Cost Accounting 101 – Did you Skip this Class?
I confess…college was a long time ago for me…and Cost Accounting was not one of my favorite classes. But since then, I’ve spent most of my career in exactly that…Cost Accounting.
If you live and work in Ohio, chances are, you work in or around manufacturing. And that’s a good thing; we still make things here. Not all of the manufacturing has gone to Southeast Asia. And like LeBron, some of it has returned home, to NE Ohio!
Like it or not, if you work in manufacturing, it is in your best interest to know a few of the basics, or Cost Accounting 101. Here’s my version of the Cliff notes, no charge:
- It’s all about inventory. Even small manufacturers are required to report inventory on their tax returns – raw materials, work-in-process, and finished goods.
- Why? If you produce, purchase, or sell merchandise in your business, Uncle Sam does not allow you to deduct the cost of those goods when you buy or make them…only when you SELL them. It’s all about timing. If your financial reporting is on the US GAAP basis of accounting, the Financial Accounting Standards Board (FASB) is similar to the IRS. The costs – of goods purchased and money spent converting the goods to finished product – are held in inventory limbo, until a finished item is sold.
- If you’re a retailer, wholesaler, or distributor, inventory accounting is fairly simple…you buy stuff, maybe hold it for a while, maybe re-package…then sell it. You may need to attach some additional costs to the stuff – the IRS and the FASB have slightly different rules for this, but it’s not too cumbersome. Essentially the inventory value is what you paid for it.
- Note: In the interest of full disclosure, we could have a stimulating discussion of LCM (lower of cost or market), FIFO (first-in, first-out), LIFO (you can guess), average cost, and more, but that will have to wait for another day.
- Inventory valuation is not quite as simple for manufacturers. They buy raw material and purchase parts. Laborers, well, labor, to turn the material or purchased components into the finished product. They run machines – lathes, mills, grinders, presses, punches – some manual, some very complex, computer-controlled machines. With or without machines, they assemble, they inspect, they package. All of the costs related to that conversion process – labor, both direct and indirect (supervision, engineering, QC) and all other manufacturing overhead (rent, utilities, depreciation, etc…) need to get attached to the product.
- How do you do that? There are as many ways to do this as there are manufacturing companies in Ohio. Methods and systems range from very simple to extremely complex.
Basic Steps to Cost Accounting
Step 1: Separate your expenses into at least these two buckets: manufacturing versus selling and administrative. This is part science and part art. Need help? Give us a call.
Step 2: Decide on a denominator…usually direct labor hours or direct machine hours. More and more, I like machine hours, especially if you have expensive CNC machinery, or when you have one laborer running two or more machines at the same time. The denominator could also be units, widgets, or pounds produced, if your product line is limited. For most manufacturing shops, machine hours are the best option.
Step 3: Estimate (yes, ESTIMATE. Inventory valuation is ALWAYS an estimate. Don’t get hung up trying to be exactly precise.). Estimate the expected manufacturing expenses (see Step 1) and expected machine hours (see Step 2) for a time period, say the next month, quarter, or year. Use historical information as a guideline, and adjust as needed, for expected changes.
Step 4: This is so easy; it doesn’t even need to be a step. Divide. Estimated manufacturing expenses divided by estimated machine hours. This gives you a rate of dollars per machine hour.
Step 5: Track the machine hours on production jobs or goods, multiply by the rate, and you have your estimate of conversion costs (labor and overhead) that need to be attached to the goods, along with the cost of the material. Did you send something out to a vendor for a process? Heat treating maybe? You need to attach those costs too.
That’s it…it’s really not rocket science. You can make it more complicated, or more ‘precise’. Each machine or machining center can have its own rate. Sometimes that makes sense. In that case, you would need to divide or allocate the manufacturing expenses to each machine or center. More estimating. It might be appropriate to skew more overhead costs to certain products or operations in the allocation process. Consider QC costs, or production engineering. Use the 80/20 rule…typically 80% of costs lie in 20% of the line items or categories, so focus your energy and attention on those costs when determining allocations that make sense. And again, there are as many methodologies for these allocations as there are manufacturers in Ohio.
One last thing – I would be remiss if I didn’t point out that our friends at the Internal Revenue Service have their own rules for which costs need to be attached to inventory for income tax reporting. They call it UNICAP or code section 263A…buzz words for IRS Cost Accounting. Again, this is a topic for another stimulating conversation.
Want some help, or a sounding board? Or Cost Accounting 201? Give me a call at 216.674.3733 or email firstname.lastname@example.org.