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Cost accounting

Cost Accounting: The process of tracking, recording and analyzing costs associated with the activity of an organization, where cost is defined as 'required time or resources'. Costs are by convention measured in units of currency.

Costs were originally considered fixed ( the term comes from a Latin root meaning constant ) which worked well for very small businesses. In larger organizations, some costs tend to remain the same even during busy periods, while others rise and fall with volume of work. A more convenient way of categorizing these costs is to define them as either fixed or variable. Fixed costs were associated with the business administration, and did not change during quiet or busy times. Variable costs were associated with productive work, and naturally rose and fell with business activity.

In the early twentieth century, as organizations began getting more complex, managers needed a simple way to make decisions about products and pricing. Since most costs at the time were variable, managers could simply total the variable costs for a product and use this as a rough guide for decision-making.

For example: in order to make a railway coach a company needed to buy $60 in raw materials and components, and pay 6 labourers $40 each: total variable costs of $300. If managers knew that making a coach required spending $300, then they couldn't sell below that level without losing money. Any price above $300 became a contribution to the fixed costs of the company (say $1000 per month for rent, insurance and owner's salary). So the company could sell 5 coaches for $3000 or 10 coaches for $4500 and make a profit of $500 in both cases.

Standard costing took the idea further, by dividing the fixed costs by the number of items produced, and treating the result as if it were a variable cost. This enabled managers to effectively ignore the fixed costs, simplifying the decision process even more.

For example: if the railway coach company produced 40 coaches per month, and the fixed costs were still $1000/month, then each coach could be said to incur an overhead of $25 ($1000/40). Adding this to the variable costs of $300 per coach produced a unit cost of $325 per coach.

This method tended to slightly distort the resulting unit cost, but in mass-production industries that made one product line, and where the fixed costs were relatively low, the distortion was very minor.

For example: if the railway coach company made 100 coaches one month, then the unit cost would become $310 per coach ($300 + ($1000/100)). If the next month the company made 10 coaches, then the unit cost = $400 per coach ($300 + ($1000/10)), a relatively minor difference.

As time went on, the practice of paying workers on a 'set-piece' basis changed in favour of paying on an hourly rate. This is because in a complex organization, an individual's work is very often dependent on someone else, and paying set-piece in that enviromnent becomes unfair. Also organizations with a wide range of products or services have many tasks common to several finished items, making set-piece impractical. Fixed costs now tend to get allocated based on things like estimates of time spent, or percentage of resources used. At the same time, equipment has become more complex and specialized. As a result, modern companies tend to have very low truly variable costs (often limited to raw material, commissions or casual workers) and very high fixed costs (interest payments, salaries, insurance). The terms direct costs and indirect costs have replaced the variable/fixed terminology, to better reflect the way allocation of overhead is actually calculated.

One effect of the above is that the practice of allocating fixed costs has a far more distorting impact on unit cost figures than it ever used to have.

For example: say the railway coach company paid its workforce a fixed monthly rate of $8000 (total) and its other fixed costs had risen to $2600/month making the total fixed costs = $10600/month. The unit cost to make 40 coaches per month is still $325 per coach ($60 material + (10600/40)), while 100 coaches would have a unit cost of $166 per coach ($60 + ($10600/100)), and 10 coaches would 'cost' $1120 each. Managers using the unit cost figure based on 20 coaches per month would likely reject an order for 100 coaches if the selling price was only $300 per unit. If they used the original fixed/variable cost distinction, they would see clearly that this order contributes to the fixed costs by $240 per coach ($300-$60 materials) and would result in a net profit of over $10,000.

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