Cost Accounting Fundamentals Essential Concepts and Examples

Steven M. Bragg

Table of Contents Chapter 1 – Overview of Cost Accounting .................................................................. 1 Learning Objective .................................................................................................................... 1 Introduction ............................................................................................................................... 1 Financial Reporting ................................................................................................................... 1 Management Reporting ............................................................................................................. 1 Problem Resolution ................................................................................................................... 3 Price Setting .............................................................................................................................. 4 Cost Investigation ...................................................................................................................... 4 Budget Formulation ................................................................................................................... 5 Constraint Analysis ................................................................................................................... 6 Cost Accumulation Systems ..................................................................................................... 6 Summary ................................................................................................................................... 6 Review Questions ..................................................................................................................... 8 Review Answers ........................................................................................................................ 9

Chapter 2 – The Cost Accountant Job Description .................................................. 10 Learning Objective .................................................................................................................. 10 Introduction ............................................................................................................................. 10 To Whom Does the Cost Accountant Report? ........................................................................ 10 What Are the Principal Accountabilities of the Cost Accountant? ........................................... 10 What Are the Qualifications of a Cost Accountant? ................................................................ 12 Who Does the Cost Accountant Supervise? ........................................................................... 13 Summary ................................................................................................................................. 13 Review Questions ................................................................................................................... 14 Review Answers ...................................................................................................................... 15

Chapter 3 – Inventory Valuation ................................................................................ 16 Learning Objective .................................................................................................................. 16 Introduction ............................................................................................................................. 16 Valuation Step 1: The Quantity of Inventory on Hand ............................................................. 16 The Periodic Inventory System ............................................................................................... 16 The Perpetual Inventory System ............................................................................................. 17 The Gross Profit Method ......................................................................................................... 18 Valuation Step 2a: Inventory Costing ...................................................................................... 19 The First In, First Out Method ................................................................................................. 19 The Last In, First Out Method ................................................................................................. 20 The Weighted Average Method .............................................................................................. 22 Standard Costing .................................................................................................................... 23 The Retail Inventory Method ................................................................................................... 23 Valuation Step 2b: Inventory Costing ...................................................................................... 24 Job Costing ............................................................................................................................. 24 Process Costing ...................................................................................................................... 24 By-Product and Joint Product Costing .................................................................................... 24 Valuation Step 3: Overhead Allocation ................................................................................... 25 Valuation Step 4: Inventory Valuation ..................................................................................... 28 The Lower of Cost or Market Rule .......................................................................................... 28 Obsolete Inventory Accounting ............................................................................................... 29

Summary ................................................................................................................................. 30 Review Questions ................................................................................................................... 31 Review Answers ...................................................................................................................... 32

Chapter 4 – Job Costing ............................................................................................. 33 Learning Objective .................................................................................................................. 33 Introduction ............................................................................................................................. 33 Overview of Job Costing ......................................................................................................... 33 When Not to Use Job Costing ................................................................................................. 34 Accounting for Direct Materials in Job Costing........................................................................ 34 Accounting for Labor in Job Costing ....................................................................................... 35 Accounting for Actual Overhead Costs in Job Costing ........................................................... 36 Accounting for Standard Overhead Costs in Job Costing ....................................................... 37 The Importance of Closing a Job ............................................................................................ 38 The Role of the Subsidiary Ledger in Job Costing .................................................................. 38 Job Costing Controls ............................................................................................................... 39 Summary ................................................................................................................................. 40 Review Questions ................................................................................................................... 41 Review Answers ...................................................................................................................... 42

Chapter 5 – Process Costing ..................................................................................... 43 Learning Objective .................................................................................................................. 43 Introduction ............................................................................................................................. 43 Overview of Process Costing .................................................................................................. 43 The Weighted Average Method .............................................................................................. 44 The Standard Costing Method ................................................................................................ 45 The First In, First Out Method ................................................................................................. 46 The Hybrid Accounting System ............................................................................................... 48 Process Costing Journal Entries ............................................................................................. 49 Problems With Process Costing .............................................................................................. 50 Summary ................................................................................................................................. 51 Review Questions ................................................................................................................... 52 Review Answers ...................................................................................................................... 53

Chapter 6 – Standard Costing .................................................................................... 54 Learning Objective .................................................................................................................. 54 Introduction ............................................................................................................................. 54 Overview of Standard Costing ................................................................................................ 54 Advantages of Standard Costing ............................................................................................ 54 Disadvantages of Standard Costing ........................................................................................ 55 How to Create a Standard Cost .............................................................................................. 56 Historical, Attainable, and Theoretical Standards ................................................................... 57 How to Account for Standard Costs ........................................................................................ 57 Overview of Variances ............................................................................................................ 58 The Purchase Price Variance ................................................................................................. 59 Material Yield Variance ........................................................................................................... 60 Labor Rate Variance ............................................................................................................... 61 Labor Efficiency Variance ....................................................................................................... 61 Variable Overhead Spending Variance ................................................................................... 62 Variable Overhead Efficiency Variance ................................................................................... 63 Fixed Overhead Spending Variance ....................................................................................... 63

Selling Price Variance ............................................................................................................. 64 Sales Volume Variance ........................................................................................................... 65 Problems with Variance Analysis ............................................................................................ 65 The Controllable Variance ....................................................................................................... 66 The Favorable or Unfavorable Variance ................................................................................. 66 Where to Record a Variance ................................................................................................... 67 Which Variances to Report ..................................................................................................... 67 How to Report Variances ........................................................................................................ 68 Summary ................................................................................................................................. 68 Review Questions ................................................................................................................... 70 Review Answers ...................................................................................................................... 71

Chapter 7 – Joint and By-Product Costing ............................................................... 72 Learning Objective .................................................................................................................. 72 Introduction ............................................................................................................................. 72 Split-Off Points and By-Products ............................................................................................. 72 Why We Allocate Joint Costs .................................................................................................. 73 How to Allocate Joint Costs .................................................................................................... 73 How to Determine Prices ........................................................................................................ 74 Special Concerns With By-Product Costing ............................................................................ 75 Summary ................................................................................................................................. 75 Review Questions ................................................................................................................... 76 Review Answers ...................................................................................................................... 77

Chapter 8 – Waste Accounting .................................................................................. 78 Learning Objective .................................................................................................................. 78 Introduction ............................................................................................................................. 78 Definition of Spoilage .............................................................................................................. 78 Accounting for Normal Spoilage .............................................................................................. 78 Accounting for Abnormal Spoilage .......................................................................................... 80 Accounting for the Sale of Spoilage ........................................................................................ 80 Cost Allocation to Spoilage ..................................................................................................... 80 Definition of Rework ................................................................................................................ 81 Reporting Rework ................................................................................................................... 81 Accounting for Rework ............................................................................................................ 82 Definition of Scrap ................................................................................................................... 82 Accounting for Scrap ............................................................................................................... 82 Impact of Waste on Manufacturing Systems ........................................................................... 83 Summary ................................................................................................................................. 84 Review Questions ................................................................................................................... 85 Review Answers ...................................................................................................................... 86

Chapter 9 – Product Pricing ....................................................................................... 87 Learning Objective .................................................................................................................. 87 Introduction ............................................................................................................................. 87 What Does This Cost? ............................................................................................................ 87 The Issue of Pricing Duration .................................................................................................. 88 The Issue of Overhead Costs ................................................................................................. 89 The Issue of Overhead Application ......................................................................................... 90 Corporate Overhead Costs ..................................................................................................... 92 What Does This Cost, Part Two .............................................................................................. 94

The Issue of the Bottleneck ..................................................................................................... 94 What Does This Cost, Part Three ........................................................................................... 95 Summary ................................................................................................................................. 96 Review Questions ................................................................................................................... 97 Review Answers ...................................................................................................................... 98

Chapter 10 – Target Costing ...................................................................................... 99 Learning Objective .................................................................................................................. 99 Introduction ............................................................................................................................. 99 The Basic Steps of Target Costing ......................................................................................... 99 Value Engineering Considerations ........................................................................................ 100 The Cost Reduction Program ................................................................................................ 101 The Milestone Review Process ............................................................................................. 102 Problems with Target Costing ............................................................................................... 102 The Members of a Design Team ........................................................................................... 103 The Role of the Cost Accountant in Target Costing .............................................................. 103 Data Sources for Target Costing ........................................................................................... 104 The Product Life Cycle and Target Costing .......................................................................... 105 Summary ............................................................................................................................... 106 Review Questions ................................................................................................................. 107 Review Answers .................................................................................................................... 108

Chapter 11 – Transfer Pricing .................................................................................. 109 Learning Objectives .............................................................................................................. 109 Introduction ........................................................................................................................... 109 Overview of Transfer Pricing ................................................................................................. 109 Market Price Basis for Transfer Pricing ................................................................................. 110 Adjusted Market Price Basis for Transfer Pricing .................................................................. 111 Negotiated Basis for Transfer Pricing ................................................................................... 111 Contribution Margin Basis for Transfer Pricing ..................................................................... 112 Cost Plus Basis for Transfer Pricing ..................................................................................... 112 Cost Anomalies in a Cost-Based Transfer Price ................................................................... 113 Pricing Problems Caused by Transfer Pricing ...................................................................... 113 The Tax Impact of Transfer Prices ........................................................................................ 114 Summary ............................................................................................................................... 116 Review Questions ................................................................................................................. 117 Review Answers .................................................................................................................... 118

Chapter 12 – Direct Costing ..................................................................................... 119 Learning Objective ................................................................................................................ 119 Introduction ........................................................................................................................... 119 Overview of Direct Costing .................................................................................................... 119 Contribution Margin Versus Gross Margin ............................................................................ 120 Direct Costing as an Analysis Tool ....................................................................................... 121 Automation Investments ................................................................................................................... 121 Cost Reporting .................................................................................................................................. 121 Customer Profitability ........................................................................................................................ 122 Internal Inventory Reporting ............................................................................................................. 123 Profit-Volume Relationship ............................................................................................................... 123 Outsourcing....................................................................................................................................... 125

Direct Costing Pitfalls ............................................................................................................ 126

Summary ............................................................................................................................... 128 Review Questions ................................................................................................................. 129 Review Answers .................................................................................................................... 130

Chapter 13 – Activity-Based Costing....................................................................... 131 Learning Objective ................................................................................................................ 131 Introduction ........................................................................................................................... 131 The Problem With Overhead Allocation ................................................................................ 131 Overview of Activity-Based Costing ...................................................................................... 134 Activity-Based Management ................................................................................................. 139 Advantages of Activity-Based Costing .................................................................................. 139 Problems with Activity-Based Costing ................................................................................... 142 The Incremental Cost Reduction Fallacy .............................................................................. 143 The Bill of Activities ............................................................................................................... 144 System Scope Issues ............................................................................................................ 144 System Integration Issues ..................................................................................................... 145 Summary ............................................................................................................................... 145 Review Questions ................................................................................................................. 147 Review Answers .................................................................................................................... 148

Chapter 14 – Constraint Analysis ............................................................................ 149 Learning Objective ................................................................................................................ 149 Introduction ........................................................................................................................... 149 Constraint Analysis Operational Terminology ....................................................................... 149 Overview of Constraint Analysis ........................................................................................... 150 The Cost of the Bottleneck .................................................................................................... 151 Local Optimization ................................................................................................................. 152 Constraint Analysis Financial Terminology ........................................................................... 153 Constraint Analysis from a Financial Perspective ................................................................. 153 The Constraint Analysis Model ............................................................................................. 154 The Decision to Sell at a Lower Price ................................................................................... 156 The Decision to Outsource Production ................................................................................. 157 The Capital Investment Decision .......................................................................................... 157 The Decision to Cancel a Product ......................................................................................... 159 Comparison of Activity-Based Costing to Constraint Analysis .............................................. 160 Summary ............................................................................................................................... 160 Review Questions ................................................................................................................. 161 Review Answers .................................................................................................................... 162

Chapter 15 – Capital Budgeting Analysis ............................................................... 163 Learning Objective ................................................................................................................ 163 Introduction ........................................................................................................................... 163 Overview of Capital Budgeting .............................................................................................. 163 Bottleneck Analysis ............................................................................................................... 164 Net Present Value Analysis ................................................................................................... 165 The Payback Method ............................................................................................................ 166 Capital Budget Proposal Analysis ......................................................................................... 167 The Outsourcing Decision ..................................................................................................... 168 The Capital Budgeting Application Form ............................................................................... 169 The Post Installation Review ................................................................................................. 172 The Lease Versus Buy Decision ........................................................................................... 172

Summary ............................................................................................................................... 174 Review Questions ................................................................................................................. 175 Review Answers .................................................................................................................... 176

Chapter 16 – Cost Collection Systems .................................................................... 177 Learning Objective ................................................................................................................ 177 Introduction ........................................................................................................................... 177 Data Entry Accuracy ............................................................................................................. 177 Data Entry with Bar Codes .................................................................................................... 178 Data Entry with Radio Frequency Identification (RFID)......................................................... 180 Document Imaging ................................................................................................................ 180 Special Considerations for Labor Tracking ........................................................................... 182 The Duration of Cost Collection ............................................................................................ 185 The Chart of Accounts .......................................................................................................... 185 The Account Code Structure ............................................................................................................ 186 The Account Code Format................................................................................................................ 187 Accounts for the Cost Accountant .................................................................................................... 188

Other Sources of Cost Information ........................................................................................ 189 Summary ............................................................................................................................... 191 Review Questions ................................................................................................................. 192 Review Answers .................................................................................................................... 193

Chapter 17 – Cost Variability .................................................................................... 194 Learning Objective ................................................................................................................ 194 Introduction ........................................................................................................................... 194 Mixed Costs .......................................................................................................................... 194 Labor-Based Fixed Costs ...................................................................................................... 195 Costs Based on Purchase Quantities ................................................................................... 196 Costs Based on Production Batch Sizing .............................................................................. 197 Cost Based on Step Costs .................................................................................................... 198 Time-Based Costs ................................................................................................................. 198 Experience-Based Costs ....................................................................................................... 199 Incorporating Cost Variability into Cost Reports ................................................................... 201 Summary ............................................................................................................................... 202 Review Questions ................................................................................................................. 204 Review Answers .................................................................................................................... 205

Chapter 18 – Cost of Quality .................................................................................... 206 Learning Objective ................................................................................................................ 206 Introduction ........................................................................................................................... 206 Types of Quality .................................................................................................................... 206 Costs Impacted by Quality .................................................................................................... 207 Reporting on the Cost of Quality ........................................................................................... 208 Summary ............................................................................................................................... 210 Review Questions ................................................................................................................. 211 Review Answers .................................................................................................................... 212

Appendix – Selected Topics ..................................................................................... 213 What is Actual Costing? ........................................................................................................ 213 What is an Avoidable Cost? .................................................................................................. 214

What is a Burden Rate? ........................................................................................................ 214 What is a Committed Cost? .................................................................................................. 215 What are Conversion Costs? ................................................................................................ 215 What is a Deferred Cost? ...................................................................................................... 215 What is a Differential Cost? ................................................................................................... 215 What is a Direct Cost? .......................................................................................................... 216 What is a Discretionary Cost? ............................................................................................... 217 What is an Expired Cost? ...................................................................................................... 217 What is Historical Cost? ........................................................................................................ 217 What is an Indirect Cost? ...................................................................................................... 218 What is an Irrelevant Cost? ................................................................................................... 218 What is Marginal Cost? ......................................................................................................... 218 What is Normal Costing? ...................................................................................................... 219 What is a Period Cost? ......................................................................................................... 219 What is Replacement Cost? .................................................................................................. 220 What is a Step Cost? ............................................................................................................ 220 What is a Sunk Cost? ............................................................................................................ 220 What is a Traceable Cost? .................................................................................................... 220

Index ........................................................................................................................... 222