Cost-Type Accounting

Resources

• Cost Accounting Slides
• Exercise and Solution

Cost-Type Accounting as the link between cost and financial accounting provides a systematic approach to categorizing and analyzing costs based on their nature and behavior. It helps organizations understand the different types of costs incurred in production and operations, enabling better cost management and decision-making. It answers the question: Which costs have been incurred?

Classification of Costs

Costs can be classified based on various criteria, including:

• Nature of input goods: Material costs, labor costs, machine costs, external services, etc.
• Attributability to cost objects: Direct costs vs. indirect costs
• Dependence on output variation: Variable costs vs. fixed costs
• Position in value chain: R&D costs, procurement costs, manufacturing costs, distribution costs, etc.
• Origins of input objects: Primary costs (from outside the company) vs. secondary costs (from within the company)

This module primarily uses a classification by the nature of input goods, structuring costs as material costs, labor costs, machine costs, and other costs (e.g., external services, energy, etc.).

In 2009, 30% of surveyed companies used more than 1000 cost classifications, with an average of 800. Using many categories allows for detailed analysis, however, requires significant effort to maintain.

Material Costs

Material costs are specifically relevant for manufacturing companies, as they represent the costs of raw materials and components used in production.

$\text{Material Cost}=\text{Quantity of Material Used}\times \text{Cost per Unit of Material}$

They can be further categorized according to their relationship with the production process:

• Direct Costs (Raw Material): Costs of basic materials that are directly used in the production process (steel, water).
• Artificial Indirect Costs (Auxiliary Material): Costs of materials that are not directly used in production but are necessary for the manufacturing process (paints, adhesives).
• Indirect Costs (Operating Material): Costs of materials that are used for maintenance, repair, and operation of machinery and equipment (lubricants, cleaning agents).

Recording Material Consumption

To determine material consumption, companies can use different methods to track and record the quantity of materials used in production. The choice of method depends on factors such as the nature of the materials, the production process, and the company’s accounting practices.

Inventory Method

This method uses inventory counts at the beginning and end of a period paired with purchase amounts to calculate material consumption. It is accurate but complex and does not provide insight into reasons for consumption (e.g. operational vs theft) or into the cost center.

$\text{Material Consumption}=\text{Beginning Inventory}+\text{Purchases}-\text{Ending Inventory}$

Carrying-On Method

The carrying-on method simply sums up material consumption as it occurs, without relying on inventory counts. It’s efficient and useful for tracing consumption to cost centers, but still needs stock-taking.

$\text{Material Consumption}=\sum \text{Recorded Material Used}$

There may be differences between carrying-on and inventory methods due to discrepancies in inventory counts, timing of purchases, recording errors, or theft. The carrying-on method provides a more real-time view of material consumption, while the inventory method may be more accurate for long-term accounting purposes.

Retroactive Accounting Method

This method calculates material usage based on production output and the bill of material (typical material requirements) for each unit produced. It assumes a standard amount of material is used per unit of output. This is often used in cost accounting because it’s simple to use BOMs stored in the system, however, these bills have to be kept up to date and stock-taking is still necessary.

$\text{Material Consumption}=\text{Production Output}\times \text{Standard Material per Unit}$

Valuation of Material Consumption

The valuation of material consumption involves determining the cost per unit of material used in production, which might depend heavily on the time of purchase. This can be done using different methods, each with its own advantages and disadvantages.

FIFO: First-In-First-Out

FIFO assumes that the oldest inventory items are used first. This method is simple and reflects the actual flow of materials in many cases, but it may not always match the physical flow of goods, especially if there are significant price changes over time.

LIFO: Last-In-First-Out

LIFO assumes that the most recently acquired inventory items are used first. Therefore it tends to apply higher valuations to material consumption during periods of rising prices, which can lead to higher cost of goods sold.

Ex-Post Average Prices

The ex-post average price method uses the average purchase price for all consumed material at the end of a period, smoothing out price fluctuations.

$\text{Average Price}=\frac{\text{Total Cost of Material Purchased}}{\text{Total Quantity of Material Purchased}}$

Moving Average Prices

Contrary to ex-post, the moving average price method updates the average price after each purchase, providing a more real-time valuation of material consumption.

$\text{Moving Average Price}=\frac{\text{Total Cost of Material in Inventory}}{\text{Total Quantity of Material in Inventory}}$

Labor Costs

Labor costs represent the expenses associated with the workforce involved in production and operations, and are particularly relevant for service and consulting companies. In industrial companies, these costs often make up 20-30% of total costs.

In countries with strict data privacy like Germany, controlling departments are not allowed to see individual salaries.

Labor costs include:

• Salaries, potentially including a 13th month salary
• Time wages (e.g., for temporary workers, based on hours worked)
• Piece-rate wages (e.g., for assembly line workers, based on units produced)
• Premium wages (bonuses or valuation for hard working conditions)
• Fringe benefits (e.g., social benefits, company cars, relocation costs)

To better allocate wages to cost objects, they are often broken down into:

• Direct Labor Costs: Costs of labor that can be directly traced to a specific cost object, such as wages of assembly line workers.
• Auxiliary Wages: Costs of labor that cannot be directly traced to a specific cost, e.g. warehouse workers. They are indirect costs and allocated through cost centers’ overhead rates.

As one-off fringe benefits are often difficult to account, they are often converted into a monthly amount a nd added to the regular salary for better cost allocation.

Machine Costs

Machine costs are relevant for all kinds of companies, from manufacturing to software. They include:

• Depreciation: The systematic allocation of the cost of a machine over its useful life. It reflects the wear and tear of the machine as it is used in production. Explained in Accounting Policy.
• Interest: The cost of financing the purchase of a machine, which can be calculated based on the loan amount and interest rate.
• Acquisition Costs: The initial cost of purchasing a machine, which can be capitalized and depreciated over time.
• Maintenance and Repair Costs: Expenses incurred to keep the machine in working condition, which can be calculated based on historical maintenance records or estimated based on the machine’s usage and condition.
• Leasing/Rental Payments: Costs incurred for leasing or renting machinery, which can be calculated based on the lease agreement terms.

Depreciation Methods

Straight-Line

Allocates an equal amount of depreciation expense each year over the useful life of the machine.
See Linear Depreciation.

$\text{Depreciation Expense}=\frac{C_{\text{acquisition}}-C_{\text{residual}}}{\text{Useful Life}}$

Declining Balance

Allocates a higher amount of depreciation expense in the earlier years of the machine’s life, reflecting the higher utility and wear in those years.
See Diminishing Balance Method.

$\text{Depreciation Rate}=1-\sqrt[\text{Useful Life}]{\frac{C_{\text{residual}}}{C_{\text{acquisition}}}}$

Arithmetic-Degressive

Allocates depreciation based on a fixed percentage of the remaining book value each year, resulting in a decreasing depreciation expense over time.
See Arithmetic-Degressive.

$\text{Depreciation Expense}=\frac{2\times (C_{\text{acquisition}}-C_{\text{residual}})}{\text{Useful Life}(\text{Useful Life}+1)}\times \text{Remaining Useful Life}$
Heads up: The remaining useful life in this formula includes the current year (1-based), so in the final period the remaining useful life is 1.

Units of Production

Allocates depreciation based on the actual usage or output of the machine, instead of time.
See Units of Production Method.

$\text{Depreciation per Unit}=\frac{C_{\text{acquisition}}-C_{\text{residual}}}{\text{Total Estimated Units}}$

Interest Costs

To determine the interest costs associated with financing operations:

1. Determine the assets required for operations and value them. The valuation uses the average between the previous and current balance sheet value; positions not essential to the operations are not considered.
2. From this, determine the capital required for operations and the interest rate. Non-interest-bearing liabilities are not considered (e.g. accounts payable, deferred income); their average is subtracted.
3. Multiply with interest rate: $\text{Interest Cost}=\text{Capital Required for Operations}\times \text{Interest Rate}$

WACC: Weighted Average Cost of Capital

The WACC is a measure of a company’s cost of capital, which takes into account the cost of both debt and equity financing, with taxes deducted.
$WACC=r_E\frac{E}{E+D}+r_D\frac{D}{E+D}(1-t)$
$r_E$/$r_D$: cost of equity/debt (below); $E$/$D$: market value of equity/debt; $t$: corporate tax rate.

CAPM: Capital Asset Pricing Model

The CAPM is used to determine the cost of equity, representing the relationship between systematic risk and expected return for assets, specifically by adding a risk premium to the risk-free rate.
$r_E=r_f+\beta (r_m-r_f)$
$r_f$: risk-free rate; $\beta$: systematic risk (beta); $r_m-r_f$: market risk premium.

In management accounting, interest costs don’t only include interest costs for borrowed capital, but also the opportunity cost of using equity capital, which is the return that could have been earned if the equity capital had been invested elsewhere (imputed costs). Therefore, the cost of capital is often calculated using the WACC, which incorporates both debt and equity costs and all capital required for operations.