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knowledge bank -applied learning Evolution of Cost Accounting

The theory of traditional Cost and Management Accounting has been under severe criticism in the recent years. Professionals working in the industry and the academia world over have critically debated over the relevance of cost and management accounting for decision-making and product costing purposes. It is argued that while cost and management accounting was an important tool in the nineteenth century and before, its importance in terms of both scope and objectives has gradually declined during the 20th century with requirements of inventory valuation taking precedence over the decision making and strategic use of this important functional area. It is widely believed that the fall of the UK and the US industry during the 1980’s and the 1990’s was caused due to wrong Product Costing, which provided with misleading inputs to managers thereby resulting in wrong and detrimental decision making. 

The focus of this article is to review the current scenario from a historical perspective so as to help readers understand the need of the emergence of modern concepts like Target and Activity Based costing. The article considers four paradigms that cover the recent history of cost and management accounting in the context of both product costing and the determination of selling price.
The traditional framework (Paradigm 1 and 2)
Since the time of industrialisation, Cost and Management Reporting has always been the responsibility of either Cost or Financial Accountants or both. Apart from the statutory Balance Sheet, Profit and Loss Account and the Cash Flow statements, the Financial Accountants of companies would provide other detailed reports to the management using the same set of historical data. However allocation and apportionment of expenses over cost centres and finally their absorption on the Finished Product continued to be the responsibility of the Costing professionals. Many companies adapted the Integrated Model to combine the Costing and the Accounting functions and get real time information, which would be of greater use than the historical data provided by financial accounts. 
However, with the advent of financial audit (early 1900s) and its increasing importance ever since, product costing systems have increasingly concentrated on the production portion of the value chain as shown below,                             
RESEARCH                DEVELOPMENT                  PRODUCTION          MARKETING              DISTRIBUTION          CUSTOMER SUPPORT

This is understandable since during the first half of the nineteenth century and perhaps till a couple of decades later, manufacturing costs accounted for the bulk of total costs incurred by the industry. The reason being the lack of competitive markets resulting in less advertising and distribution costs coupled with very little marketing and customer support. Manufactures worked in a monopolistic or a near monopolistic environment with products having long product life cycles and so did not require to incurr large quantum of expenditure on functional areas like Research, Development etc. With most of the money being expended on the production function, reports provided by financial accountants for inventory valuation purposes gave enough information to the management about the majority of expenses being incurred by the company. The other costs incurred in the other than production functions of the value chain were considered discretionary and since the total quantum of such costs would not be huge, frequently they were excluded from decision-making purposes.  

However, manufacturing costs computed then were typically characterised by simplistic assumptions, with the use of ‘blanket’ overhead rates and simple labour overhead recovery bases being the common practice. This would result in wrong product costs, the detrimental effect of which was understood only during times of fierce competition and growth, beginning 1980s.

The traditional era of cost and management accounting
The traditional era of cost accounting can be divided into the following two phases;
First half of the 20th century – Costs were classified as Direct costs and Manufacturing overheads. (Paradigm 1)
Second half of the 20th century- Costs were classified as Direct costs, Fixed overheads and Variable overheads. (Paradigm 2)

A Cost Sheet prepared in the first half of the 20th century would appear as follows;
Cost Sheet as prevalent in the first half of the 20th century (Paradigm 1)
(in Rs)
Capacity : --------- units
Description Total cost Direct Cost per unit Overheads per unit Cost per unit
Bill of Material Cost xxx xxx ------- xxx
Direct Labour xxx xxx ------- xxx
Manufacturing overheads xxx ------- xxx xxx
Marketing and administrative  overheads xxx ------- xxx xxx
Total cost per unit xxx
Add desired profit xxx
Desired selling price/unit xxx

There are two debatable issues which immediately cross ones mind on looking at the cost sheet drawn above. They are;
1. #What volume of activity should be used to project overheads so as to arrive at unit cost?
2. What should be the criteria to determine desired profit?
#possible answers to the volume of activity question, which needs to be addressed to determine the total unit cost, usually point towards expected volume or the capacity of the plant or the normal level of production.

 The answer to the second question is generally subjective. However, the use of ‘cost of capital’ concepts remains the most widespread. 

# In case one looks carefully at the Cost Sheets drawn above, it shall be clear that whose ever prepares the Cost Sheet has got enough information on the volume of activity to be conducted by the concerned company, because only if this information is available can one actually predict the amount of manufacturing overheads to be incurred in a future period. In a competitive market, one may safely argue, one can only know the volume of activity to be performed by having in his mind a tentative Market Price, strangely however, this is one of the primary objective of a Cost Sheet. Similarly the issue of desired profit, the calculation and computation of which is extremely subjective and hence debatable.

As mentioned above, there are very subtle differences in the Cost Sheets prepared in the first half of the 20th century when compared to Cost Sheets made in the second half. Unlike the first half, Cost Sheets prepared during the latter period were characterised by the fixed and variable concepts. By doing so, they answered,* to a certain extent, one of the debatable issues mentioned during the previous era that is;
Since variable cost of units is determined by engineering standards and other analytical techniques, they do away with the volume of activity question, which essentially then pertains to fixed costs.

A Cost Sheet prepared in the second half of the 20th century would appear as follows;
Cost Sheet as prevalent in the second half of the 20th century (Paradigm 1)
Capacity : --------- units
                                       in Rs                      
Description Total Cost Total Fixed Cost Total Variable Cost Fixed Cost per unit Variable Cost per unit Total Cost per unit
Bill of Material Cost xxx ------- xxx ------- xxx xxx
Direct Labour xxx ------- xxx ------- xxx xxx
Manufacturing overheads xxx xxx xxx xxx xxx xxx
Marketing and administrative  overheads xxx xxx xxx xxx xxx xxx
Total cost per unit xxx xxx xxx
Add desired profit xxx
Desired selling price/unit xxx

*The second half of the 20th century is popularly known as the era of ‘Cost Volume Profit Analysis’, in which the manufacturing overheads were segregated into fixed and variable. Whereas variable overheads could be identified with the production pattern with ease, the fixed overheads needed to be imputed over the products. This used to be done by identifying appropriate Cost centres and Overhead absorption rates. Fixed manufacturing overheads were initially allocated over the Cost centres and then finally absorbed over the output at the rates, which were pre-established.  The overhead rates were established considering the maximum output, which could be achieved by the specific cost centres as compared to the budgeted costs, which would be incurred for that level of activity. The result was that in case a company did not produce to potential, certain amount of these fixed overheads would not be absorbed over the products and hence remains unabsorbed. Such overheads were subsequently charged to the Profit and Loss Account and also provided the management with information about the productivity of the workers on the shop floor. However, Product Costing done on the basis of  imputing fixed costs gives approximate results and is only useful in case the product has a long life cycle in the market. In the present competitive scenario, where innovation is the rule of the day, product life cycles have shortened and the competition has increased amongst companies at an unprecedented level. Such a scenario requires companies to produce in small batches as   per customers requirements (implying higher raw material costs due to smaller purchases than before) , deliver quickly and efficiently (higher incidence of cost on the customer support and distribution functions of the value chain)and most importantly be prepared for product obsolescence Traditional costing may not be appropriate today as what it was when the market conditions were different. 

Activity Based Costing (Paradigm 3)
The debatable issue of volume of activity remained in the post 1940 era although it then concerned only the fixed overheads. As pointed out above, the concept of imputing fixed cost per unit had its own shortcomings. 

To a large extent, such anomalies are done away with the use of Activity Based Costing (ABC). A Cost Sheet prepared with ABC concepts is shown below;

Cost Sheet (ABC)
Variable costs per unit Rs
          Direct materials Xx
          Direct labour Xx
          Variable manufacturing overhead ;
             Variable with number of units Xx
          Variable with product complexity(number of                batches) Xx
          Variable with product diversity(number of products) Xx
Variable marketing and administrative Xx
Total variable cost per unit Xx
Fixed costs
Fixed manufacturing overhead Xx
Fixed marketing and administrative Xx
Total fixed cost per unit Xx
Grand total cost per unit Xx
Desired profit (mark up) Xx
Target selling price per unit Xx

 A careful study of the differences in the traditional Cost Sheets and the Activity Based Cost Sheet shows that ABC recognises two additional variable costs (reducing the fixed component) and is essentially designed to improve the accuracy of the total unit cost thereby impacting favourably the fixation of selling price. These two additional variable costs are as follows;
Costs, which vary with product complexity, such as number of batches.
Costs that vary with product diversity, such as number of products.
Although, there are many critics of ABC who contend that the technique is nothing but an improvement over the traditional concepts, it is easy to see how ABC would be a better tool during times when customers become demanding in terms of ‘features’ of products because of which companies have to cater to slightly different types of production processes for essentially the same product. The Textile Machinery and Picture Tube   industry in India faced such a situation during the mid 1990s when the government had allowed foreign companies to enter the Indian markets and the import duties on second hand goods, SKDs and CKDs were reduced drastically. Customers then had more choices; product diversity and complexity were the need of the hour. The benefits of ABC during such times are immense.   

Market driven standard costs (Paradigm 4)
Unlike traditional costing concepts where a target selling price is established after computing the cost of a product, paradigm 4 uses the selling price it believes the market will allow in order to determine the allowable cost. Hence, the allowable or target cost per unit is a market driven standard cost that has to be met if the desired profit are to be achieved. 
Cost per unit under paradigm 4 is computed as follows;

Target Cost Sheet (Rs per unit) 
Selling price (prevailing in a competitive setting) Xx
Less desired profit Xx
Target or allowable cost Xx

Hence in Target Costing what counts is the need to produce at an allowable cost. This idea may mean that now the distinction between fixed and variable components is immaterial. It also implies that in case one intends to continuously improve, this allowable target cost should be reduced over time. Such reductions shall need an empowered workforce because it is the one, which is nearest to the action and so in the best position to lead towards a path of continuous improvement.   

The scope and objective of cost and management accounting has changed over a period of time. New tools and techniques like ABC and Target Costing have been introduced, keeping in mind the changing economic environment, which has increased competition. Activity Based Costing is a substantial improvement over the traditional costing techniques because of its identifying more variability in expenses incurred in the production process. However, it is unable to do away with the contentious issue of computing the ‘desired profit’. In today’s competitive environment, Target Costing, with its emphasis on market driven costs is perhaps the best way to survive productively. 

1. Johnson and Kaplan - Relevance lost: the rise and fall of management accounting.
2. Cooper, R (1996) - Activity Based Costing and the lean enterprise: Journal of Cost Management.
3. William L.Ferrara, CPA, and Management Accounting (USA): Cost/Management Accounting: the 21 st century paradigm.

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