Cost Accounting for Manufacturing Organizations - Concept

Financials > Business Performance > Cost Accounting for Manufacturing Organizations

Before diving into absorption costing and reviewing how Beas Manufacturing works with it, in this chapter you can read about some fundamental concepts of cost accounting that will play a key role in guiding you through this whole set of definitions and processes. Otherwise, it could be difficult to rationalize why certain processes must take place and their importance for enhancing a company’s decision-making capability by providing indispensable costing information.

Cost Accounting for Manufacturing Organizations

In a business environment, costs represent a decisive factor in the companies strive for survival and growth. If a company has a non-competitive cost structure, it will ultimately become unfeasible to operate, as its profits will fall below acceptable levels, or its prices will soar above what the market is willing to pay for its products. Additionally, even when cost structures are competitive, incorrect costs appropriation might overburden some of the companies’ products while unburdening others, turning profitability analysis into a difficult and inaccurate task, and possibly leading to wrong business decisions. Therefore, understanding costs and being able to distribute them properly across the products is critical to success in a competitive environment.

If we think on retail or wholesale organizations, costs seem straightforward and are clearly identifiable in the products. Companies can easily tell for how much they purchased their goods and pricing decisions are generally not complicated, as administrative expenses are either common to the entire company or related to product divisions and therefore easily linked to the goods. In this scenario, lowering purchasing prices and reducing structural costs have a direct impact on profitability, and understanding current profits does not require much effort.

For manufacturing organizations, on the other hand, costs have a much higher degree of complexity, which arises especially from the fact that many manufacturing-related costs cannot be directly linked to a particular product. Nevertheless, instead of jumping straight into the tools we have for solving such problems and transforming complicated data into reliable and accurate costing information, let’s have a look at the components and definitions of cost for manufacturing companies.

There are three categories in which manufacturing costs are normally divided:
 

•Direct material: the costs of all direct materials consumed for manufacturing a product. If we think on a machined sandblasted metal piece, the direct material costs would come from how much metal we used to produce it, whereas other materials (such as sand wasted in the sandblasting process, drill bits, and end mills) whose measuring results impossible for that piece are treated as manufacturing overhead;

•Direct labor: all costs associated to the workforce physically and directly involved in the process of manufacturing a certain product. This accounts for machine operators and assemblers, but not for indirect labor, such as production supervisors, maintenance technicians and quality control operators;

•Manufacturing overhead: all other manufacturing costs which do not fall into the categories of direct material and direct labor are manufacturing overheads. This category includes costs of indirect materials (cleaning supplies, disposable safety equipment, disposable tools, fittings and fasteners, etc.), maintenance staff, quality control staff, equipment depreciation, utilities, factory rental, property taxes on the production facilities, production managers and supervisors, and many others. Manufacturing overheads do not include, however, administrative expenses not related to production—only indirect production costs can be considered as overheads.
 

Although it is fairly easy to measure direct materials and direct labor for manufacturing a product, understanding how much overhead costs each product should receive is always a complicated endeavor. For example, consider a company who produces liquid chemical products. Do all chemicals require the same reaction times on reactors and have the same viscosity? Not at all, and both higher reaction times and viscosity might represent a higher burden on maintenance and cleaning activities after production, as these products could wear the reactors faster and occasionally cause clogs which can be hard to clean. Besides, if the company constantly switches between different types of products using the same production resources, more cleaning and machine preparation times might be required than when producing multiple times the same product, which also increases manufacturing overheads significantly.

Using the traditional costing method, all manufacturing overheads would be summed and divided by the amount of a particular cost driver (which are the factors responsible for generating manufacturing costs), like the number of produced units, processed kilograms, or labor hours. Then, each and every product receives a share of manufacturing overheads based on how much of that same cost driver it contributed to increase. However, considering the existing variables in real production environments, should all products receive the same share of manufacturing overheads? If we produced 100 kilograms of a very difficult to process chemical, should it receive the same costs as 100 kilograms of an easily processable chemical? When the goal is to achieve a more accurate profitability analysis, the answer is no. And this leads to our next and fundamental question: how to make sure that each product receives a fair share of the correct manufacturing overheads?

For this question, the answer comes from one of the alternative methods to appropriate manufacturing overheads to products called absorption costing, which is precisely our next topic in this article. Using absorption costing, companies can base their costs appropriation on the costs related to direct or indirect manufacturing cost centers and on how much they affected production.

See:
Absorption Costing - Setup

Absorption Costing - Introduction

Absorption Costing - WORKFLOW
Absorption Costing Report - Concept