysis easier. This support external analyses, such as pricing and product-mix decisions. Managers can also use such data for analyzing internal operations, such as equipment acquisition and changes in the production process or in product design. Control and analysis are the primary uses for cost information, and the information is straightforward in most cases.

Limitations

As simple as cost accounting is conceptually, implementation can involve major problems. Product costs mirror both purchases and the production process. Thus, cost accounting can be extremely difficult in complex production settings like those of an integrated manufacturing company or a hospital, where it is difficult to associate costs with products or segments of the production process. In such cases, inaccurate product costs often lead to weak analysis, while inaccurate costs for production areas can lead to weak control. Equally serious is the familiar problem of assigning fixed overhead costs to products, which lessens the value of cost information for analysis.

Inputs

Inputs are the cost categories of an income statement. Assigning costs to departments, such as engineering, marketing or finance- or determining total material and labor assigned to a department- is relatively simple. These cost summaries are usually sufficient to satisfy external reporting requirements even though an organization has poor cost control or limited product-cost

information.

It is often far more difficult, however, to control material and labor costs incurred in production. Ideally in an effective cost system, managers should be able to compare actual and planned costs in detail by department, by employee, by work station, and by product. Frequently, however, only limited comparisons are possible; what can be provided at reasonable cost depends on the setting. For example, physicians, electronics repair technicians, chefs, or others in complex service organizations may perform 20 tasks each hour. Recording how they spend their time might take longer than performing the tasks themselves and could interfere with operations.

Manufacturers of complex products, such as automobiles often encounter an equally difficult problem. Material and labor used by production departments are not recorded as expenses; they become part of the cost of a product. Associating costs with products is hard to do because most production costs are first associated with parts or subassemblies, and these components can be used in many different finished products. The complex transaction details needed to describe such a process can lead to major errors in product cost and in inventory cost.

Outputs

The accuracy of product cost information is highly dependent on setting. Measuring variable costs by product presents a number of problems that are specific to a setting, while cost allocations present more general problems:

Variable costs. In some instances, it is easy to associate variable costs with products. Consider, for example, an injection molding company producing an order of auto taillight covers. Here direct labor cost can easily be recorded by product, since one employee will spend several days on a product or job. Material is also issued and recorded by product, so measuring material cost is similarly straightforward.

Integrated manufacturing companies, however, usually produce parts and subassemblies for inventory. As it is not known at the time of production which finished product will use which part or subassembly, associating costs with products is hard. Variable costs also present a problem for complex service organizations. As mentioned, it is also often difficult to measure variable costs without interfering with operations. In cases like these, managers often use estimated costs.

Allocated costs. Although some academics consider fixed overhead allocations irrelevant for operating decisions, allocations are widely used in product pricing decisions, apparently as estimates of long-run variable costs. Although allocated costs are in no sense the true cost of anything, they may be the best estimates of the long-run cost of producing a product, and are useful for this reason. Allocations present well-known problems, however-

If a year's production volume is unusually high or low, fixed overhead per unit will be unusually low or high. To avoid this effect, a company can base overhead costs on the normal production volume.

Fixed costs are based on historical costs in most cases. It is often useful to know the value of fixed costs if a company has new equipment or equipment of the same age of that of a competitor.

While there is no single, correct way to allocate costs to products, some methods are more sensible than others. For example, most companies allocate overhead costs based only on labor costs. While satisfactory in the past, with automation this method of accounting shows lower overhead costs for products turned out on expensive equipment and therefore higher overheads for other products.

OPERATION CONSTRAINTS

Ideally, a cost system provides both actual and standard costs. Some managers have a strong preference for actual costs, but in certain circumstances it is impractical to measure actual product cost. In these cases it may be necessary to use standard costs and to calculate variances in order to estimate actual costs.

Companies can determine variable production costs by several methods. They can record costs by job, batch, department, or individual operation. Alternatively, they can make cost estimates, which they can use without verification, or which they can partially verify by spot checks. It is often reasonable to use estimates for small companies or for simple production processes.

Product types and production processes mainly determine the appropriate cost system for a company, and focusing on these two factors can narrow the range of options.

Job-order production

A job-order production process is usually the setting where it is easy to install a cost system and where its value is seen as highest, since many such companies need frequent cost information

A job-order cost system provides detailed cost control and accurate product costs. Since managers have a choice of using standard or actual costs, there is little else that one could want from a cost system.

Discrete-part products

The most technically difficult setting for cost accounting is discrete-part production by batch or by assembly process. Examples include computers, electronics equipment, or other products with numerous component parts. A relatively uniform cost system based on detailed production records has always been possible for such products. With high-speed, low-cost computers such systems are now practical.

Discrete-part products produced by batch or assembly process are not well suited to job-order costing or to determining actual costs. The manufacturer usually assembles customer orders from parts and subassemblies that have been produced before the order is received, so the cost of the order cannot be recorded by job. Actual products costs are also difficult to calculate since they require a record of actual costs for each part and subassembly.

Standard cost systems provide satisfactory results for batch process. Companies can record variances either for each batch produced in a department or for each operation or work station. The latter method provides more detailed control but it is far more expansive.

Computer cost systems that calculate variance by batch are not generally available in standard software but a company can design and install a fairly inexpensive tailor-made system in a few months. Operations cost systems, however, are far more expensive and time-consuming to develop. Standard software packages for batch or operations cost systems are included as modules in a few materials requirements planning (MRP) systems. The cost of a computerized MRP system, including hardware, is several hundred thousand dollars for a company with a few hundred employees, and implementation may require two years to refine standard costs and production records.

An alternative approach is to use standard costs in an informal cost system. As standard costs in this case are not compared with actual inputs, they may inaccurate and lead to large inventory errors. Such a system is inexpensive and simple to maintain, however, and thus is a reasonable choice for small manufacturing companies.

Another problem in setting out an accounting system for discrete-part products is cost aggregation. Because costs are accumulated through various levels of production, many cost systems, especially the older ones, aggregate them, thus making it difficult to separate product costs into material, labor and overhead components or into variable and fixed costs. A well-designed cost system can easily overcome this problem.

Cost accounting for discrete-part products produced by an assembly process has all the problems of batch production plus another: an assembly line usually produces simultaneously several models, so it can be hard to associate material or labor with a particular batch.

One option is to calculate an overall variance for the production department for a given period, such as a month. Variances by department may provide accurate product-cost information, and such a system is inexpensive. It provides relatively weak financial control, however, since disaggregating variances within a department may be a problem.

It is also possible to calculate production variances by work station using an operations-cost system. As in the case of a batch-production process, a cost system that provides detailed variances for an assembly line is expensive, while using standards without verification provides inaccurate product-cost information and almost no cost control.

Few material inputs

With few material inputs, cost accounting has few technical problems. Where the time spent on a task is brief, however, obtaining detailed operating information is usually not feasible and cost accounting information is based either on estimates or on industrial engineering kinds of studies. With medium-volume operations, installing a simple actual-cost system is often practical. But where volumes are low, usually only an informal cost system, without comparison to actual inputs, can be justified.

High-volume processes with few material inputs are often so automated and so straightforward from a cost accounting view that managers can control costs and estimate estimate product costs without a formal cost system. Products usually have one or two material inputs and the labor tend to be minor. An experienced manager can estimate product costs if he or she knows average costs of raw materials and rates of production. Although managers typically use process-cost systems, these provide little information not obtainable by real time measures. In such settings, cost systems are generally used to verify other information and to value inventory. Physical measures of activity can replace financial measures, since costs are effectively controlled through use of gauges and computer displays.

Service companies

High-volume service companies can use effective cost systems, while service companies with low volumes present some of the most difficult problems in cost accounting. Consider a high-volume fast-food restaurant chain. Since the menu is limited to a few prepared items, material inputs can be recorded on a daily basis. Similarly, the labor involved tends to be simple and repetitive, so it is easily recorded in detail.

In such a setting, managers can tightly control costs and accurately measure product costs. In addition, such cost systems are inexpensive and do not interfere with service.

A general hospital lies at the other extreme; it is generally a law-volume service organization. Consider the cost of o nurse. He or she may spend an average of three minutes with each patient, performing say, five functions for someone with a complex illness. Recording time spent for each function could require that a hospital double its nursing staff. Similar costing problems exist for physicians because of the complexities of diagnosis and treatment.

These industrial engineering types of studies are unlikely to lead to highly detailed, general-purpose cost measurement systems such as discrete-part products operation might use. Instead, hospitals can use illness acuity profiles to develop a simplified standard cost system. No records need be kept of actual time spent servicing each patient or by actual time of hospital service. However, the hospital can compare the total actual staffing for each floor with the planned staffing as a rough check on efficiency.

Most specialized service companies face similar problems. Cost systems that record actual product costs are likely to prove unworkable because it is difficult to specify the product and because labor time is too brief to justify recording.

Joint products

In many situations a production process yields several products from one or more material inputs, and it is possible to monitor costs through process controls. Analysing product costs, however presents difficulties.

If there is a choice of output, for example in a petroleum refinery, determining product costs is even more complicated. When the company's objective is to use a raw material in such a way that it will generate the most profit, cost accounting has little value. Instead, managers can use mathematical programming techniques to determine both the level of production and what should be produced.

Many managers consider cost accounting to be a straightforward, general-purpose management tool. In practice, however, it is complex and related to the setting. Changes in computer technology now offer a great opportunity to improve cost systems in certain settings, such as batch or assembly production. Elsewhere there is less scope for major advances and the challenge is to develop a cost system that is reasonable for the circumstances. By recognizing the relationship between a cost system and its setting, it is possible to improve a company's cost system significantly and, in turn, the working relationship between the accounting group and other departments.