One of the first questions I ask our Warehouse Management students is, “Do you know your operating costs?” and our Production Planning Management students, “Do you know the cost to produce one of your items?” After ten years of training, I can count on one hand how many students were able to answer these questions, which immediately tells me their company does not utilize cost accounting.
The reason students are unable to answer the question is their company only has what is called financial accounting in place. Financial accounting focuses on historical and estimated data management needs to conduct ongoing operations, report to the IRS and owners/shareholders, and plan long-range. Financial accounting’s purpose is to accumulate financial information to make economic decisions.
Financial accounting focuses on gathering historical financial information to prepare financial statements that meet the needs of investors, creditors, and other external users of financial information. The statements include a balance sheet, income statement, retained earnings statement, and statement of cash flows. Although these financial statements are useful to management and external users, additional reports, schedules, and analyses are required for management’s use in planning and controlling operations.
Financial accounting focuses on the company’s operations and cannot provide the detail necessary to determine product costs and pricing accurately. At best, all they can do is provide averages. In addition, cost accounting provides the detailed cost information management needs to control current operations and plan for the future. Management uses this information to decide how to allocate resources to the business’s most efficient and profitable areas.
Managerial accounting, like cost accounting, enables management to properly allocate costs such as raw materials, labor, and other factory resources to the products using them instead averaging them overall products. Without cost accounting, expenses such as:
- major investments in physical assets, developing the workforce,
- machine maintenance and repair,
- materials handling,
- production setup,
- production scheduling, selling, and administrative expenses
are usually lumped together to create an overhead rate added to a product as an overhead markup. The true cost is never determined, which means the company is charging too much for some products and not enough for others. For example, if you manufacture a product that needs to be heat-treated, and you are averaging your utility costs over all your products, you will be charging too much for the products that are not heat-treated and not enough for those that do.
Principles of cost accounting have been developed to enable manufacturers to process the many costs associated with manufacturing and provide built-in control features. The information produced by a cost accounting system provides a basis for determining accurate product costs and selling prices, and it helps managers plan and control operations.
Determining Product Costs and Pricing
Cost accounting procedures provide the means to determine product costs that enable the preparation of meaningful financial statements and other reports needed to manage a business. The cost accounting information system must be designed to permit the determination of unit costs and total product costs. Unit cost information is also useful in making important marketing decisions such as determining the selling price of a product, meeting competition, bidding on contracts, and analyzing profitability.
Planning and Control
One of the most important aspects of cost accounting is the preparation of reports that management can use to plan and control operations. Planning is establishing objectives or goals for the firm and determining how they will meet them. Effective planning is facilitated by clearly defined objectives of the manufacturing operation and a production plan that will assist and guide the company in reaching its objectives.
Cost accounting information enhances the planning process by providing historical costs that are a basis for future projections. Management can analyze the data to estimate future costs and operating results and make decisions regarding the acquisition of additional facilities, any changes in marketing strategies, and the availability of capital.
Effective control is achieved by assigning responsibility for each detail of the production plan by establishing cost centers. All managers should know precisely their responsibilities in terms of efficiency, operations, production, and costs. The key to proper control involves using responsibility accounting and cost centers by periodically measuring and comparing results and taking necessary corrective action.