Relation of Cost Accounting to General Accounting
The purpose of cost accounting, a branch of general or commercial accounting, is to provide detailed information as to the separate components of cost which have entered into a product. General accounting shows merely the total profit or loss of the business as a whole; cost accounting shows the profit or loss on each unit, whether the unit be the job, contract, line of product, operating department, or process. It is “accounting for units” that differentiates cost accounting from general accounting.
In a plant with a cost system, however, cost accounting and general accounting are carried on concurrently. A close relation exists between general records and cost records. In fact, the two classes of records in a modern cost system are “tied up,” or unified, by the use of controlling accounts, such as Raw Material, Work in Process, Finished Product, and those used for the analysis of expenses.
Theoretically, any type of accounting which discloses the result of the operations of the various divisions of a business, such as the system used in department stores or the system used on farms, might be called cost accounting. In common usage, however, the term “cost accounting” is applied only to that type of accounting which deals with the costs of the operations of an institution producing a line of product, and so the principles of cost accounting discussed in this book are explained and illustrated in their application to manufacturing rather than to merchandising concerns. Manufacturing firms most sorely need the details of cost.
Insufficiency of General Accounting
With a good system of general accounting, the manufacturer can ascertain at the close of each fiscal period the amount of his total profit or loss. If the books show a profit, he may be satisfied even though it is small. If, however, a loss has been suffered, the books may not be in such detail as to enable him to ascertain the cause or the way to prevent future losses. Unless prices in the trade are rising, the remedy of increasing his selling price is not open to him, as he must meet the competition of fellow-manufacturers. In order to determine whether or not he can continue to manufacture his various articles profitably, he must have a system which will show the costs and profits of his different products. A general accounting system will not do this; a cost system will. With a cost system the manufacturer can concentrate his efforts on manufacturing and selling the more profitable lines, and at the same time be able to reduce his costs through the knowledge given by the detailed figures.
General figures may be misleading. A concern as a whole may be making satisfactory profits, yet .some departments may have to carry the losses of others. If a good system is installed, such conditions will be disclosed. A manufacturer, to be sure, may maintain some departments at a loss, simply because of their advertising value. He should do so, however, with his eyes open. Such a policy can be controlled intelligently only when actual costs are known.
“Selling” a Cost System
The demand for the serv1ces of the cost accountant comes primarily from the progressive manufacturer who knows that his plant’s progress can be accelerated by substituting a cost system for a general accounting system, or by improving the existing cost system. The special opportunity of the cost accountant concerns itself, however, with the manufacturers who have not seen the light. There are still a vast number of manufacturers who have not yet realized that a general accounting system has serious limitations. Many more look upon a cost system as a mere salvaging device. If the cost accountant can make clear to these men the justification for cost accounting—can “sell” the idea—the possible growth of his business is very great.
If the cost accountant has to “sell” a cost system, however, he must be able to answer satisfactorily the objections raised by the manufacturer and be able to explain convincingly the numerous advantages of a worth-while cost system. Since the manufacturer’s objections to a cost system must be overcome before he can fully appreciate its advantages, his common objections are here discussed first.
Objections Made to Cost Systems—1. Uniqueness of Business
Many manufacturers object to a cost system on the grounds of the peculiarity of their businesses. They feel that even though a system is adequate for competitors it will not apply to their own unique concerns. In fact, this feeling may even cause the manufacturer to believe that no system whatever could be devised to furnish him with accurate costs. This feeling is mistaken, as, while it is true that each business has its distinctive peculiarities, these are often exaggerated in the minds of the owners. Uniqueness itself does not preclude the possibility of designing a satisfactory system of accounts.
Ideal cost systems, it is true, cannot be installed readily in all firms. The difficulties in installation may be owing to numerous technical operations, or they may be owing merely to opposition on the part of the management and workers, which sometimes cannot be entirely overcome. Nevertheless, while this opposition may be discouraging, it should not prevent the installation of practical features which would improve the existing system. In certain circumstances it is good policy to install only the most important at first, and to extend their application and add new ones as the co-operation of managers and workmen is gained.
Trade association conventions, and the dissemination of cost information through the medium of the collecting, compiling, and distributing agencies of such associations, have changed the feelings of many proprietors that their concerns are unique and unadapted to cost systems. Many manufacturers have come to realize that the “other fellow’s” problems are much like their own.
2. Opposition of Managers and Workers
The fact that in many cases managers, foremen, and workers are opposed to a cost system is frequently put forth as an argument for its rejection. It is true that internal opposition, rather than the character of the system itself, or the inability of the cost accountant, has caused the discontinuance of many cost systems. For this reason, the antipathy of all persons concerned must be overcome. The desire of every cost accountant, therefore, should be to gain the good-will and co-operation of the management and workers before attempting to put in a system. So important does one reputable cost accountant regard mutual understanding, that he absolutely refuses to install a cost system unless he is given permission beforehand to include interest on invested capital in the manufacturing costs. All known differences of opinion should be ironed out before installation begins. Indeed, successful cost accountants attribute a large part of their success to their knowledge of the human factor.
3. Cost of Installation and Operation
Another common objection to a cost system is that the red tape involved makes the installation and operation of a cost system too expensive. The term “red tape” is relative. What is needless formality in one concern may be essential in another. The mere statement that a cost system has too much red tape, without further explanation, is not a valid objection.
Red tape, when actually found, is misapplied, or too much, system. The complexity of a system is no guarantee of its accuracy. For example, one factory for a long time charged Advertising and credited Stable Garage Expense for advertising placed on automobiles. The question of installing a cost system should receive the same sort of consideration as any other question which bears on factory efficiency. Do the advantages of the cost system outweigh its disadvantages? While the expenses of installing and operating a cost system are treated as expense items in the profit and loss statement, the benefits derived from such outlays continue year after year. In reality, therefore, a cost system is an investment rather than an expense. A cost system, however, like any other investment, should be used intelligently if it is to be a source of profit. It is only a diagnosis of business ills— not a cure for them.
4. System Unnecessary
Another objection that a manufacturer will frequently make to a cost system is that he is in such close touch with his business that he does not need a system. He may state with a good deal of pride that he has made money and does not need any newfangled notions involving additional expense for clerical hire.
Inertia, too, is a powerful factor in his reasoning. An inherent reluctance to adopt new methods is too prevalent. This unwillingness brings t’o mind the story of a mountaineer who followed his father’s custom of placing a stone in one end of his grain sack in order to balance it on his saddle before starting to the mill. A tourist suggested that the stone be left out and the grain distributed equally in both ends of his sack. The mountaineer replied emphatically, “What was good enough for Dad is good enough for me.” The “business graveyard” is full of concerns whose managers had similar feelings.
A cost system should be accepted or rejected on its merits. Expensive ones have been discarded before they have been given a fair trial. Cost accountants are not infallible and their work is not always of a high grade. As a result, cost systems have been junked because they were inherently faulty, or because they have been improperly operated, even though practicable.
Assistance from Agencies in Overcoming Objections
A convincing selling talk is easier to make today than a decade ago, because opposition to cost systems has been decreased by the campaign of education conducted by numerous agencies, such as trade associations, the National Association of Manufacturers, the Federal Trade Commission, the National Association of Cost Accountants, and others. These agencies are disseminating information which has disclosed the value of a cost system to many who were formerly ignorant of its advantages. Nevertheless, despite the good work of such agencies, too many manufacturers are still unaware of the value of a cost system. The cost accountant should be able to state forcefully what its advantages are.
Advantages of a Cost System—1. Accurate Unit Costs
One of the most important advantages of a good cost system is that it shows accurate unit and total costs. A progressive manufacturer wants to know the costs of his individual units of product. Total costs alone do not satisfy; neither do average costs for the business as a whole.
actual case will illustrate this point. Two manufacturers, A and B, produced several grades of soil pipe. The former kept only average unit costs for all products. The latter recorded separately the exact unit costs of his different products. At the close of a fiscal period A’s profits were disappointing because his gross sales had been large. An analysis of his sales showed that most of the increase was in one line. A calculation of the costs of this line showed that he had been selling it below cost. Since B had realized that he could not meet A’s “below cost” price, he had been gradually discontinuing the manufacture of this line and buying it from A. Most of A’s sales had been made to B, and A’s ignorance of his exact costs had forced him to the verge of bankruptcy.
With exact costs, profitable and non-profitable lines are clearly recognized. Thus, sales departments can select the lines on which to allow commissions, can decide on the
‘amounts of commissions, and can choose the lines to “push.” Unprofitable lines, it is true, are not always abandoned. They
t may be continued—
1. For the sake of their advertising value.
2. For the purpose of completing a line.
3. For maintaining production in slack seasons because
of organization and equipment which is expensive, due to the fact that part of the overhead is fixed, and continues regardless of changes in the volume of production.
The overhead formerly charged to a product which is no longer being made must be borne by the products still being manufactured. If the production of the remaining units is increased sufficiently, thus taking up the “slack,” so to speak, higher unit costs do not necessarily result. The main effort is to increase the sales of the paying product.
2. Aids All Departments
One advantage which is too little appreciated is that a cost system aids all divisions of an enterprise—the production, selling, and financial. Cost records should not be regarded simply as post-mortem data. While auditors should not use accounting data for purposes of prophecy, the cost accountant works under no such ethical prohibition. One of the chief functions, indeed, of the cost accountant is prophecy.’ Aided by him, the production and selling divisions use the historical value of records as an aid to prophecy. Instead of looking backwards, they scan the future, so as to detect anything which indicates a squall or a storm. Many progressive financial managers and treasurers estimate immediate and future capital requirements with the aid of cost data. Thus they prevent the tying up of too much capital in inventories, and can arrange with commercial banks for seasonal loans to be used in carrying the “peak” load of the business.
In order to accomplish this triple purpose, cost data should be timely, and available for analysis shortly after the close of each cost period. If the data are slowly assembled, it is impossible for the production division to ascertain the causes of cost fluctuations in time to apply effective remedies. In the old phrase, it is of no avail to lock the barn after the horse is stolen. The sales division wants prompt information also. It should not be forced to plan its campaigns on the basis only of normal or average costs. It needs up-to-date information of current and unusual costs in order to push sales with vigor and intelligence. Much of the value of a cost system is lost by the financial division unless the cost of current units can be studied. Unfortunately, there are still many non-progressive financial divisions that are interested in the “where, when, how, and why” of disbursements, and are apt to regard records as mere history. The influence of progressive officials, however, is making itself felt. When the soundness of their view is universally recognized, prompt assembling of data will be regarded as a necessary characteristic of a usable cost system.
3. Waste Eliminated
In all industries, idleness of machines means a dead loss and should be reduced as much as possible. Cotton manufacturers, for example, cannot always sell their product at their own figure. They may be forced to sell in a “buyer’s market” or to let their machinery stand idle. A great advantage of a cost system under such circumstances is that it shows the mill-owner the fabrics which afford the largest returns and which therefore he should manufacture.
Concerns which manufacture new specialties that are patented, frequently have no cost systems because the selling prices are much higher than possible costs. Even in such cases, however, much waste could be eliminated if costs were known. As the date approaches on which the patent expires, the need for a cost system increases, because the advantage of the patent does not exist after the expiration, except as it may have built up good-will. Even a more important reason for a cost system in this case is that more money could be made during the life of the patent with a cost system than without one.
4. A Basis for Fixing Selling Prices
It is impossible to fix intelligently the selling prices of products unless costs are known. As Lord Bryce has remarked: “Three-fourths of the mistakes a man makes are made because he does not really know the things he thinks he knows.” It is no longer safe to operate a business by simply adding to prime cost an arbitrary percentage deemed sufficient to cover both factory burden and selling and administrative expenses, and then to trust blindly that the selling price will be high enough to cover all costs and to allow the desired margin of profit. In many concerns today, costs are figured in no such blind fashion but are carried to the fraction of a cent. That fact often turns failure into success.
These detailed costs depend largely on the time necessary to make the product. Indeed, according to an advanced concept of modern management, the ultimate unit which is sold in a producing or trading business is time, namely: the time of the machinery and equipment, the time of the employees, the time capital is tied up in raw materials and supplies, and the time of management. It would seem fair, therefore, to charge higher for the products which require the greatest amount of time components, considering, of course, the costs thereof, and assuming that the use of time is economical; and to charge higher for work of a complex nature than for work which is simple.
5. A Basis for Standardizing Costs
The cost used as a basis in fixing selling prices should be the standard costs of normal production rather than abnormally low costs or abnormally high costs. Standard costs occur, according to some authorities, when the plant is running 80% or 90% of its possible capacity. If the plant is running overtime, production is above normal and costs are below normal, provided the concern is operating under the law of decreasing costs or increasing returns; selling prices based on such costs may be inadequate to cover the costs when production slumps. On the other hand, if selling prices are established when production is below normal and the costs above normal, they may be above the competitive level; as a result, only a small volume of orders may be secured. Thus the importance of standards is seen. Standards are not immutable; they often change overnight. While they are fixed and applicable, however, their worth in planning and in enabling comparisons to be made against them is inestimable.
One valuable feature in standardizing costs is the predetermination and application of standard or normal departmental burden rates. (See Chapter XVII.)
Inasmuch as cost systems enable manufacturers to determine standard prices, and therefore facilitate price-fixing, a few economists believe that the adoption of uniform cost systems will paralyze the vigor of our prevailing system of competition. Standards, however, are not always observed. For example, manufacturers may openly or secretly fix selling prices in defiance of law instead of basing them on their own individual costs. After leaving the “price-fixing” conference, many manufacturers book orders at a price lower than the “set” price. This fact tends to show that a uniform cost system per se does not result in secret price-fixing.
It is granted, however, that the use of such systems tends to stabilize prices by reducing cut-throat and ruinous competition which has been due to ignorance of accurate costs. Moreover, a more widespread use of cost standards would have prevented many uneconomical consolidations. Consolidations of competing firms often disclose the fact that the selling prices of some of the constituent firms have been below cost. Any manufacturer who produces without a knowledge of costs is a gambler. He is a menace to his trade and the community at large.
Two Business Fundamentals
In determining selling prices the manufacturer should hold in mind two business fundamentals:
1. “Every manufacturer who furnishes a product of good quality and who can make reasonable deliveries, is entitled to his share of the available business at a fair and reasonable profit.”
2. “Any concern which purchases a product below the cost of production is enjoying something to which it is not entitled and which really belongs to the manufacturers of the particular product.”1
6. An Aid in Preparing Statements and Tax Returns
If perpetual inventories for raw materials, work in process, part-finished stock, finished stock, etc., are kept, it is not necessary to take physical inventories prior to the compilation of financial statements. (See Chapter XXIX.) As a result, balance sheets which reveal the financial status of the concern can be prepared monthly; profit and loss statements showing the monthly changes in the financial status of the manufacturing, selling, and administrative departments can also be drawn up; and in addition a statement which includes the sales of each salesman, or the sales for each geographical unit, etc., can be made.
The data in financial statements is also used in preparing tax returns. An honest manufacturer neither wishes to evade his share of the taxes nor to pay more than his share. In order to feel sure that he is preparing correct tax returns, he must know his costs. Probably the income and excess profits tax laws, as much as the intensity of competition, have caused manufacturers to realize the value of a cost system.
Financial statements also have a credit value. A manufacturer can more easily obtain an adequate line of credit if he presents his creditors with accurate and intelligible financial statements based on a good cost system. In fact, some creditors absolutely refuse to grant credit unless the debtor furnishes financial statements. The manufacturer himself, before deciding to extend credit, relies largely on his customer’s financial statements. His ability to interpret these statements
1C. E. Knoeppe!, ”The Philoioph7 of Costs.” Induotrial Managemtnt. September, 1919.
—to create from the figures a picture of his customer’s business—reduces considerably his bad debt losses.
Furthermore, the manufacturer must know the sales, costs, and profits of customers’ accounts before he can judge as to whether it is profitable to carry certain customers. Such data also enable the manufacturer to decide whether he will sell his goods to his old customers at a lower price than to his new customers, or whether to allow the former some concessions in the way of additional work.
7. The Basis for Comparing Periodical Costs and Profits
With accurate profit and loss statements it is possible to make comparisons for different periods of the costs and profits of the whole business and the subdivisions thereof, such as the operating, selling, and administrative departments, and for the processes, jobs, and lines of product. Furthermore, with detailed cost data a basis is provided for the comparison of total cost and the various elements of cost with the past costs of similar units, with estimated or predetermined costs of the same unit, and subsequently with the cost of similar units. In order to make cost data valuable for comparisons as between different periods, it is often necessary to keep the details in terms of units of material and labor as well as in monetary terms.
By comparing balance sheets as well as profit and loss statements, changes in assets, liabilities, and capital can be ascertained.
8. An Aid in Formulating Policies
After comparisons are made, future policies can be formulated with more assurance, because they are based on accurate knowledge rather than on guesswork. Even so, many of the manufacturer’s activities still partake of the nature of gambling. He makes experiments on new designs which often prove worthless. He hires new employees who do not always come up to expectations, and whose discharge increases the labor turnover.
Despite the growth of scientific methods in business under the competent direction of industrial engineers and cost accountants, manufacturing is still more of a gamble than the banking business and most merchandising businesses. Banks make loans up to a certain percentage of the current assets of the borrower, thus amply protecting themselves. Merchandising establishments operate under a more extensive code of standards than manufacturing enterprises, which minimizes their risks. The hazards of manufacturing, however, are being constantly reduced by standardization.
While standards have long been the buttress of the older sciences, such as the natural sciences, their importance in the science of business has only been realized within recent years. As Clinton E. Woods2 well states, the standardization of product is the engineer’s first problem. Standardization results in the reduction of the lines carried. The most successful plants are the ones with comparatively few lines, because their activities can be consolidated, and more attention can be given to large-scale production if the concern operates under the law of increasing returns (or the law of decreasing costs).
Too many firms vary their production with changes in sales conditions by increasing production as sales increase, and vice versa. In periods of depression, equipment and labor may be idle with the result that unit costs increase. In many cases it would be better to cut the selling prices slightly rather than to “hold the market,” because the plant could then run more normally, and turn out product that could absorb the “fixed” overhead, which otherwise would be a dead loss. Production, therefore, should be as normal as possible. It is
•In “Unified Accounting Methods for Industrials,” Ronald Press Company, 1917.
helped by standardized equipment which depends on a close correlation between operating departments, so that all may operate as uniformly as possible.
Normal production is also helped by standardization of labor, which materially decreases the labor turnover. One of the aims of scientific management is to bring about a standardization of labor approximating in degree the standardization of equipment which has been accomplished largely through the interchangeability of parts for machines.
9. Carrying Out Policies
While immediate steps to effect savings can be taken subsequent to the installation of a system it is not until the end of the month, or later (depending on when financial statements are completed), when comparisons between the costs under the old system and the new system can be made, that the full effect of economies introduced can be felt. As stated, new policies are then determined, and the results are measured at the close of the next fiscal period.
During the period, efforts should be made to reduce wastes of material, labor, and overhead. If cost records are maintained, these wastes can be determined and unnecessary leaks can be remedied. On account of the constantly increasing costs of labor, due among other things to the demands of the workers for higher wages and shorter hours, which if granted do not always increase production, and the increasing costs of material and burden, the manufacturer is forced to do all within his power to decrease the reducible charges. Actual costs aid in predetermining or estimating costs. A predetermination of costs prevents the birth of waste or at least stunts its growth.
It is only by the use of cost records, therefore, that the activities of modern business conducted under the factory system can be visualized, and proper policies formulated and carried out. In the days when industry was in the handicraft and domestic stages, the need for a cost system was not so imperative, since the owner of the business was intimately in touch with its details. Today this is seldom the case. However, one present-day example of simple management may be cited. A small producer of neckties has his business in a small room with his desk in the center and his operatives around him. A shortage of labor or materials, or a breakdown in machinery is soon discovered. Contrast the situation of this manufacturer with that of the president of one of our largest corporations today. It is a physical impossibility for him to be present in all of the operating subsidiaries. Hence, he must rely on records in visualizing the conduct of the business in all its ramifications. With a cost system tied up with the general records by means of controlling accounts, his sight is intensified, and he becomes a modern Argus.
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