Cost Systems in Accounting

A cost system is a method of accumulating and assigning costs. It is essential that a manufacturing company know quickly the cost of making a product, performing a factory operation, or carrying out any other activity of the business. Decisions of the highest importance depend on the accuracy of the cost data. For 'example, an understatement in the cost of producing an automobile would result in a lower selling price than warranted and cause losses of perhaps millions of dollars. Trading and service companies, as well, have developed cost systems for their operations.

A good cost system also provides a means of cost control. Thus management can compare cost data with budgets and standards to effectively plan and control all business activities.

Job Order Cost System

Under this system the cost of raw materials, direct labor, and factory overhead are accumulated according to the particular job order or lot  number. To arrive at the average unit cost the total cost is divided by the number of completed units.

Generally, the job order cost system is most suitable where the product is made to individual customer's specifications and where the price quoted is closely tied to the cost. (For instance, cost plus 15%).

Process Cost System

Under this system, the costs are accumulated according to each department or process for a given time period. Thus the average unit departmental cost for a day, week, month, or year is arrived at by dividing the total departmental cost by the number of units (or tons, gallons, etc.) produced in the particular period.

The process cost system is used by manufacturers of goods such as paper and steel, which are produced in large volumes on a continuous basis.

Supplementary Costing Practices

Either of the following two procedures can be used in conjunction with the job order system or with the process cost system.

Standard Costs

A large number of manufacturers determine representative costs ahead of time and use them to predict actual costs. Special variance accounts are provided to pinpoint the discrepancies between standard and actual. Standard costs and the related subject of budgets are discussed later on.

Direct (Variable) Costing

Under this procedure, only costs which increase in direct proportion to the volume produced become part of the cost of the product. Thus, raw materials costs, direct labor cost, and some items of overhead are included; but items such as rent and administrative salaries, which do not change with the quantity produced, are excluded.

Direct costing brings the cost of goods sold into closer relation with the sales for the period. When full costs-that is, variable plus fixed costs-are used, the average cost per unit goes down as more units are produced. This might suggest higher profits than is the case; actually, a larger portion of the fixed costs is now included in the inventory cost.

Flow of Goods: Equivalent Units

Usually the products for which process costing is employed will have a number of different production operations performed on them. Thus, the goods pass from one department to another and the costs applied to date are maintained in the cost records. Now, usually, not all the work begun during the period will be finished at the end of the period: there will be an ending inventory of units in various stages of completion. Likewise, there will be an opening inventory of units only partially completed during the previous period. This more general situation is described by the flow equation.

Units Available During Period = Units Disposed of During Period

opening inventory + units        unit transferred to next dept

 put into production                  +ending inventory

When any three terms in the flow equation are known, the missing piece of data can be computed from the equation itself.

Flow of Costs

With all inventories and production reduced to equivalent units, we can calculate unit costs for use in conjunction with FIFO, LIFO, weighted average, or some other inventory costing method. It should be emphasized that the number of equivalent units involved is determined solely by the manufacturing process and is quite independent of the choice of costing method.

Different costs would be obtained under LIFO or weighted average. If LIFO is used, the 5,500 units transferred would be assumed to consist of the