new cost accounting concepts

New Cost Accounting ConceptsAuthor(s): George GibbsSource: The Accounting Review, Vol. 33, No. 1 (Jan., 1958), pp. 96-101Published by: American Accounting AssociationStable URL: http://www.jstor.org/stable/242014 .

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NEW COST ACCOUNTING CONCEPTS GEORGE GIBBS

Associate Professor, Claremont Men's College

IN an activity such as Cost Accounting in the modern dynamic industrial age the term "new" is a relative term.

Many aspects of this subject are con- tinually changing. These changes involve both the requirements by management and the procedures employed to meet those requirements. This study presents a discussion of the "concepts" of cost accounting and not the "procedures." It involves the requirements of management and government agencies because these requirements set the pattern for cost accounting.

XWithin the last few years there have been many groups interested in the problem of cost accounting. There have been many special research bulletins of the National Association of Cost Accountants; there is a special committee of the Ameri- can Accounting Association; the English magazine Accounting Researchi has had several articles bearing on the subject; and the Journal of Accountancy has devoted space to the subject.

As cost accounting is closely related to cost control and the planning of business enterprises, other academic disciplines have shown more interest in the problem in recent years; articles written by economists, statisticians, and engineers have ap- peared in increasing number. The economists are related to the subject through their discussion of the economic situation of business firms operating under different cost conditions and different market situ- ations. The statisticians are interested in accounting as it relates to the application of statistical techniques which may draw more useful conclusions from large quan- tities of data. Engineers are interested because of the physical plant being used and because of the implications for effi-

ciency inherent in new developments such as "automation."

Most of the references in this study will be to manufacturing functions, but the concepts are similarly applicable, in differ- ing degrees, to distribution, selling, and other functions of business as well as to government and to nonprofit organiza- tions.

Purposes of Cost Accounting

There are several main purposes of cost accounting:

1. Income determination, with the cost of goods sold and the inventory valuations being the main results of cost accounting.

2. Balance sheet presentation, with the inventory items, the balances in the pre- paid and accrued expense accounts and the residual value of fixed assets being related to cost accounting.

3. Control of cost by management made possible by having available adequate data to judge performance quickly and also having data for future planning.

Mr. John G. Larson has stated that, in terms of time, there are three kinds of costs involved in carrying out the stated purposes.'

1. Past costs for profit determination 2. Present costs for cost control 3. Future costs for planning In an attempt to obtain data for these

purposes, the profession has developed over a period of time procedures involving variations of:

1. Job cost 2. Process cost

and in either of these there may be the use

1 Larson, John G., "Utilizing Past, Present and Future Costs," N.A.C.A. Bulletin, February, 1952, p. 695.

96



New Cost Accounting Concepts 97

of "standards" for specific operations of each product or cost center of the business. Further, there have been developed procedures for describing variable and fixed costs and for sorting the "so-called" semi-variables into either "variable" or "fixed" for the purpose of computations.

In 1947, Mr. Theodore Lang wrote an article entitled "Concepts of Cost, Past and Present." He did not forecast the future but helped explain why cost accounting is where it is today. He traced the early attempts at accumulating costs and dividing by the number of units to obtain "unit" cost and concludes that "actual costs are really accidental costs and, therefore, strangely enough not true costs as the term is understood today. "2

The shortcomings of actual cost led to the development of standard costs but there is a question as to whether the profession would now agree wholeheartedly with the conclusion, made in 1947, that "The cost accountant has come a long way, gradually abandoning faith in an actual cost and going wholeheartedly over to the idea that a standard cost is really the true cost."3

Among the "new" concepts of cost accounting are direct costing, marginal costing and variations of these two concepts on actual and standard bases.

Direct Costing Direct costing has been defined by Mr.

Nielsen as a system in which . . . direct labor and direct material costs are identified with products. Any other costs directly and conveniently traceable to products are identified with them also .., other items of manufacturing expense are considered to be over-all costs of operation in the period of occurrence.4

The development of this system is shown in the N.A.C.A. research bulletin entitled

,'Lang, Theodore, "Concepts of Cost, Past and Present," N.A.C.A. Bulletin, July 15, 1947, p. 1377.

3ibid., p. 1389. 'Neilsen, Oswald, "Direct Costing-The Case

'For',' Tsiz AccoUNTING REVIEW, January, 1954, p. 89.

"Direct Costing." The accumulation of variable costs separate from fixed costs permits preparation of analytical statements directly from the records rather than from an analysis of variances, as in the case when fixed and variable com- ponents are mixed. Part of the confusion in terminology has arisen in that what is called "direct" costing in the United States is called "marginal" costing in Great Britain.

The bulletin also contrasts "direct" costing with "absorption" costing. "Ab- sorption" costing is a term used to cover the various conventional methods whereby fixed costs are applied to production and included in inventory.5

Mr. Hepworth, a critic of the direct costing system, defines it as a "technique whereby the cost of a product is restricted to the inclusion of variable manufacturing costs with fixed manufacturing costs being considered as period expense. It must be noted that this is not the same concept which regards only direct or prime costs as product costs, all overhead or burden costs being considered as period expenses."8

Thus, the older system of allocating all the overhead to the product or to each cost center is not to be used in the "direct" costing system. It also must be carefully noted that the concept of direct labor plus direct material (the sum known as prime costs) is not the "direct" cost in this system. "Full" cost has been known as "prime" cost plus "overhead."

Up to this point there has been no dis- tinction between average and marginal cost, whether "full" or "direct." The discussion of "cost at the margin," which is perhaps a better term than "marginal cost" will be undertaken later.

The accumulation of direct costs, or

5 N.A.C.A., "Direct Costing," Research Series #23, April 1953, p. 1082.

6 Hepworth, Samuel R., "Direct Costing-The Case Against," THE ACCOUNTING REVIEW, January, 1954, p. 94.



98 The Accounting Review

variable costs as they are called by the economists, is very valuable to management for internal reports on current operations. The variable costs are those that each manager of a segment of a plant (cost center) can control, and for this reason the system seems reasonable. However, to go further and state that the costs in the general ledger should contain only the "direct" or variable costs is misleading. The "cost" of production for purposes of income determination and the "cost" of the inventory for balance sheet purposes should be based on full cost. Referring to economic analysis, the costs considered in the direct costing system are those that vary in the "short run." The term short run is a useful way of saying that, for the time being considered, the plant is "fixed" whereas in the "long run" all costs (variable plus fixed or "full" costs) are variable. Also, in the long run full costs must be covered or the firm will be out of business.

Therefore, it is important to know where the cost in each cost center is in terms of the average direct cost curve, not just to know the average direct cost. It is easy to draw a hypothetical curve on a piece of paper but difficult and expensive to obtain real data to plot. However, many factories have data for cost of varying outputs with a given fixed plant. Mr. Charles R. Fay, Comptroller of Pittsburgh Plate Glass Company, has called "direct" costing a multiple-purpose management tool and claims that, combined with a standard cost system, this procedure is far superior to conventional cost accounting procedures. His application of direct costing eliminates the necessity for volume variances, and the fixed costs are "seen in rela- tion to sales volume . . . " and which is "proper because we must look at fixed expense as a cost of being ready to do business."I7

7 Fay, Charles R., "Direct Costing as a Multiple- Purpose Management Tool," Accounting, Auditing and Taxes, American Institute of Accountants, 1953, p. 74.

Thus, it is seen that although the knowledge of "direct" costs and the nature of a direct cost curve, plotted from various outputs, is valuable for management, it does not appear to be a substitute for the accumulation of full costs for the product or cost center and for the operation as a whole. Also over an extended period of time a manufacturing firm which prices its product or products, giving recognition only to the unit variable cost of production will gradually consume its investment in long-lived assets and may cease to exist as a going concern. If this analysis were to be carried, on this point, to its logical conclusion it would be necessary to discuss in detail perfect and imperfect competition, but it suffices to say that in perfect competition the selling price is fixed by the market and the producer adjusts his output along his cost curve to maximize his profit which will be the average profit for the industry. However, if the producer has special advantages, due to some mo- nopolistic feature or product differentiation, he will adjust along the same cost curve, but reach a higher profit figure.

Mr. Roger Wellington of Scovell, Wellington & Co., states that the management of a company using direct costing is furnished with periodic income and cost statements in which costs that vary with volume are distinguished from fixed costs. In making de- cisions on many questions faced in business operations, such information concerning marginal costs is essential.

This recognition of the need of the knowledge of variable costs by management is significant, but the direct cost concept should not be confused with marginal, as there is either total, full average, or marginal "direct" cost. Mr. Wellington concludes his comments by stating that ''management . . . should have the benefit of internal statements that analyze costs . . . between those that are variable and

' Wellington, Roger, "Direct Costing and Its Impli- cations in Financial Reporting," Accounting, Auditing, Taxes, American Institute of Accountants, 1953), p. 56.



Neu) Cost Accounting Concepts 99

those that are fixed" and that "the conventional basis, properly developed and adequately reported, seems definitely superior for general use."9

The "direct" costing needs the marginal concept to be complete, as the direct costs can be discussed for a given output in terms of total direct cost, average direct cost or marginal direct cost.

Marginal Costing

It has been shown that there is a con- nection between the "direct" costing system and the "marginal" costing system and the latter will now be considered in some detail. It appears that "marginal" costs are the same as "differential" costs. A reference to economic analysis is necessary at this point. In the short run (no change in plant or fixed assets) adjust- ments are made by the individual firm in the variable or "direct" costs--namely, direct labor, direct material, variable overhead and supplies. In the long run, ad- justments are made to plant or fixed assets. In both these periods marginal analysis may be employed, as the cost of an increase in a unit of output can be considered in either case. The next step is to proceed with a theoretical analysis of these concepts and the conclusions which can be drawn from them. Many firms have data to draw the necessary curves-that is, cost data at various levels of output.

Short Run

Profit is maximized at the point where marginal cost equals marginal revenue (price) whether the firm is in a perfect or imperfect market. The marginal cost is the additional or incremental cost to produce one more unit or batch at any given point on the curve and refers only to the variable costs.'"

Thus it is seen that if a curve or schedule

I Ibid., p. 68. 10 Blodgett, Ralph H., Oitr Expanding Economy, an

introduction to economic principles and practices, Rinehart & Co., 1955, p. 283.

of direct costs can be computed for production at different levels, that the total full, average and marginal "direct" cost can be computed from the curve. If the total at each level of production is known, even roughly, then the average and the marginal can be computed. From the marginal cost curve or schedule, the important conclusions for management can be drawn by a comparison with the demand curve. If the situation in the market is one of perfect competition (many buyers and many sellers, no one buyer or seller large enough to affect the market, and a standard product) the demand schedule is hori- zontal from the point of view of any one producer. In other words, he cannot set the price for his product but must adjust to the market. On the other hand, if he has control over prices in the way of monopoly of supply, price differentiation or patent control, he can maximize his gain (or minimize his loss) by setting price and output at points indicated by the equality of marginal revenue and marginal cost. This variation has been mentioned to complete the price picture but will not be expanded in this article.

Chart 1 shows hypothetical curves for total variable, fixed and "full" costs. "Full" costs is the sum of fixed and variable costs. Since marginal costs vary with output, the variable cost curve is not a straight line as the assumption of a straight line might lead to erroneous conclusions. As output increases the efficiency per unit of input of variable factors increases at first, then de- creases. The increase in efficiency is shown by a decrease in the average variable cost (chart 2) up to 65 units of output; then the decrease in efficiency is shown from there on by a rising average variable cost curve. However, the average full cost declines to the point where 80 units are produced because average fixed cost is declining at a rate greater than the increase in average variable cost.

Inspection of chart 2 shows that the



100 The Accounting Review

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New Cost Accounting Concepts 101

breakdown point (price = average full cost) is at an output of 44 units, the point of lowest average full cost at an output of 80 units, and the point of maximum profit (price= marginal cost) at an output of 90 units. On chart 1, this point of maximum profit is found where the total full cost line and the total revenue lines are farthest apart, in mathematical terms where the tangents are parallel.

Thus it is seen that marginal analysis involves, to some degree, a series of concepts developed by the economists and now used by cost accountants. While this analysis of the short run, under conditions of perfect competition, is quite theoretical, it reflects many of the concepts that have been partially discussed in the articles referred to earlier. Some of the confusion in both terms and conclusions, it appears, has come from the use of incomplete theoretical patterns. These patterns can be valuable tools for analysis when correctly used.

Long Run

In the long run, all costs are variable because in this period plant size can be adjusted upward or downward. This situation has not been explored in detail by the proponents and critics of marginal costing, but it is obvious that the total, average and marginal long-run full costs could be computed and used for management purposes. Charts showing this situation could be drawn similar to those shown for the short run.

Conclusions on Marginal Analysis

Marginal analysis, both short and long run, can contribute to management accounting and is consistent with conventional accounting techniques. The variable costs can be accumulated and an- alyzed for management purposes and the fixed costs can be allocated for the inven-

tory figures shown on the financial statements.

Mr. Amerman, writing in A ccounting Research, presents a series of mathematical equations to analyze marginal costing and uses the term "conventional absorption cost income statement." He concludes that the objections to the conventional statement may be overcome by:

(1) abandoning the present concept of profits and reporting it as the difference between income and the sum of variable cost of goods sold plus total fixed costs in- curred or,

(2) retaining the present concept of profits, but reclassifying the income statement in such a way that the direct cost profit is first computed and the absorption cost increment, constituting the fixed cost component of inventory difference, there- after added.""

Mr. James E. Earley, in discussing recent developments in cost accounting concludes that "cost accounting principles are fast incorporating the wisdom of the economists" and "that marginal accounting is peculiarly adapted to multidimensional enterprise, losing much of its rationale if applied to the simple firm of most conventional models."'12

It has been shown that some concepts said to be "new" are not so new, that some terms do not mean what they appear to mean, that economics has much to contribute to cost accounting and that there is much to be gained by the cost accountant through correct analysis of his problem on a theoretical level before he starts to gather the data that will aid him in answering the questions of management.

11 Amerman, Gilbert, "Facts about Direct Costing for Profit Determination," Accounting Research, April, 1954, p. 161.

2 Earley, James S., "Recent Developments in Cost Accounting and the Marginal Analysis " The Journal of Political Economy, June, 1955, p. 227.



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