Deliverable 4 - Costing and Decision Making

Why is Cost Accounting Important?

Any company that is required to have their financial statements audited by an independent accountant must comply with Generally Accepted Accounting Principles (GAAP) (IFRS outside of the US). This means that that ALL product costs will appear on the inventory line on the balance sheet until the product is actually sold and then transferred to the income statement as cost of goods sold to match expenses with revenues.

Overview of Product Costing Methods

Companies will use one or more product costing method to assign the appropriate costs to a manufactured product. Regardless of the method that is used, the goal is the same: To assign the appropriate amount of cost to a product using the best product costing method for that particular production and decision-making environment. There can be a substantial difference in cost depending on the method used, so management must be careful when choosing a method and what its intended use is. For example, a costing method intended for incremental analysis may not be appropriate for long-term decision making. In addition, there are only certain methods that are approved to use in financial statement preparation.

Deciding on the Method of Costing

Choosing the best method really depends on the decision environment and whether the cost information is for external or internal reporting.

External Reporting:

· Absorption Costing:

· GAAP

· Variable Costing:

· Not GAAP

· Throughput Costing:

· Not GAAP

Internal Reporting

· Absorption Costing

· Used to save costs

· Variable Costing

· Used to evaluate performance and for decision making

· Throughput Costing

· Used for short-term capacity decisions

Inventory Costs

· Absorption Costing:

· Direct materials

· Direct labor

· Variable overhead

· Fixed overhead

· Variable Costing:

· Direct materials

· Direct labor

· Variable overhead

· Variable SG&A expenses*

· Throughput Costing

· Direct materials

Period Costs (expensed when occurred)

· Absorption Costing:

· SG&A expenses

· Variable Costing:

· Fixed overhead

· Fixed SG&A expenses

· Throughput Costing:

· Direct labor

· Variable overhead

· Fixed overhead

· SG&A expenses

External reporting means that the costing information is going to be used external to the company. Anytime financial information is released to the public, it must comply with U. S. GAAP. For external reporting, the only GAAP approved costing method is called absorption costing. This costing method requires that the product cost include ALL manufacturing costs. This basically means that product costs may be incurred in one period (when goods are produced) and recognized in another (when goods are sold). All other costs (non-product) are recognized when incurred and called period costs.

Internal reporting means that the costing information is only going to be used within the company for decision-making process. Internal reports do not have to comply with U. S. GAAP and can be designed by management to suit the needs of the organization. For internal reporting, absorption, variable and throughput costing methods are often used.

Costing Methods

Absorption costing is where the product “absorbs” all manufacturing costs, both fixed and variable. Manufacturing costs are assigned to one of three inventory accounts (raw materials, work in process, finished goods) prior to the sale, and then transferred to the income statement (cost of goods sold) upon sale to comply with the matching principle. All other costs, typically selling and administrative costs, are expensed in the period they are incurred and referred to as “period costs” since they do not benefit any future period. Absorption costing can be used for both internal and external reporting as it is the only method that is GAAP approved. Some companies use absorption costing for both internal and external reporting to save time and money by using just one method.

Variable costing is where ALL costs are divided into fixed and variable categories and only variable costs are inventoried. Variable costing is often used by companies to hold production managers accountable for only the costs that they have some control over, applying the theory that a production manager cannot change or effect a fixed cost. Variable costing is typically used for short-term decision making. Keep in mind that a company still needs to cover their full costs to stay in business.

Throughput costing is where only direct materials are inventoried. All other costs, direct labor, manufacturing overhead and period costs are expensed as incurred. Throughput costing is also used for short-term decisions. It can also be useful in making special order type decisions where there is extra factory capacity involved.

Costing methodologies can produce significant variations in what we call total costs. Before a costing method is selected, we must fully understand what the information is going to be used for. Once we understand the use of the information, we can select a method that best fits our needs under that circumstance.

Resource(s)

Wiley GAAP 2019 : Interpretation and Application of Generally Accepted Accounting Principles