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New Book Announcement: Cost Accounting Made Simple

Cost Accounting Book CoverJust a brief announcement for today. We’ll return to our more typical discussion material on Friday.

My new book Cost Accounting Made Simple is available on Amazon. The book is meant to serve as a followup to Accounting Made Simple, which has been my best-selling book over the last several years.

The print version is temporarily on sale for 50% off the normal list price (i.e., just $7.50 rather than the usual $15).

What is Cost Accounting?

Cost accounting is the process of measuring how much it costs a business to supply customers with the goods or services that it sells.

Cost accounting is important because it provides business owners/managers with information that is critical to running the business. For example, if a business doesn’t know how much it costs to produce each of its products, it will make poor decisions about how much to charge for them.

Similarly, if a business has inaccurate information about how much it is spending to run one of its divisions, it may continue running that division for years, losing money the whole time without even realizing it. The opposite problem can occur as well. For example, if costs are inappropriately allocated to a given product line, the business may incorrectly think that the product line is unprofitable (and choose to shut it down) when the division is actually earning a net profit for the company.

Cost accounting is also useful for finding the source of a problem. For example, if a business reaches all of its sales goals, but still has a less profitable month than it had anticipated, cost accounting provides the tools to figure out exactly which costs were higher than anticipated.

What Does the Book Cover?

As with the other books in the “in 100 Pages or Less” series, this book seeks to provide a concise, understandable introduction to the topic. The book discusses:

  • Fixed costs, variable costs, contribution margin, and how to use those concepts to project a business’s income or loss for a given level of sales;
  • Direct costs, indirect costs, and how to assign each of them to products/departments for better decision-making;
  • How to budget for a business;
  • How to use variance analysis to identify potential problems when results vary from budgeted amounts;
  • Product costs, period costs, and why the distinction is important;
  • Job order costing and process costing; and
  • How to use activity-based costing to allocate costs.

Click here to see the book on Amazon.

To Learn More, Check Out the Book:

Cost Accounting Made Simple: Cost Accounting Explained in 100 Pages or Less

Topics Covered in the Book:
  • Cost accounting terminology (fixed costs vs. variable costs, product costs vs. period costs, direct costs vs. indirect costs, etc.)
  • Cost-volume-profit analysis
  • Job order costing, process costing, activity-based costing
  • Budgeting and variance analysis
  • Click here to see the full list.

Direct Costs vs. Indirect Costs

The following is an adapted excerpt from my book Cost Accounting Made Simple: Cost Accounting Explained in 100 Pages or Less.

“Direct costs” are those that can be directly traced to a specific cost object. (As a reminder, a cost object is typically a product.) “Indirect costs” are those that cannot be directly traced to a single cost object. Because they cannot be traced directly to a specific cost object, indirect costs must instead be allocated to all of the products they are used to produce.

EXAMPLE: For a manufacturer of rock climbing gear, the cost of nylon for climbing ropes can be directly traced — it’s obviously a cost of producing the ropes. It is a direct cost. Similarly, the aluminum used for carabiners is a direct cost because it can be directly traced as a cost of producing the carabiners.

But what about the electricity that’s used to power the company’s manufacturing facility? The facility produces several different products, including climbing ropes, carabiners, and climbing harnesses. As a result, the cost of electricity cannot be directly traced to a single product. It is an indirect cost. The firm will have to use some sort of system to allocate the cost of electricity among the various products that the electricity is used to produce.

To recap: Direct costs get directly traced. Indirect costs have to be allocated.

Direct Materials and Direct Labor

Direct manufacturing costs are further divided into two categories: “direct materials” and “direct labor.” Direct materials include all materials that eventually become part of the finished product and that can be directly traced to a given product in an economical manner (e.g., the nylon used in a climbing rope). Direct labor includes the compensation for any labor that can be directly traced to a cost object. Of note: This includes not only wages/salary, but also other types of compensation such as health insurance, retirement benefits, and so on.

Indirect Manufacturing Costs (Manufacturing Overhead)

Indirect manufacturing costs — also referred to as manufacturing overhead costs — includes three types of costs: indirect materials, indirect labor, and other manufacturing overhead costs.

“Indirect materials” include all materials used in manufacturing which cannot be traced to specific cost objects in an economically feasible manner. Common examples of indirect materials would be cleaning supplies and lubricants for machinery. Screws, nuts, and bolts would often be included in indirect materials as well, because while it would be possible to directly trace them to specific products, it would not be cost-effective to do so. (That is, because screws, nuts, and bolts are so inexpensive, it doesn’t often make sense to spend much time/money tracking them.)

“Indirect labor” includes costs for labor that is used in manufacturing but which cannot be directly traced to a specific cost object. Supervisors for a plant (who oversee production for all of the company’s products) would be categorized as indirect labor. The cleaning crew that cleans the plant would also be indirect labor, as would the maintenance crew that handles repairs for the plant.

“Other manufacturing overhead costs” — also referred to as “other indirect manufacturing costs” — is just what it sounds like: any other costs of manufacturing that cannot be traced to a specific cost object. For example, if a manufacturing facility is used to produce multiple products, most costs applying to the entire facility (e.g., rent, insurance, utilities) would be in the other manufacturing overhead category.

To Learn More, Check Out the Book:

Cost Accounting Made Simple: Cost Accounting Explained in 100 Pages or Less

Topics Covered in the Book:
  • Cost accounting terminology (fixed costs vs. variable costs, product costs vs. period costs, direct costs vs. indirect costs, etc.)
  • Cost-volume-profit analysis
  • Job order costing, process costing, activity-based costing
  • Budgeting and variance analysis
  • Click here to see the full list.

What is a Business’s Contribution Margin?

The following is an adapted excerpt from my book Cost Accounting Made Simple: Cost Accounting Explained in 100 Pages or Less.

Revenue and total variable costs are the two things that change as a business’s sales/production volume changes. The difference between a business’s revenues and total variable costs is referred to as its “contribution margin.” That is:

Contribution margin = Sales – Variable costs

EXAMPLE: Joe has a food truck from which he sells tacos. In the month of July, his fixed costs were $900, his total variable costs were $4,000, and his revenue was $10,000. Joe’s contribution margin is $6,000 (i.e., his revenue minus his variable costs).

Contribution margin is particularly helpful when looked at on a per-unit basis. The per-unit contribution margin for a product is the difference between the product’s selling price and the per-unit variable costs necessary to produce the product.

Contribution margin per unit = Selling price – Variable cost per unit

In other words, the per-unit contribution margin for a product is the amount that each unit of sales contributes toward the company’s profits.

EXAMPLE: Joe sells his tacos for $5 each. His variable cost per taco is $2. His contribution margin per taco is $3 (i.e., $5 selling price minus $2 variable costs). Each taco sold contributes $3 toward covering his fixed costs. And after his fixed costs are covered for the period, each taco sold contributes $3 of profits.

Breakeven Analysis

One common way to use contribution margin per unit is to find a business’s “breakeven point”—the number of units the business would have to sell in order to precisely break even in a given period.

EXAMPLE (continued): What is Joe’s breakeven point? That is, how many tacos does he have to make and sell in order to break even in a given month?

Again, we know that Joe’s fixed costs are $900 per month. And we know that his contribution margin is $3 per taco. (That is, each taco sold contributes $3 toward covering his fixed costs.) We can calculate his breakeven point by dividing his fixed costs by his contribution margin per unit.

Breakeven point (in units) = Total fixed costs
Contribution margin per unit
Breakeven point (in units) = $900
$3 contribution margin per taco

Breakeven point = 300 tacos

Reaching a Target Operating Income

We can also calculate how many units of a product must be sold in order to achieve a given level of operating income (i.e., profit before interest and income tax expenses).

As we discussed previously, a company’s contribution margin is equal its revenue minus variable costs. Another way to state that would be to say that a company’s contribution margin is essentially its profit before considering fixed costs.

For example, if Joe wants to earn a profit of $5,100 in a given month with his taco truck business, and his fixed costs are $900 per month, how much contribution margin would be required? That is, how much contribution margin would be necessary to cover Joe’s fixed costs and still provide the desired level of profit?

Required contribution margin = Target operating income + Fixed costs

Required contribution margin = $5,100 + $900

Required contribution margin = $6,000

If Joe’s contribution margin per taco is $3, how many tacos will he have to sell in order to reach his desired level of operating income for the period?

Required units sold = Required contribution margin
Contribution margin per unit
Required units sold = $6,000
$3 contribution margin per taco

Required units sold = 2,000 tacos

Contribution Margin Income Statement

In managerial accounting, businesses will often prepare an income statement (such as the one below) formatted in a way that highlights contribution margin.

Contribution Margin Income Statement
  Total Per Unit
Sales (2,000 units) $10,000 $5
Variable costs ($4,000) ($2)
Contribution margin $6,000 $3
Fixed costs ($900)
Operating income $5,100

With a traditional income statement, you begin with revenue, then subtract cost of goods sold (which includes both variable and fixed production costs) to arrive at gross profit. Then you subtract selling and administrative expenses (both fixed and variable) to arrive at operating income.

In contrast, with a contribution margin income statement, all variable costs (i.e., variable production costs as well as variable selling and administrative costs) are grouped together and subtracted from revenue to arrive at contribution margin. Then, all fixed costs (both production-related ones as well as selling and administrative ones) are grouped together and subtracted from contribution margin to arrive at operating income.

Simple Summary

  • Contribution margin refers to a business’s revenue minus variable costs.
  • Contribution margin per unit is equal to the per unit selling price minus the per unit variable costs. In other words, it’s the amount that each unit of sales contributes toward the business’s profits.
  • When you know the contribution margin per unit, you can find a business’s “breakeven point” — the number of units the business would have to sell in order to precisely break even in a given period.

To Learn More, Check Out the Book:

Cost Accounting Made Simple: Cost Accounting Explained in 100 Pages or Less

Topics Covered in the Book:
  • Cost accounting terminology (fixed costs vs. variable costs, product costs vs. period costs, direct costs vs. indirect costs, etc.)
  • Cost-volume-profit analysis
  • Job order costing, process costing, activity-based costing
  • Budgeting and variance analysis
  • Click here to see the full list.

Separate Equivalent Units for Direct Materials and Conversion Costs

Equivalent units are often measured separately for direct materials costs as opposed to conversion costs (i.e., direct labor and manufacturing overhead). This is done because direct materials costs are often added entirely (or mostly) at the beginning of the manufacturing process, whereas conversion costs are incurred more evenly throughout the process.

EXAMPLE: Choice Chocolate Company is a chocolate bar manufacturer. In the production process, each bar of chocolate passes through three departments: mixing, molding, and packaging. The molding department doesn’t add any direct materials to the process. (In contrast, the mixing department adds materials such as cocoa butter, sugar, milk, etc.) So every single unit of production in the molding department’s inventory will be considered 100%-complete with respect to direct materials (because the department has no further DM costs to add to any unit). But the units will each have varying levels of completeness with respect to conversion costs.

When measuring equivalent units separately for direct materials costs and conversion costs, the overall process works exactly the same as we discussed in the book, except that in steps 2-5 each calculation is performed separately for direct materials and conversion costs instead of everything being lumped together into one calculation.

EXAMPLE: During the month of January, Choice Chocolate Company’s molding department completed 1,500 physical units and transferred them to the packaging department. At the end of the month, the molding department had 1,000 physical units in Work-in-Process inventory. Those Work-in-Process units are estimated to be 100% complete with respect to direct materials and 30% complete with respect to conversion costs.

Direct Materials Conversion Costs
Ending Work-in-Process 1,000 1,000
Percent complete x 100% x 30%
Equivalent units 1,000 300
Units transferred out 1,500 1,500
Percent complete x 100% x 100%
Equivalent units 1,500 1,500
Total equivalent units 2,500 1,800

From this point, the remaining steps of process costing would be followed just as discussed in the book, but with separate calculations for direct materials and conversion costs. That is, we would use our information about direct materials costs and direct materials equivalent units to compute a direct materials cost per equivalent unit. And, separately, we would use our information about conversion costs and conversion cost equivalent units to compute a conversion cost per equivalent unit. Then we would use those two separate per-unit costs to calculate the costs for the units that were completed and transferred out and for the units still in ending Work-in-Process inventory.

EXAMPLE: Let’s assume that, in steps 3 and 4 of process costing, the molding department calculates direct materials cost of $1.25 per equivalent unit and conversion costs of $0.75 per equivalent unit. How would the department know how much to reflect as the ending WIP balance and the amount transferred to the next department?

To calculate ending Work-in-Process, we see that there are 1,000 direct materials equivalent units at a cost of $1.25 per equivalent unit, giving us a cost of $1,250. And we see that there are 300 conversion cost equivalent units at a cost of $0.75 per equivalent unit, giving us a cost of $225. Therefore, our total ending Work-in-Process balance is $1,475 (i.e., $1,250 + $225).

That is, total costs in end WIP:
(1,000 x $1.25) + (300 x $0.75) = $1,475

To calculate the amount transferred to the next department, we see that there are 1,500 direct materials equivalent units at a cost of $1.25 per unit, giving us a cost of $1,875. And we see that there are 1,500 conversion cost equivalent units at a cost of $0.75 per unit, giving us a cost of $1,125. Therefore, our total cost of units completed and transferred out to the next department is $3,000 (i.e., $1,875 + $1,125).

That is, total cost of units completed and transferred out:
(1,500 x $1.25) + (1,500 x $0.75) = $3,000

To Learn More, Check Out the Book:

Cost Accounting Made Simple: Cost Accounting Explained in 100 Pages or Less

Topics Covered in the Book:
  • Cost accounting terminology (fixed costs vs. variable costs, product costs vs. period costs, direct costs vs. indirect costs, etc.)
  • Cost-volume-profit analysis
  • Job order costing, process costing, activity-based costing
  • Budgeting and variance analysis
  • Click here to see the full list.
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