4. The accountant s product costing art
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1 4. The accountant s product costing art How to move from cost pools to product costs Define an appropriate number of cost pools Each cost pool aggregates costs associated with some set of activities Estimate cost behavior by estimating a (sub-)cost function that describes behavior of costs in each single cost pool (local linear approximation) For this procedure to be precise we require separability of costs in each cost pool as well as linearity Typically non of this is present Pretending it ends up in some approximation Cost is allocated to products We distinguish direct and indirect cost pools and period cost pools Costs are either traced or allocated to a product For cost allocation an allocation base needs to be chosen 1
2 How do accounting procedures differ from economic procedures? Economist takes a theoretical view basic assumption: all factor inputs, all factor prices and the cost function are known The accounting system tries to emulate the economists derivations given that non of the above is (fully) known Differences: Items included in economic costs are not included in accounting costs Timing possibly differs Economic and accounting depreciation differ Three building blocks of the Accounting procedure: Aggregation, linear approximation, allocation 2
3 Local linear approximation I FIGURE 5.1 Presumed and Approximate Cost Curve for Transportation Cost Pool Approximated cost curve Uses output or some synthetic variable as the independent variable Should approximate costs reasonably well in the relevant range A cost and benefit from information trade off drives the effort put in estimating the curve 3
4 Cost Allocation LLA is used to assign costs in a cost pool to other cost pools or products This procedure is specific to accounting In economics costs are never allocated It is simply unnecessary as the economist knows the cost function The accounting uses allocation in order to try to say something about a point on an unknown cost curve The LLA typically contains a single explanatory variable More than one is possible Allocation assigns costs to any combination of Products, various overhead cost pools or the period The structure of the LLA is related to its type designation Direct cost pool: Indirect cost pool: 4
5 Cost Allocation Note that: Allocation of cost closes the cost pool The allocation procedure is tied to the LLA If products (output units) are used as explanatory variable, allocation is based on products If a synthetic variable (e.g. labor input) is used as explanatory variable, allocation is based on that variable Cost may be allocated to or from a cost pool E.g. via depreciation cost is assigned to a period cost pool Cost pool Type Allocation Base 1 Direct product Units produced 2 Indirect product Machine Hours 3 Period Not allocated 5
6 Short run or long run? Back to the economist s view: We know that in a multi product firm marginal cost is the only meaningful concept When estimating unit costs does the accountant estimate Short-run cost Long-run costs? 6
7 5 Fundamental Accounting procedures The accounting system aggregates cost in Product cost pools Costs aggregated in product cost pools are assigned to products Period cost pools Costs aggregated in period cost pools are assigned to the period and not affect product cost Direct cost pools include Direct labor Direct material Indirect cost pool Overhead Note: direct cost is the cost of material or labor the firm finds useful to associate directly with products, indirect cost are chosen to be recorded in indirect product or period cost pools as chosen by the firm 7
8 An extended Illustration Two products: job 1 and job 2 What is the cost of each product? What are possible procedures to allocate costs to products? 8
9 Cost pools Cost are aggregated in seven cost pools 9
10 Local Linear Approximations LLAs for Overhead cost pools: Specification is given Overhead A: Total direct labor cost is used as the synthetic variable Overhead B: Total direct material is used as synthetic variable 10
11 1. Actual total overhead cost assigned Finer details from LLAs are ignored Actual costs are allocated based on actual totals of synthetic variables 11
12 2. Estimated (normal) total overhead costs are assigned (full or absorption costing) Using normal rather than actual costs allows for more timely job cost predictions Finer details from LLAs are still ignored However, we use LLAs to estimate cost (assume below normal total DL$=40 and total DM$=50) ignore slope and intercept Create a new LLA through the origin 12
13 Product costs and Income Note that allocated cost now differs from actual cost Typical accounting procedure: Over- and under-allocations are included in cost of goods sold 13
14 3. Normal variable overhead costs are assigned (variable costing) Finer details of LLAs are used to determine product cost We use the slope of the LLA to describe the marginal effect of increasing the synthetic variable The marginal effect is allocated to products The intercept is treated as a period cost 14
15 Income effect Aside: Standard Cost Systems Unit costs are constructed using estimated prices and quantities for each production factor Variable or full costing can be applied 15
16 Comparing full and variable costing What is the better estimate of marginal costs? Unit cost with full costing exceeds unit cost with variable costing Long run versus short run marginal cost Full cost system more suitable to estimate long run marginal cost Variable cost system more suitable to estimate short run marginal cost Underlying assumption of both statements LLAs are accurate; the intercept measures short-run fixed costs Institutional view Many accounting systems require full costing Some also allow for variable costing 16
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