Cost Accounting Essay Example

Our lives are full of things that most of us take for granted in everyday activities. Everything we buy comes from a manufacturer that has invested time, money, and materials into it. Although we can easily assign simple, costs like direct materials and direct labor to individual products, it can be complicated to allocate general costs of production like factory overhead and equipment insurance that help to facilitate the production process smoothly and safely. There are a variety of costing methods used by companies that all depend on the style of management and the type of business.

This leads us to ask, how do these costing systems work? To answer this question, we must first identify the different types of costing systems. There are two primary costing systems commonly used. These are Absorption Costing and Activity Based Costing. “Absorption costing and activity-based costing differ in approach. Absorption costing assigns costs to individual units, whereas activity-based costing focuses on company activities as a central cost and then attempts to assign indirect costs to units.” (The Blueprint) This is the main concept that differentiates these two systems. Absorption costing is a simpler but less accurate allocation method. For most businesses, Activity Based Costing can prove to be an unnecessary addition of time and money for a minimal benefit. “Absorption costing allocates fixed overhead costs to a product whether or not it was sold in the period. This type of costing method means that more cost is included in the ending inventory, which is carried over into the next period as an asset on the balance sheet.” (Tuovila) Absorption costing does a great job of keeping fixed costs organized and variable costs accounted for. For the sake of simplicity and to save money, most businesses lean towards absorption as their primary business costing system.

We have already established that absorption costing is simpler, cheaper, and more popular in the world of business, so what are the advantages of an alternative costing method and Wwhy would a company choose to spend the time and money to implement an Activity Based Costing system? “Absorption costing is easier to implement yet recognized as perfectly compliant with generally accepted accounting principles and IRS reporting requirements. The downside, however, is that it may offer less insight to those charged with making strategic decisions regarding production practices and costs.” (The Blueprint) The main goal of an activity-based costing system is to increase the profitability and overall performance of a company. However, with this system being more expensive and time-consuming, most of the businesses using these systems are in very competitive markets or are already very well-established and profitable businesses that can justify spending the extra resources. The reason for this is that they will make their money back by cutting off miscellaneous costs that are loose ends in the company. One major advantage of activity-based costing is that it allows companies to understand the true cost and profitability of individual units produced or services rendered. This increased accuracy is the result of essentially assigning indirect costs as direct costs. For example, in an Activity-based system, a company has an electrical bill of fifty thousand dollars for the year. In the same year, the company used two-thousand five-hundred machine hours to get a cost driver of twenty dollars per machine hour. This rate can be very useful in determining how much energy from overhead is used in the production of various products. If this company manufactures mountain bikes, and each bicycle requires ten machine hours to produce, then the overhead cost assigned for the product is two hundred dollars per bike. This would not be the case for an absorption costing system as the cost of overhead machinery and operations would be absorbed evenly into each product. Absorption costing results in the same overhead costs for every type of unit produced. Activity-based costing is most useful for companies that manufacture and sell a wide variety of products. Huge companies like Target, Home Depot, and Ford can benefit from knowing the amount that their overhead costs are being utilized on each product. However, smaller companies such as like Subway, Chipotle, and other small businesses or chains do not need this sort of detailed costing system. Their overhead costs help keep a building running, making the extent of their knowledge irrelevant. 

Although absorption and activity-based costing are the two main systems we have studied in class, there are many more systems for job costing including variable costing, job-order costing, absorption costing, marginal costing, and more. What is the point of having so many different systems for something like this? Well, allocating overhead costs is not as simple as some may think. “A costing system is designed to monitor the costs incurred by a business. The system is comprised of a set of forms, processes, controls, and reports that are designed to aggregate and report to management about revenues, costs, and profitability. The areas reported upon can be any part of a company, including its customers, departments, facilities, processes, products and services, research and development, and sales regions.” (Bragg) Costing systems are used for fine-tuning company operations, deciding where to cut costs, and creating strategic plans for the company to maximize profitability and efficiency. The reason there have been so many alternative costing systems lies in the companies’ money. Costing systems are one of the main ways companies account for revenue. For this reason, business owners want their money handled very carefully and in very specific ways. All these variations are a result of this. Some costing methods only work for select businesses that the management has specially requested. Every business is different in its needs and goals and choosing the right costing system is a part of the process of running a successful business.

One of the key components in accounting is controlling costs. “Cost accounting helps the management foresee the cost price and selling price of a product or a service, which helps them formulate business policies. With cost value as a reference, the management can come up with techniques to control costs to achieve maximum profitability” (Krishnan) This is another reason why all the corporate officers must understand the costing system being used. Without a clear consensus on the costing methods used by the company, departments will struggle to keep their operations organized and profitable. For example, if the mountain bike company used an absorption-based costing system to allocate costs of their product and then decided to make the switch to an Activity-based costing method, the company could run into complications in their practice if there is no clear communication between departments. If the overhead in the wheel manufacturing department was allocated through absorption, the cost of the wheels may include overhead costs that were already assigned to the frames department. This could easily result in a double charge on the wheel as the cost was exaggerated when the benefits of the Activity-based method were overlooked. Another concern would be fraud. An error on the side of the accounting department when attempting to allocate the costs of various parts may be a threat to a company. This could result in a scenario where the books contain cost errors that lead to a confusing and stressful investigation of where these costs ended up. 

There are so many variations of cost accounting, and it can be a real challenge to keep them all in order. However, most businesses rarely change their accounting methods for costing, and switching back and forth is not a common occurrence in the field. However, this does not mean that it is notsn’t important to understand how different methods work. The security of a company’s money is a top priority, and it is not sensible to only understand how to use one method when there are so many others that may be a factor in a future accounting career.