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11.1 Accounting

Consider a company that uses one production plant to make various models of several products, each sold at different prices. How can the company determine how much profit it makes on each model of each product? Consider a job shop that bids on jobs from customers. How can the company determine the amount of profit it will make at different bid levels? Consider a company that makes a certain part that goes into its product. How can the company determine how much it costs to make that part in order to compare that cost to the cost of buying the part from a supplier? Consider a company that is considering purchasing a new machine to reduce the time needed to manufacture a part. How can the company determine if the reduction in time is worth the cost of purchasing the machine?

Cost accounting, and its newer variant Activity Based Costing, are ways to answer those types of questions. A lot of common sense goes into cost accounting. The cost for a company to make a product includes:

1. Direct material cost.
2. Direct labor cost.
3. Everything else.

Costs in the first two categories are relatively easy to compute. For example, in the first category, the product might need a certain amount of high grade steel, which the company purchases from a particular supplier. The IE can find out from the purchasing department how much the company pays for steel from that supplier. Scrap must be taken into account in computing the cost of the steel that goes into the product. In the second category, the labor cost can be computed for each worker who helps produce the product by using the hourly rate (including benefits and vacation time) and the time that worker spends on the part. That time would probably have been determined by the IE using methods we discussed in Section 9.4

The hard part is, of course, the third cateogry which includes all the costs that can’t be directly allocated to any one product: machinery, office supplies, salaries for maintenance workers, salaries for management, and so forth.

Traditional accounting usually allocates these costs in proportion to direct labor costs or in proportion to machine hours used by each product. If manufacturing one type of product takes 2/3 of the direct labor costs of a plant, then traditional accounting allocates 2/3 of the overhead costs to that product. The goal is to use the allocation basis that best reflects what causes the cost.

Activity Based Costing extends the idea of linking costs with causes of costs. First the costs in category 3 (above) are allocated to activities (for example, purchasing, customer service, running the machine shop) and then those activity costs are allocated to specific products. For example, costs of paper might be allocated to activities based on the number of office workers assigned to each activity (having more office workers causes more use of paper); the costs of the customer service activity might be allocated among products based the number of customers or the number of customer orders for each product (having more customers or having more orders causes more need for the activity of customer service).

The article , from MMS Online, does a great job of explaining Activities Based Costing (ABC).