Before total costs may he assembled and the goal of cost accounting reached, all charges which make up those costs must be recorded separately and in detail. This raises an inquiry as to the meaning of the term “cost.” The conceptions of the term are by no means uniform; but the various concepts of cost can at least be grouped into two main classes: (1) non-technical, and (2) technical. Each of these two classes might be subdivided. Under (1) would fall the individual’s and the economist’s concept of cost; and under (2) the merchant’s and the manufacturer’s concept of cost.
Non-Technical Concepts of Cost
The individual’s concept of cost is usually one of outlay. He measures the cost of an article by the amount of expenditure. He says, for example, “My hat ‘cost’ me $5.”
The economist’s conception of cost is essentially the same as the individual’s, but he subdivides the costs of an enterprise into its production factors, namely: land, labor, capital, and management. The casts of the factors are rent, wages, interest, and profits. Some economists regard land as a class of capital and not as a separate production factor. Some economists do not consider profits as a cost but as the difference between selling price and costs. A discussion of the economic theories of rent, wages, interest, profits, alternative costs, and opportunity costs does not fall within the scope of this volume. For that, the reader is referred to any good work on the principles of economics. The interest here lies only in the general concepts of costs and the classifications of cost.
Technical Concepts of Cost
The merchant’s first concept of cost is the invoice price of goods bought. This concept does not include items such as freight, cartage, warehousing, insurance, traveling, and marketing charges. The merchant adds these items to his initial invoice cost after goods are received and merchandising plans are put in operation.
Theoretically (as mentioned in Chapter I), any type of accounting which shows costs by “units” can be called cost accounting. But as the subject matter of this book is limited to cost accounting in factories, this chapter deals only with the manufacturer’s conception of cost. To him “costs” are heterogeneous, including many and various elements or components.
Every element or component of cost comes under one of the following classes:
1. Direct material, as the wood used in making a chair.
2. Direct labor, as the wages of the employee who makes
3. Overhead, as supervision, depreciation, etc., charge
able to the chair.
The classes of material, labor, and overhead are multifarious, but the general principles underlying the accounting of each class are the same.
Definition of Cost ,
Thus cost may be defined, as the term is used m cost accounting, as follows: any payment or charge for direct ma
terial, direct labor, or overhead, the purpose of which is to create marketable assets—finished product. Various combinations of cost arise 1n the creation of marketable assets. This point may be made clear by drawing an analogy between a cost system and a water purification system. The impure water flows into a reservoir. It is purified by chemical treatment and as it flow.; out of the other end of the reservoir it has become a commercial commodity. The expenses of purification have made it a marketable product. Just so, raw material flows into the receiving room. To its cost is added the cost of direct labor and overhead, and the material flows out of the shipping room as a finished marketable product.
It is important to observe that capital expenditures (expenditures for assets) and exchanges of certain assets for other assets are not costs within the meaning of the above technical definition of cost. While the purchase of a machine, for example, in the non-technical sense “costs” money, it is not a cost as the term is used in cost accounting. This purchase with other capital expenditures, to be sure, is entered in the general books of the purchaser, but not in the cost books. This does not mean, however, that the two classes of books are divorced, for, as a matter of fact, they are interlaced into a finished fabric by the thread of controlling accounts.
Although committees of various accounting societies have been working for years to standardize terminology, until a short time ago little uniformity of cost classification, or cost terminology, or cost allocation existed as between different firms even in the same industry. Much has been done recently within given industries—whose members have adopted socalled uniform cost systems—towards uniformity in terms, but little has been accomplished as between unrelated industries. In the ma1n, cost systems are still as different as indi
22 COST ACCOUNTING
viduals. What is a direct charge in one cost system may be an indirect charge in another.
Classification of Costs
Costs may be divided broadly into two large groups:
1. Manufacturing or production
2. Selling and administra’.ive
In the former group are heat, light, power, wages of employees, etc. In the latter group are salesmen’s salaries, office expenses, advertising, etc. No attempt is made here to enumerate the various items in the two groups.
One purpose of the classification just given is to enable the costs of the two primary divisions of a business to be ascertained separately. Responsibility for production and for selling and administration should not, under any form of management, be shouldered by one and the same individual. The need of this separation of responsibility is particularly in evidence when the factory and general offices are not in the same locality. If divided responsibility exists, means should be provided to control it. Control is dependent on information with regard to both the manufacturing and the selling branches of the business. The information necessary for control is the cost data. Hence, a cost system should be so planned as to maintain a distinct separation between factory accounts and selling and administrative accounts, and to unify both classes of accounts by controlling accounts. This A B C of cost accounting has been emphasized in cost literature only within recent years, although the principle has been known and observed for some time.
Direct and Indirect Costs
After costs have been classified in such a way as to separate the manufacturing from the selling costs, they must next be subclassified in order that a maximum of accuracy in recording may be obtained. Costs are therefore further divided into direct costs and indirect costs.
Direct costs are payments or charges for labor and material expended upon a definitely determined unit or product. Small costs, however, are not charged directly to the product, even when the latter can be determined, unless the increased accuracy of the records justif1es the clerical work entailed. It follows, therefore, that indirect costs are those which cannot be charged economically or directly to the product. An example of a direct cost is the cost of the raw material is a chair. Indirect costs arise from the following sources:
1. Indirect material—rags used to wipe off chairs and
tools; or new tools used to replace those discarded are good examples.
2. Indirect labor—for instance, wages of foremen who
supervise the employees in several departments where chairs are made.
3. Fixed charges—depreciation, taxes, insurance, etc.
Adherence to the above cost classification adds to the accuracy of the records for this reason: By charging items directly to the cost units (when economical), the remaining costs (indirect costs) are less than if certain items legitimately “direct” were treated as indirect costs. Indirect costs are distributed over the product in as accurate a manner as possible, but such charging is less accurate than direct charging. For instance, raw material can be accurately measured and charged directly against the chair. The depreciation of the equipment used in manufacturing the chair cannot be determined with any measuring device. It must be estimated. Consequently, the total depreciation of equipment is distributed over all units of product (chairs) made. Any charging, therefore, which reduces the distributable costs, thereby increases auto matically the accuracy of the cost records. The growing observance of the principle of direct—that is to say correct— charging has done much to improve the exactness of cost accounting.
The exercise of a little judgment in correct costing more than pays for the effort expended. The salary of a foreman, for example, who works only in department A should be charged only to A. But his pay very often is incorrectly treated as indirect cost and apportioned to several departments, none of which, except A, received any benefit from the foreman’s services, and consequently should not be charged with any portion of his salary.
In the early days of accounting, in all probability, no distinction was made between direct costs and indirect costs, since concerns were interested in the total costs of the business and not in unit costs. If one wishes to buy a suit he simply inquires as to the total price. If, however, he wishes to buy only a pair of trousers, or two pairs of trousers with one suit, he naturally ascertains the prices of the separate garments.
Necessity of Controlling Costs .
If a druggist wishes to mix a compound, he secures enough of each chemical element necessary to the admixture. In order to obtain the compound desired he requires unequal amounts of different ingredients. Such is true if the mixture is not homogeneous. As mentioned before, costs are heterogeneous. In making his article or product, the manufacturer, assuming that he has his equipped plant, incurs three elements of cost—material, labor, and overhead—which are as diverse as the chemicals of the druggist. The inherent character of these elements, without any productive act of the manufacturer, marks them as distinct. The manufacturer must simply recognize the fact, and model his system so as /
to preserve the distinguishing characteristics of each. Furthermore, like things are usually easier to control than unlike things. Two high-spirited horses or two plugs in a team are easier to control than one of each in a team, even granting that the impetuosity of one is partially curbed by the sluggishness of the other, for the reason that two independent wills must be reckoned with, and the same method of control cannot be applied to each. So it is in cost accounting; unlike items require different accounting treatment and different methods of control.
Furthermore, the advent of the factory system and largescale production has called for large and varied disbursements. The differentiation of expenses is an outgrowth of mass production and the important principle of production today, that unit costs decrease as production increases, assuming that certain overhead items are “fixed.”
If different costs are to be controlled, their amounts must be known and compared with past costs and with standard costs. Costs cannot be subjected to the highest degree of control unless they are known, and then compared with standard costs.
Relation of Terms: Expense, Burden, Overhead
Indirect costs—synonymous with overhead costs—are variously termed “expense,” “burden,” “overhead,” and “loading.” The English equivalent of “loading” is “oncost.” There is some merit in not regarding as synonymous the terms expense, burden, and overhead. The word “expense,” for example, might be applied to cost items (other than prime or direct cost) when they are originally incurred and charged to accounts with descriptive titles; for example, Teaming Expense, Heat, Light, and Power Expense, etc. These accounts are split up, broken down, or distributed to various departmental burden accounts. They may, in fact. first be closed into other accounts which accumulate the expenses of indirect, non-productive, or service departments. These accounts in turn, along with all other expense accounts, ultimately are closed into departmental burden accounts and hence never appear in the unit cost sheets of finished product.
A departmental burden account is kept for each productive department. The word “burden,” therefore, would be used as the name of the account which accumulates all costs (other than prime costs) for each productive department. The word “overhead” might be reserved to indicate the entire class of indirect cost, which is in turn divided into “expense” (originating) and “burden” (final).
While the above differentiation between the terms expense, overhead, and burden is in present-day practice not adhered to generally, it is here offered in the interest of clearness.
Determining the Selling Price
Despite differences in terminology, fairly well-defined ideas are held as to items that compose manufacturing cost, which is also known as “factory cost,” “production cost,” or the “cost to make.” These items are direct material, direct labor, and overhead. They make up the cost of finished product, which should not include any selling or administrative expenses. A manufacturing superintendent, for example, who is partly a manufacturing official and partly a selling and administrative official, consequently spends a part of his time in the factory and part in the selling and administrative offices. Hence his salary should be charged to the factory and to the office respectively, in proportion to the benefits that each derives from his services.
To the manufacturing cost of an article is added selling and administrative expense. The sum of these is the total cost of the article or its cost to make and sell. Examples of selling expenses are salesmen’s salaries and commissions, traveling expenses, etc. Administrative expenses consist of salaries of general officers and clerks, etc. To total cost is added the prof1t desired and the result is the selling price.
Philosophy as an Aid to Technique
An understanding of the philosophy of cost accounting will dignify the technique of the subject. The technique is the road to the desired goal, namely, accurate costs and accurate financial statements. The philosophy of cost accounting interprets the practice of cost accounting. With the aid of correct theory, the accountant sees each cost component in its proper perspective. His vision of the ultimate aims of cost accounting is not obscured by the detailed work—oftentimes of a “hack” nature—which piles up before him.
Just as one must slowly and carefully climb a mountain peak in order to enjoy fully the grandeur of the summit which he knows is there, so the cost accountant must wrestle with the details of his cost system before he experiences the joy of work well done and realizes his ultimate purposes. The subsequent chapters deal with the technique of cost accounting.
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