MA Chapter 3: Cost Accounting

Costing System Definition

A costing system is the way a company calculates the cost of what it produces. It divides into 2 parts: Job costing and Process Costing. (Both also separate into absorption costing and variable costing)

Job Costing Definition

Job costing is used when products or services are different from each other, for example a custom ship, a wedding cake, or a consulting project. Job costing is for unique or customized work, so each job gets its own cost calculation.

Process Costing Definition

Process costing is used when many identical units are produced, for example bottles of Coca-Cola or chocolate bars. Process costing is for mass production, where all units are similar, so the company calculates an average cost per unit

Absorption Costing Definition

Absorption costing includes both variable and fixed manufacturing costs in the product cost

Variable Costing Definition

Variable costing includes only variable manufacturing costs in the product cost, while fixed manufacturing costs are treated as period costs

Cost Pool Definition

A cost pool is a group of indirect costs put together

Allocation Base Definition

An allocation base is the method used to spread those indirect costs to cost objects, such as direct labor hours or machine hours

Note: the same cost can be direct or indirect depending on the cost object

Traditional costing systems (single stage)

means the company uses one simple step to allocate overhead to products. So instead of carefully separating overhead into many departments or activities, all overhead is usually placed into one big pool and then spread to products using one allocation base.

Actual Costing Definition

In actual costing, both direct costs and indirect costs are based on actual numbers. So actual direct material, actual labor, and actual overhead rates are used.

Normal Costing Definition

In normal costing, direct costs are still based on actual amounts, but indirect costs are allocated using a budgeted overhead rate. This is practical because companies often do not know the exact real overhead rate until the end of the year.

Budgeted Overhead Rate =

(the denominator literally means = total expected quantity of the cost driver)

Traditional costing with multiple stages

The goal is still the same: allocate overhead to products. The difference is that we no longer throw all overhead into one big pool and immediately divide it over products. Instead, we first split overhead across departments or cost centers, and only after that do we allocate it to products. So multiple stages means more steps, but usually more accurate costs. The weakness is that one allocation base is being used for everything, as if all overhead costs are caused by direct labor hours.

Two stage allocation process advantages

Higher accuracy

Heterogeneity of overhead intensiveness across departments

Product-department relations

What is the criticism of the traditional method?

Even with two stages, traditional costing can still be too simple. It often uses too few cost centers, too few allocation bases, and not enough variety in allocation bases. Many allocation bases are still volume-based, such as labor hours or machine hours, even though overhead may actually be caused by other things, like setups, inspections, or purchase orders. So the big problem is that traditional costing may fail to track the real physical activities that consume resources. When that happens, product costs become inaccurate.

Activity Based Costing (ABC)

The basic idea of ABC is to get more accurate product costs. It does this in two ways. First, it breaks overhead into more detailed parts, instead of putting everything into one big overhead pool. This reduces aggregation error, meaning we avoid mixing very different costs together. Second, it uses better cause-and-effect relationships. For example, setup costs should be linked to number of setups, not necessarily to number of units. This improves decision-making, but the disadvantage is that ABC is more complex and takes more effort to use.

Basic Steps of ABC

1) identify the cost object and the indirect costs related to it. The cost object is what we want to calculate the cost of, for example a product

2) identify the meaningful activities that consume resources, such as purchasing, setup, packaging, or inspection

3) assign the indirect costs to those activities

4) assign the activity costs to the products based on how much each product uses each activity

Cross-subsidizing meaning

Cross-subsidizing means that one product/customer/service is charged too much, while another is charged too little, because costs are allocated inaccurately. This slide explains why cross-subsidizing happens. Some costs are batch-related, meaning they happen per batch, not per unit. For example, setting up a machine may cost roughly the same whether the batch contains 100 units or 10,000 units. If we allocate setup costs based on number of units, high-volume products get too much of the cost, and low-volume products get too little. So traditional absorption costing often overcosts high-volume simple products and undercosts low-volume complex products. That can lead to bad decisions, like pricing complex products too low.

Cost Hierarchy

1. Unit-level activities happen for every unit produced, such as direct materials, direct labor, machine costs, or energy costs.

2. Batch-level activities happen for each batch, not each unit, such as machine set-up, moving materials, processing an order, or first-item inspection.

3. Product-level activities support a specific product type, such as product-specific marketing, product design, or product-specific equipment.

4. Facility-level activities support the whole organization, such as plant management, building costs, heating, and lighting. This hierarchy helps us understand what really causes costs: units, batches, products, or the entire facility.

What are the four types of errors in costing systems?

specification error, aggregation error, measurement errors, measurement errors in cost drivers

Specification Error Definition

A specification error happens when the wrong cost driver is chosen. For example, using direct labor hours for setup costs would be wrong if setup costs are actually caused by the number of setups.

Aggregation Error Definition

An aggregation error happens when too many different costs are grouped together in one cost pool. For example, putting setup costs and machining costs together may hide the fact that they are caused by different things.

Measurement Error Definition

Measurement errors in overhead cost pools happen when the company measures the amount of overhead in each pool incorrectly.

Measurement Errors in Cost Drivers Definition

Measurement errors in cost drivers happen when the company measures the driver wrongly, such as counting the wrong number of setups or assigning the wrong number of machine hours to a product.

Benchmark Costing System Definition

The benchmark costing system is treated as the most accurate reference system. It separates costs by both department and activity.

Over-absorption and Under-absorption Definitions

This happens because companies often use a budgeted overhead rate during the period, before they know the real overhead cost. At the end, they compare what they allocated to products with what actually happened. If they allocated too much, it is overabsorbed. If they allocated too little, it is underabsorbed.

When is ABC less useful?

ABC is not very useful for standardized mass production. If a company produces one simple product in huge quantities, there is not much complexity to capture. Traditional costing may be enough. ABC becomes useful when there are many indirect costs, many different products, clear differences in how products use resources, and strong competition. Strong competition matters because wrong product costs can lead to wrong prices.

Why do companies abstain from using the ABC method?

Many manufacturing firms tried ABC, but only a minority fully implemented it. The reason is simple: ABC is expensive, time-consuming, difficult to keep updated, and not always useful enough to justify the effort. Many companies also do not integrate ABC into the official accounting system. So ABC is often not used for inventory valuation or CoGS. Instead, it is used as a separate tool for strategic analysis, such as product profitability, customer profitability, capacity analysis, or pricing decisions. In practice, ABC may be updated once or twice a year rather than continuously.