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The construction of a cost system requires a thorough understanding of (1) the organizational structure of the company, (2) the manufacturing procedure, and (3) the type of information which management requires of the cost system.
1. The organization chart gives a graphic picture of the ranking authority of superintendents, department heads, and managers who are responsible for (a) providing the detailed information needed by the accounting division in order to install a successful system; (b) incurring expenditures in personnel, materials, and other cost elements, which the cost accountant must segregate and report to those in charge. The cost system with its operating accounts must correspond to organizational divisions of authority so that the individual supervisor, department head, or executive can be held ‘‘accountable’’ for the costs incurred in the department.
2. The manufacturing procedure and shop methods lead to a consideration of the type of pay (piece rate, incentive, day rate, etc.); the method of collecting hours worked; the control of inventories; the problem of costing tools, dies, jigs, and machinery; and many other problems connected with the factory.
3. The organizational setup on the one hand and the manufacturing procedure on the other form the background for the design of a cost system that is based on (a) recognition of the various cost elements, (b) departmentalization of factory and office, and (c) the chart of accounts.
Any cost system should be perfected so that it will (1) aid in the control and management of the company; (2) measure the efficiency of personnel, materials, and machines; (3) help in eliminating waste; (4) provide comparison within individual industries; (5) provide a means of valuing inventories; and (6) aid in establishing selling prices. In an organization departmentalized or segmented along product lines, it is often arbitrary to allocate certain indirect costs especially when common facilities or personnel are shared. This is because there is no objective basis to compute a division of common costs. Control methods for evaluating performance often rely on the segment margin statement.
The cost system’s value is greatly enhanced when it is interlocked with a budgetary control system. When budget figures are based upon standard costs, the greatest benefit will be derived from such a combination.
Basically, two types of cost systems exist: (1) the actual (or historical) and (2) the standard (or predetermined). The actual cost system accumulates and summarizes costs as they occur and determines a final product cost after all manufacturing operations have been completed. The job is charged with actual quantities and costs of materials used and labor expended; the overhead or burden is allocated on the basis of some predetermined overhead rate. This predetermined overhead rate shows that even the so-called actual system does not entirely live up to its name. Under a standard cost system all costs are predetermined in advance of production. Both the actual (historical) and the standard cost system may be used in connection with either (1) the job-order cost method or (2) the process cost method.
Budgets And Standard Costs
A budget provides management with the information necessary to attain the following major objectives of budgetary control: (1) an organized procedure for planning; (2) a means for coordinating the activities of the various divisions of a business; (3) a basis for cost control. The planning phase provides the means for formalizing and coordinating the plans of the many individuals whose decisions influence the conduct of a business. Sales, production, and expense budgets must be established. Their establishment leads necessarily to the second phase of coordination. Production must be planned in relation to expected sales, materials and labor must be acquired or hired in line with expected production requirements, facilities must be expanded only as foreseeable future needs justify, and finances must be planned in relation to volume of sales and production. The third phase of cost control is predicated on the idea that actual costs will be compared with budgeted costs, thus relating what actually happened with what should have happened. To accomplish this purpose, a good measure of what costs should be under any given set of conditions must be provided. The most important condition affecting costs is volume or rate of activity. By predetermining, through the use of the flexible budget, the expenses allowed for any given rate of activity and comparing it with the actual expense, a better measurement of the performance of an individual department is achieved and the control of costs is more readily accomplished.
In the construction of overhead budgets the volume or activity of the entire organization as well as of the individual department is of considerable importance in their relationship to existing capacity. Capacity must be looked upon as that fixed amount of plant, machinery, and personnel to which management has committed itself and with which it expects to conduct the business. Volume or activity is the variable factor in business related to capacity by the fact that volume attempts to make the best use of the existing capacity. To find a profitable solution to this relationship is one of the most difficult problems faced by business management and the accountant who tries to help with appropriate cost data. Volume, particularly of a department, is often expressed in terms of direct-labor hours. With different rates of capacity, a different cost per hour of labor will be computed. This relationship can be demonstrated in the following manner:
The existence of fixed overhead causes a higher rate at lower capacity. It is desirable to select that overhead rate which permits a full recovery of production costs by the end of the business cycle. The above tabulation reveals another important axiom with respect to fixed and variable overhead. Fixed overhead remains constant in total but varies in respect to cost per unit or hour. Variable overhead varies in total but remains fixed in relationship to the unit or hour.
Standard Costs
The budget, as a statement of expected costs, acts as a guidepost which keeps business on a charted course. Standards, however, do not tell what the costs are expected to be but rather what they will be if certain performances are attained. In a well-managed business, costs never exceed the budget. They should constantly approach predetermined standards. The uses of standard costs are of prime importance for (1) controlling and reducing costs, (2) promoting and measuring efficiencies, (3) simplifying the costing procedures, (4) evaluating inventories, (5) calculating and setting selling prices. The success of a standard cost system depends upon the reliability and accuracy of the standards. To be effective, standards should be established for a definite period of time so that control can be exercised and variances from standards computed. Standards are set for materials, labor, and factory overhead. When actual costs differ from standard costs with respect to material and labor, two causes can generally be detected. (1) The price may be higher or lower or the rate paid a worker may be different; the difference is called a material price or a labor rate variance. (2) The quantity of the material used may be more or less than the standard quantity or the hours used by the worker may be more or less. The difference is called material-quantity variance or labor-efficiency variance, respectively. For factory overhead, the computation is somewhat more elaborate. Actual expenses are compared not only with standard expenses but also with budget figures. Various methods are in vogue, resulting in different kinds of overhead variances. Most accountants compute a controllable and a volume variance. The controllable variance deals chiefly with variable expenses and measures the efficiency of the manager’s ability to hold costs within the budget allowance. The volume variance portrays fixed overhead with respect to the use or nonuse of existing capacity. It measures the success of management in its ability to fill capacity with sales or production volume. These two variances can be analyzed further into an expenditure and efficiency variance for the controllable variances and into an effectiveness and capacity variance for the volume variance. Such detailed analyses might bring forth additional information which would help management in making decisions. Of absolute importance for any cost system is the fact that the information must reach management promptly, with regularity, and in a report that is analytical, permitting quick comparison with targets and goals. Only in this manner can management, which includes all echelons from the foreman to the president, exercise control over costs and therewith over profits.
