02 Cost Accounting

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Cost Accounting

The cost engineer must be familiar with cost accounting since it is theaccountant who keeps the cost records. Moreover the cost engineer should bepart of a team in the allocation of overhead and other indirect costs. The firstpart of this chapter discusses the basic concepts of cost accounting and how

they are used on a project. The second part discusses various classifications ofaccounts. Although the presentation in the first part of this chapter favorswork associated with engineering and construction for the oil and chemicalindustries, the principles are general.

Readers interested in a more detailed discussion of the subject are referredto Humphreys (1991). This book, written under the sponsorship of the AACEInternational, the Association for the Advancement of Cost Engineering, givesan extensive treatment of the subject.

2.1PROJECT COST ACCOUNTING

An understanding of the terms total costandprofitis essential to gain anunderstanding of cost accounting. For a business to be successful, it must earna profit. Several terms for sales are employed by accountants, including sellingprice, contract value, or billable value. They represent the total expectedincome from the customer.

Considered next are the estimated costs of producing the product, be it amanufactured item or a service. Many firms use the term total base costandcommonly have a standard list that defines all the elements that account forthe cost of the work. Subtracting the total base cost from the estimated projectsales or income gives what is commonly termedgross profitor total overheadand profit. Another term used isgross margin.

Considered also are the costs involved in selling the product or service.

The most common terms used are overhead cost or selling and generaladministrationexpenses. These elements of overhead costs are discussed in

Copyright 2005 by Marcel Dekker


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more detail below. After deduction of the overhead costs there remains theprofit or loss before taxes. (Taxes were discussed in Chapter 1).

2.2ROLE OF COST ACCOUNTINGCost accounting, the principal subject of this chapter, expands the techniquesof financial accounting and is part of managerial accounting, as opposed tohistorical or audit functions. A general definition of accounting is:

Accounting is the art of recording, classifying, and summarizing in asignificant manner and in terms of money, transactions and events whichare, in part at least, of a financial character, and interpreting the results

thereof (Grady, 1965).

All accounting systems include three basic steps: recording, classifying, andsummarizing economic data, all three in terms of money. Classification ofaccounts is based on a listing called the chart of accounts, which plays amajor role in all accounting systems. It is employed extensively in computerapplications in the form of management information systems. A good chart ofaccounts structure provides the following:

A standard method by which a business prepares cost estimates in aconsistent manner

A means for recording and classifying cost to permit direct comparisonwith estimates and budgets

Facilities for creation of cost centers such as department or sections Means for dividing cost centers into smaller segments for ease of

control and for obtaining unit return cost data

The opportunity for cost engineers to follow the chart of accounts intrending the project costs and in preparing cost forecasts andmanagement cost reports.

Cost engineers should be completely familiar with their company s chart ofaccounts. Table 2.1 is an illustration of a general chart of accounts.

2.2.1Accounting TermsBefore we can consider various classifications of cost, some cost definitionsand a few additional accounting terms need to be examined briefly. Thedefinition for cost is:

the amount measured in money, cash expended or liabilityincurred, in consideration of goods and/or servicesreceived(AACE, 2003).

The most commonly used terms are listed in Table 2.2; these are all defined


either in the text of this chapter or as noted in Appendix B.


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Accounting uses a double-entry system for every transaction with valuation

always in terms of money. By way of example, in engineering with noaccumulation,

Input=Output

and similarly in accounting

Credit=Debit

The terms debitand creditare conventional and have no particular significanceas such. The distinction between the terms can always be resolved by reducing a

Table 2.1 Pro Forma Chart of Accounts

These are summary-level accounts, sometimes called control accounts. More detail can be provided by usingsubaccounts as required.Source: K.K.Humphreys, Jelens Cost and Optimization Engineering, 3rd ed., 1991, McGraw-Hill, Inc.,New York, p. 535. Reprinted by permission.



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transaction to a transfer of money between accounts with the accountantacting as an intermediate who transfers the value from one account to another.Suppose that a company pays a supplier $500 cash that is owed to the supplier.The account for the company records a balance transaction as follows:

Table 2.2 Accounting Terms

aAACE Standarddefinition in Appendix B.bSee Burden in Appendix B.

Here the suppliers account is a debit since $500 was put into the suppliersaccount. Similarly the cash account is a credit since $500 was obtained fromthe cash account.

Two basic classes of accounts must be distinguished:Real accounts: Real accounts are allowed to accumulate indefinitely and are

not closed out at the end of the year.Revenue and expense, or nominal accounts: These are cleared into capital atthe end of the year.

Real accounts are of two types. If they are owned by the business, they arecalled assets. Conversely those owed by the business are called liabilities. Inaccordance with the double-entry equation,

Debits=credits

Assets=liabilities and ownership

where ownership represents the owners equity in the business.The meaning of terms used in cost accounting varies from company to

company. Hence it is necessary to know exact meaning of terms as used bythe cost engineers company as well as the general meaning. For example, tosome accountants the term manufacturing expense does not include factoryoverhead since factory overhead is part of product cost and will funnel intothe expense stream only when the product costs are released as cost of goodssold. Cost of goods soldis a widely used term that is somewhat misleading inconnection with the meaning of cost (see next section). Cost of goods sold is



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an expense because it is an expired cost and is as much an expense as aresales commissions. Cost of goods sold is often called cost of sales.

The distinction between direct costs and indirect costs can cause confusion.The topic is discussed more fully below.

2.3CLASSIFICATION OF COSTS

Costs can be classified as unexpiredand expired, as summarized in Table 2.3.Unexpired costs (assets) are those which are applicable to the production offuture revenues. Expired costs are those which are not applicable to theproduction of future revenues and for that reason are treated as deductions

from current revenues or are charged against retained earnings. Some examplesare:1. Equipment and machinery. This could be automobiles, trucks, desks,

computers, or machines in a machine shop. All are assigned an estimateduseful life, and they are written off or depreciated over a given period of time.The useful life of any piece of equipment is determined by government regulationor by guidelines set by historical data. The guidelines are flexible and may bechanged from time to time by modern technology.

When the writeoff is made, the cost becomes an expired cost. The writeoffor depreciation, depending on what it is for, can be classified as direct, indirect,or overhead cost.

2. Raw materials inventory. An accumulation of unused items or components(raw materials) related to producing a product is called an inventory. Items inthe inventory may have been acquired at different times and at different prices.In such cases a rule or guideline is required to determine the value at which

Table 2.3 Unexpired and Expired Costs



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these units shall be transferred out of inventory and into expired costs. Therule applies to pricing and has nothing to do with which unit is removedphysically from the inventory.

A common method of inventory costing is FIFO, or first in, first out. Thecost of the oldest unit in inventory is used. Under conditions of increasingprices or inflation, lower acquisition prices are matched with higher sellingprices, resulting in higher accounting profit figures and higher income taxes.To avoid these effects, a method of evaluation can be used known as LIFO,or last in, first out, which matches current costs with current revenues. Howeverthe lower-cost items remain in inventory. The use of an average valuationrepresents an effort to find a compromise between the two methods.

3. Prepaid costs. These are costs for which cash has been expended for aservice or benefit that extends over more than one production cycle, or 1 year.For example, a 3-year $300 insurance premium may be charged originally toan asset account, Prepaid Insurance. Subsequent accounting for the cost willhinge on (a) the amount applicable to the current period, say $100 for the firstyear, and (b) the purpose of the insurance coverage.

Insurance on factory machinery is inventorial and is therefore transferredfrom Prepaid Insurance to an inventory account. Insurance on a sales office is

not inventorial and is therefore transferred from Prepaid Insurance to anoutright expense account. The same determination has to be made for localtaxes and rent.

4. Salaries. These can be an unexpired cost. Work on a particular productcould be done perhaps months before the final assembly of the items iscompleted. Also a portion of the product could be fabricated outside andreturned for final assembly. The salary is written off to the job or to productsin the end. Unexpired costs are found in balance sheets, and expired costs are

found in the profit and loss (income) section of the final statements.Cost data found in conventional financial statements, however, are for the

specific purpose of reporting to interested outsiders and are not necessarilyuseful for other applications. The requirement of selecting the appropriatecost type for individual objectives is important. No general rules are possiblebecause of the wide variety of circumstances.

Table 2.4 provides a summary.

Table 2.4 Classification of Costs



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2.3.1Direct Costs

Direct costs are also calledprime costs and are traceable directly to the productbeing manufactured or fabricated, such as the fabric in clothing. For an

engineering and construction firm one of the prime costs on a project is thedesign department workhours or salary.

In a manufacturing operation, costs are accumulated through three separateaccounts:

1. Direct material. Cost of materials, assemblies, and parts which areused for the completion of the project

2. Direct labor. Wages of workers who are participating in the

completion of the product3. Overhead.The costs of all other factors contributing to the completion

of the product (see Appendix B)

Material cost consists of the basic purchase price and all other expenses requiredto transfer the materials to the purchasers premises, such as transportation,insurance, and tariff duties.

Labor cost is made up of many different factors. It includes the basic hourly

rate for hours worked, overtime pay, social security taxes, vacation pay,holidays, sick leave, and so on.

2.3.2Indirect Costs

Indirect costs are all the costs of manufacturing that cannot be classified asdirect costs because it is either impractical or impossible. Each classificationis initially accumulated in a separate account and at the end of the accountingperiod is allocated to individual benefiting activities, such as a cost center orproject. It is a two-step procedure: accumulation and allocation.

Supervisory services, for example, benefit many units of profit and the costaccumulates in a separate account. At the end of the accounting period thecost is allocated to individual products as part of the overhead.

Modern technology tends to increase the share of indirect costs while theshare of direct labor cost is declining. This is really the purpose of automation

to replace direct labor cost with the indirect cost of machines.All businesses are organized by departments or cost centers, but the twoare not necessarily synonymous. Costs are accumulated by cost centers, whichmay or may not coincide with operating departments. Cost centers are locatedwhere costs can be measured and recorded as conveniently and accurately aspossible. The advantages of having departments and cost centers are:

1. A more accurate selling price can be gained for a product.

2. Cost can be controlled more easily.3. Long-range forecasting can be more exact.



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Cost engineers should maintain a close liaison with the cost accountants andthose who design and apply the cost accumulation system. Cost engineersneed to make the requirements known so that all work can be accomplishedwithin appropriate cost and practicality limitations.

2.3.3Overhead Costs

The classification includes all product costs that are not considered primecosts (direct material and direct labor). There is no limit to the possible numberof overhead classifications; however, principal groups are:

Indirect materials (also known as supplies): materials, such as lubricants,that do not become a part of the finished product.Indirect labor: the wages and salaries of employees who are not directly

connected with the manufacture of a product, such as supervisors,maintenance workers, and internal transportation workers. Frequentlythe cost of fringe benefits is included in this classification.

Facilities costs: both short-term cost of the current year and the depreciatedpart of long-term costs for the current year. The former includes

building and equipment maintenance, local real estate taxes, andother periodic items; the latter includes buildings and equipment.Service department costs: for facilities that support productionfor

example, accounting, laboratories, stores, cafeteria, and first-aidstations.

Overhead is considered one of the most tedious problems of cost accounting.Accumulated overhead costs are allocated in stages. First the overhead costs

are allocated to the cost centers and in turn are allocated to job order costsand process costs. With a large number of indirect cost classifications and alarge number of cost centers, the computations can be voluminous.

Cost engineers must recognize that the cost data that emerge from thesecalculations are affected significantly by the measures used for allocation,and they should understand fully the techniques used for the allocation. Abasis must be selected to allocate the costs fairly. Consider building maintenanceas an example. Measurement can be made on the basis of square feet and

allocated on the basis of floor space occupied by each cost center. In turn, costcenters must have a measure to allocate this overhead, which might be laborhours, machine hours, material, and so on.



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A simple illustration will show how overhead is applied to an individualjob at a cost center with allocation based on labor dollars.Thus job 504 would be allocated $4000 of the total overhead of $50,000 forcost center A.

Allocating overhead based on actual data has two distinct disadvantages:(1) it is complicated, and (2) the information is not timely. Units made at thebeginning of a month cannot be priced out until the end of the month whenactual data become known, and use of actual overhead cost is subject tofluctuation from period to period for such items as taxes, which may occuronly once a year. A shortcut method, called an estimated burden rate, hasbeen devised. Managers predict an amount for the overhead cost for a fixed

period, usually a year, and determine the measure or basis for charging a jobor product for its appropriate share of the overhead cost. Direct labor hasbeen used most widely for this basis.

A rate can be established by dividing total estimated overhead cost by theestimated quantity of the selected basis, which becomes the burden rate. Theseare estimated amounts and variances will occur. The variances should bereviewed periodically and adjusted accordingly.

The advantages of the estimated burden rate method are (1) savings of

time, and (2) increased possibility of obtaining better data for determinationof operating efficiency.

2.3.4Standard Costs

Standard costs and budgets are not identical. Standard costs usually refer to aunit of production, and budget to a total concept like a department. In a sensethe standard is the budget for 1 unit of production. The purposes of standard

costs are:

To build a budget and feedback system To aid in management predictions To save in bookkeeping cost To aid in cash flow forecasting

Standard costs are determined with scientific techniques and objective quantity

measurements. The costs developed do not necessarily represent expectedperformance but rather, desired objectives. Standard costs are merely referencesto which actual costs are compared. The variances are used in managementreports as a valuable tool to highlight areas of good and poor performance.

For example, consider a manufacturer producing 10,000 heavy ashtrays.Standards are developed for direct materials and direct labor. The standardsbased on historical data are:



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certain stage of production, the split-off point, is reached. A product for whichthere is little or no demand is called a by-product. Joint costs are combinedcost up to the point of separation. Since joint costs cannot be traced directly tounits worked, the apportioning of the costs to various units of production hasto be arbitrary. Joint cost distribution is limited to purposes of inventorycosting and income measurement.

There are two basic approaches for distributing the cost to various products:(1) physical measures, and (2) net realizable value (relative sales value method).

Example 2.1

Consider the following flowsheet:

Both of these products become finished goods at the split-off point. Let the$900 cost up to the split-off point be allocated on the basis of the physicalmeasure gallons. For $900 to be spread over 1500 gal total, the cost pergallon is $0.60, and the allocation becomes:

The income statement becomes:



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There is a loss for A and a profit for B.Now consider an allocation based on net realizable value.

The income statement becomes:

Now A and B both show the identical margin percentage of 10%. Cost engineersmust be aware of the dangers associated with cost allocations for joint products,since the allocation can have a decisive impact on the cost data and on

subsequent decision-making.

2.3.6Job Order and Process Costing

The two basic types of accounting techniques for accumulating productioncosts are (1) job order costing, and (2) process costing. In job order costing the

production cycle and the cost cycle are of equal length. Job order costing isused for specialized production jobs for which costs can be recorded accurately,but for which considerable work is involved. Job orders can be issued forindividual customers or for stock items.

Process costing is used for continuous process industries which operate 24hours per day, such as chemical, steel, and so forth. The production cyclecontinues without interruption while the cost cycle is cut off for each accountingperiod to determine the result of operations. Process costs use averages and

are less accurate than job order costs, but they are simpler and cheaper tooperate. The method is applicable to mass-production industries as well as toprocess industries.



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REFERENCES

AACE Standard Cost Engineering Terminology. (2003). AACE Standard No. 10S90. Morgantown, WV: AACE International.

Grady, P. (1965). Inventory of Generally Accepted Principles for Business Enter-prises. AICPA Accounting Research Study 7. New York: American Instituteof Certified Public Accountants, p. 2.

Humphreys, K.K. (Ed.) (1991).Jelens Cost and Optimization Engineering. 3rd ed.New York: McGraw-Hill.

RECOMMENDED READING

Adrian, J.J., Adrian, D.J. (1998). Construction Accounting: Financial, Managerial,

Auditing & Tax. 3rd ed. Champaign, IL: Stipes Publishing Co.Cokins, G. (2001). Measuring costs across the supply chain. Cost Eng. 43(10):2531; Morgantown, WV: AACE International.

Delaney, P., Epstein, B.J., Nach, R., Budak, S.W. (2003). Wiley GAAP:Interpretation and Application of Generally Accepted AccountingPrinciples 2004. New York: John Wiley & Sons.

MasterFormat: Master List of Titles and Numbers for the Construction Industry.Current ed. Alexandria, VA: Construction Specifications Institute.

Miller, C.A., OConnell, E.F. (1958). A proposed standard cost code. AACE Bull.1(1):811; Morgantown, WV: AACE International.

Palmer, W.J., Coombs, W.E., Smith, M.A. (1995). Construction Accounting andFinan-cial Management. 5th ed. New York: McGraw-Hill.

Sillak, G.C. (2002). Project Code of Accounts. Recommended Practice No. 20R98. Morgantown, WV: AACE International.

Sillak, G.C. (2002). Project Code of Accountsas Applied in Engineering,Procurement, and Construction for the Process Industries. Morgantown,WV: AACE International.

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