Cost Accounting For Dummies. Kenneth W. Boyd
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In a nutshell, cost accounting is the process of analyzing and planning what it costs to produce or supply a product or service. The analysis helps reduce costs — and possibly eliminate them. Lower costs, of course, allow for increased profits.
Business folks use cost accounting to determine the profitability of a product. The rule is simple: The price should cover the product cost and generate a profit. Competition may dictate the price charged for a product. In other instances, a profit is added to a product cost to create a unique price.
This chapter introduces cost accounting and how to compare and contrast cost accounting with other accounting methods. The chapter also explains how cost accounting can help you improve your business, such as by using pricing, budgeting, and other tools that can help you become more profitable.
Comparing Accounting Methods
Accounting is the process of recording, reporting, and analyzing business transactions. It’s the written record of a business. Cost accounting is the process of capturing all the costs of “production,” whether a business manufactures products, delivers services, or sells retail items. Cost accounting is used for all types of businesses.
Often, cost accounting overlaps with other types of accounting, such as financial accounting and management accounting. If you have some knowledge about these other areas of accounting, that background can help you understand cost accounting. If not, no big deal. This section helps clarify what cost accounting is, how it’s used, and how these accounting methods relate.
Financial accounting is a reporting process. An accountant reports on the financial position of a firm and the firm’s performance by creating financial statements. The statements are mainly used by external (outside) parties to show how the company is doing. External parties include shareholders, creditors, and regulators.
The external parties may not have an accounting background, so there are many rules of the road (and they are very specific) for creating financial statements. The rules exist so that each set of financial statements is standardized. If all companies follow the same set of rules to create financial statements, the information is usually comparable.
Financial accounting looks backward. It’s retrospective. The accountant is creating financial statements for transactions that have already happened. So unlike cost accounting, financial accounting doesn’t provide any planning or forecasting.
Your external users want financial statements on a periodic basis. Companies typically issue financial statements on a bi-annual, or annual basis. External users want to know how you’re doing — for a variety of reasons.
Considering your shareholders
If you own a business, shareholders own shares of your company in the form of common stock. That also means that shareholders own equity in your business. You may pay them a share of company earnings as a dividend, or retain the earnings for use or investment in your business.
Shareholders are interested in seeing the value of the business increase. As your sales and earnings grow, your company is seen as more valuable. A shareholder reviews your financial statements to see if sales and earnings are increasing. If they are, your shareholder is happy — they may even buy more of your common stock.
As sales and earnings grow, other investors may be willing to pay a higher price for your common stock. An existing shareholder might then sell their investment in common stock for a gain.
Mulling over creditors
Creditors are lenders. They lend your company money so you can purchase assets, which help your business operate. Assets are defined as items you use to make money in your business, like machinery and equipment. You sign a loan agreement with a lender, and that agreement states the interest rate for the loan and when the loan payments are due. You pay interest on the loan and also repay the original amount borrowed — the principal amount.
Instead of a bank loan, you can issue debt directly to the public by selling bonds. The bond certificate states the terms of the bond. That document lists the interest rate and the maturity date. The bond investor is repaid on the maturity date.
A creditor is interested in your ability to pay the interest and repay the loan. Like a shareholder, a creditor wants to see a company that generates earnings and an increasing level of sales. If you create earnings, you eventually collect more cash than you spend. That additional cash pays the principal and interest on the loan.
Addressing concerns of regulators
Nearly every business falls under some sort of regulation. Regulators protect the public by enforcing laws and regulations. Part of that process involves reviewing your financial statements.
In addition to the “standard” set of financial reports (covered later in the book), regulators may require extra information from you. This specialized reporting is required to address a specific regulation or law. For example, if you’re a food manufacturer, the Food and Drug Administration (FDA) requires you to disclose food ingredients on a food label. That’s a form of specialized reporting for a regulator.
Using management accounting
Management accounting is the process of creating accurate and timely reports for managers. Managers use the reports to make decisions. There are many theories and accepted practices in management accounting for developing reports. Ultimately, management accounting uses the “whatever works” method to create reports. Any report that provides the best possible information to solve a problem is a good one.
Management accounting is an internal reporting process. The information you create isn’t shared with the outside world. So you can put together any type of report that’s helpful to you.
Financial accounting looks backward. You report on past events. Management accounting is forward-looking. It’s prospective. You’re using the reports to make decisions about the future. For example, a decision whether to manufacture a product component or buy it from someone else is a typical management decision based on management accounting.
Fitting in cost accounting
Cost accounting is closer to management accounting than financial accounting. Cost accountants gather information to make decisions about the future. Also, cost reports are considered to be internal reports. Both of those traits apply to management accounting.
You see overlap between cost and management accounting.