Changes in Cost Accounting and the Different Cost Systems That Companies Use - Coursework Example

Accounting is an information system that identifies records and communicates the economic events that occurred within an organization to different users (Weygant, 2002). The principles of accounting have been around for over 500 years. One of the major areas of study of accounting which has numerous practical applications for the accounting systems of businesses worldwide is cost accounting. The industrial revolution created the need for companies to determine how much was the cost of the products companies were producing in giant scales. Managers needed a way to determine the cost of its products. During this revolution manufacturing operations were labor intensive. The traditional cost accounting systems determine cost by adding direct material, direct labor and overhead. Direct labor is utilized as a cost driver in the determination of overhead. The purpose of this paper is to analyze changes in cost accounting and the different cost systems companies are utilizing which eliminate the profession's historical reliance on determining products cost utilizing direct labor as its main variable. Major changes in the way business is perform in the 21st century made the utilization of direct labor as a cost driver obsolete. A study performed on 37 factories revealed that sophisticated automated equipment was increasingly replacing direct labor and in these factories direct labor accounted for only 10% of its direct sales (Garrison & Noreen, 2003). Direct labor is becoming a variable whose correlation with sales is becoming smaller as businesses continue to evolve. CPA Mike Weir mentions that traditional costing systems do not reflect costs in the various stages of production accurately nor do they provide feedback on the cost changes affecting planning and job estimates (Nash, 1999). Accountants are starting to use different methods to calculate costs other than absorption costing (DM+DL+OH). A new type of accounting which visualizes and determines cost in a different manner is lean management accounting. The methodology utilized in the accounting system follows a similar line of thinking to the engineering lean manufacturing methods as far as eliminating waste or unnecessary processes from a system or method. The reporting of costs within production must be such that the waste is clearly visible to the people responsible of the process allowing transactions to be created when the product is completed on the floor (Maskell & Baggaley, 2007). Traditional accounting methods followed the path of tracing costs as they moved from department to department which did not provide a clear basis of determining if any value was create in any particular process. One of the main advantages of lean management accounting is that it provides manager the cost information necessary to measure performance and effectively control and continuously improve the value stream (Maskell & Baggaley, 2007). Accounting information systems are suppose to provide the decision makers with up to date accurate information about the costs incurred. When dealing with projects such as those in the construction industry the project manager must be able to control and monitor costs to enable successful completion of the project. These professionals utilize different forecasting cost control activities to help them determine overall costs. Some of the techniques utilize by project managers are: budgeted costs, estimated total costs, cost commitment, cost exposure, cost to date and over / under (Cmu). Absorption costing system do have the capability of providing project managers with precise updated data they can utilize to determine the progress of the project. Engineers and inventors require a cost system that allows them to visualize and determine cost for different particular elements within their design process. Current cost modeling is not adapted to deal with multiplicity levels of abstraction associated with an emerging design (Scanlan, J. et al., 2002). One constraint that traditional cost models have is that is cost elements are limited, thus activities such as conceptual design provide difficult to accurately keep tract of associated costs. Scientist found that Implied Cost Evaluation System (ICES) is a good method to measure cost of complicated and innovated projects. The advantage ICES include: Provides the ability to measure uncertainty of cost, 'Cost Tolerance' Ability to measure incremental costs of subsequent more advanced models It gives designers input about high cost uncertainty and high risks areas (Scanlan, J. et al., 2002) Accounting is supposed to provide the information the user needs. Traditional cost systems were developed in a time when sophisticated projects such as those within the aerospace industry were not within the realm of imagination of accounting professionals. Tools such as ICES provide the cost analysis scientist require. The most recognized and commonly used alternative cost method to standard cost is activity based costing (ABC). Activity based costing can be applied to various industries and it does based its cost calculation on utilizing direct hours as the main cost driver to determine costs. ABC divides costs into various pools in which each pool has an allocation base with its own allocation rate. The system provide cost analyst with better information regarding what are the exact factors that influence the cost of a product. The information allows managers more alternatives to reduce the cost of an operation by targeting the activities in which they can apply cost reduction initiatives. ABC maps all the workflows and processes in order to trace each activity that contributes to cost within a system (Cross, 2002). Providence Portland Medical Center is a non-profit community hospital which applied activity based costing into its operation and was able to save over $1 million by implementing the ABC system (Ioma's Report, 2003). The management of the hospital used to concentrate its efforts on TQM, specifically on process improvements. The methodology seemed like a good idea, but the executives were not focusing on the relationship between cost and benefits of the different procedures and departments of the hospital. The organization did not keep track of overall performance data. This hospital was non-profit organization, but despite the fact such an entity is not looking for profit they are obligated to maximize its resources in order to provide the maximum about of benefits and services to its clientele. The root of the problem was the administration of medicine and related processes of its nursing units. ABC provided this hospital with the following benefits: Identify cost reduction opportunities in its medication related activities Provided financial value within the process improvement activities Determination of cost of patient per day Ability to forecast benefits of process improvements Control over resources (Ioma's Report, 2003). Nortel Corporation is an research and development (R&D) organization with over 20,000 employees and an R&D budget of over $2 billion annually. The company requires comprehensive cost analysis since it runs hundreds of projects simultaneously. This company utilized activity based costing to its advantage. Projects are realized on global level and ABC allowed the company to determine project costs, if they had utilized traditional costing systems the costs could have only been determined on a departmental level. The utilization of ABC at Nortel is a perfect example of how the system allows alignment of actual costs to a set of tasks which are grouped into activities or projects representing deliverables of the product design process (Dorey, 1998). The determination process of calculation pools and allocation rates is a very costly process for enterprises. The overall costs is one of the reason many companies do not utilize activity based costing systems. Accounting theory stipulates that if the overall costs of system exceed the benefits it should not be implemented, because there is no value created in the process. Additional cost drivers in an Activity based costing system increases the cost accuracy while at the same time it increases overall administrative costs. In 1993 Babad and Balachandran developed a cost drivers optimization model (CDO) to identify representative cost drivers by considering the trade-off between benefits of precise costing information and informative costing results (Levitan & Mahesh, 1996). These scientist utilize the power of mathematics to create an optimization function to the maximum amount of cost drivers a manager can utilize within a system without exceeding the overall cost of creating the information. Activity based costing systems can be utilized to increased the overall profitability of a company. It provides managers with better information regarding the identification and reduction of non-value added activities, streamlines processes and it allows companies to work with both customers and suppliers in a more effective way (Devine & Lambert & Priscilla, 2005). Devine and his colleagues theorized that activity based costing could be taken a step further and it could be utilized to analyze the return on assets and on investment within a company. Their concept is based on assigning assets to activities. "To determine if asset allocation is likely to an organization, management is to considered differences in demand placed on assets by different products and customers" (Devine, et. al, 2005). These new concepts seem interesting and have a lot of potential, but considering that typical absorption costing systems are still not the gold standard in the industry it would be hard to convince a lot traditional accountants that the application these professional developed is a realistic cost effective measure. Activity based costing systems revolutionized the way accountant determine cost since its creation about 15 years ago. The new development in the accounting profession is called economic value added (EVA). This metric measures weather a business is truly earning its cost of capital (Mariotti, 1996). EVA is much more powerful than ABC in a lot of areas. It allows determination on the profitability of goods and better analysis on return on capital. The marketplace has changed and the global environment created greater logistic challenges for global enterprises. New issues concerning cost have recent in the international environment which ABC is not able to measure. For example suppliers now realize business with foreign firms in which they spend a lot of money on customer service. "Suppliers need to thoroughly evaluate the cost of a deal including the cost to serve the demanding large customer" (Mariotti, 1996). Economic value added is new tool which provide financial managers better information concerning the profitability of product lines. The business world in the 21st changed and became more complicated due larger volumes and globalization. The accounting profession changed as well and simplistic measures such as standard cost are no longer as valid as they used to be 50 years ago. New techniques such as activity based costing, economic value added and implied cost evaluation system are changing are more suited to determined the cost of organization realizing business today. Everything in life changes through time and professional must adapt to the trends in the marketplace. References Cmu.edu. Cost, Control, Monitoring and Accounting. Retrieved July 29, 2007 from http://www.ce.cmu.edu Cross, L. (2002). Costing Systems Starts with ABC. GAM Editorial. Retrieved July 29, 2007 from http://www.gammag.com Devine, K. , Lammert, T. , Priscina, O. (2005). Product Line and Customer ROI. The Next Generation of ABC. Management Accounting Quarterly, 50(1), 6. Retrieved July 29, 2007 from EBSCOhost database. Dorey, C. (1998). The ABC of R&D at Nortel. CMA Magazine, 72(2), 19. Retrieved July 29, 2007 from EBSCOhost database. Garrison, R.H., Noreen, E.W. (2003). Managerial Accounting (10th ed.). New York: McGraw Hill Irwin. 43. Ioma's Report (2003). How ABC will save PPMC over $1 million a year. Financial Analysis, Planning & Reporting, 3(11), 6. Retrived July 29, 2007 from EBSCOhost database. Levitan, A. , Mahesh, G. (1996). Using Genetic Algorithms to Optimize the Selection of Cost Drivers in Activity Based Costing. International Journal of Intelligent Systems in Accounting Finance & Management, 5(3), 129. Retrieved July 29, 2007 from EBSCOhost database. Maskell, B.H. , Baggaley, B. (2007). Lean Management Accounting. BMA Inc. Retrived July 29, 2007 from http://www.maskell.com/LeanArticle.htm Nash, D. (1999). NorthWinds Press Rolls with New Pricing Policy. Montana State University. Retrieved July 29, 2007 from http://www.montana.edu Scalan, J. , Terry, H. , Marsh, R. , Christophe, B. Martin, D., Paul, C. (2002). Journal of Engineering Desing, 13(3), 264. Retrieved July 29, 2007 from EBSCOhost database. Weygant, J.J., Kieso, D., Kimmel, P.D. (2002). Accounting Principles (6th ed.). New York: North Wiley & Sons. 2. Read More