The Vital Role of Cost Accounting in Driving Profitability in Manufacturing

Cost accounting is a specialized discipline not always found within the strengths of a manufacturing company’s accounting department. Leaders may have a feel for how their company is performing overall, but they may not have a clear sense of which parts of their business (customers, products, production lines) are helping or impairing overall performance.

Review key information to help increase your knowledge and understanding of basic costing concepts, how manufacturers use costing information, and common mistakes made in the interpretation of costing calculations.

Cost accounting and its practical uses

Cost accounting is a method of allocating expenses associated with production. The focus of this article is on costing used for internal analysis and decision making. Cost methods for external financial reporting may be different.

Common uses of costing calculations for internal purposes include:

• Helping to set pricing
• Driving business strategy decisions
• Monitoring production

While the complexity of costing calculations varies significantly depending on available information and intricacies of a company, there are some basic concepts and definitions worth summarizing.

Cost pools

Cost pooling is the grouping of all identified expenses (costs) associated with production.

Costs typically fall into one of four basic categories:

1. Direct costs — Material and labor expenses directly associated with production of a unit.
2. Variable costs — Expenses incurred that fluctuate in association with levels of production.
3. Overhead — Indirect expenses incurred during the manufacturing process that cannot be directly attributed to a job.
4. Fixed costs — Expenses that are predictable and consistent over a relevant range of production. Some typically significant fixed costs included in costing models are:
   • Depreciation of equipment
   • Rent or depreciation of facility
   • Administrative labor
   • Business insurance
   • Property taxes

Cost drivers

A cost driver is a costing model factor used to apply expenses within cost pools to the units of production.

Questions often arise as to what costs to include as part of the allocations and what costs to exclude. While the answer to this question depends on the purpose of the calculation, most internal costing systems will consider all company expenses.

An effective cost accounting system is one that — to the greatest extent possible — aligns the cost pools with the drivers of the behaviors and incorporates the concepts of capacity utilization and increased efficiency. When putting together a cost accounting system, consider collaborating with a team of experienced operational and cost accounting professionals.

Six common mistakes of costing

Here are some basic misconceptions that business leaders encounter when using or implementing costing.

Not understanding the differences between Generally Accepted Accounting Principles (GAAP) reporting and management cost accounting

Costing done for GAAP reporting is primarily done for the purpose of external financial reporting, while management cost accounting is done for the purpose of providing management information for operational decision making. Both are valuable to the business leaders, but they are often mistaken as the same.

Oversimplification

A starting point for many costing calculations is based on a simple mathematical calculation that applies a small set of cost pools to production using a single cost driver (e.g., direct labor hours). The challenge in having simple mathematical calculations is the results can be easily misunderstood — as both sides of the calculation can change.

Not accounting for excess capacity and assuming optimal efficiency

Costing calculations often rely on a flawed assumption that the current level of production is the full capacity and that the plan is operating at an efficiency consistent with other entities in the market. If an organization is not operating at full capacity or has significant efficiency challenges, it is important to consider the costs of these factors in the costing calculations.

Underutilization may be more appropriately segregated to its own cost bucket rather than having it impact all the cost elements of a measuring business area (underutilization is often a sales problem, not a cost to be improved by production). Failure to understand and appropriately manage the cost impact of underutilization can lead to incorrect conclusions and influence poor business decisions.

Not collecting or tracking accurate data

Implementing a sophisticated technology infrastructure is an investment sometimes overlooked by manufacturing companies. Costing calculations in general are greatly influenced by the accuracy as well as the timing of production data.

The affordability of technology to track, compile, and report on production data is improving and should be part of any manufacturer’s digital transformation strategy. Consider both hardware and software as well as professional resources to implement, structure, and interpret data.

Relying on costing as sole determination for pricing

While understanding the cost of a product is an important piece in setting sales prices, it is at least equally important to consider market conditions. It is not practical for an organization to raise or lower prices solely on the results of a costing calculation.

Failing to monitor for changes in cost structures or behavior

It is important to continuously re-evaluate how costing calculations are performed and how they apply to current business practices. Occurrences such as changes in product mixes, improved efficiency in operation, changes in capacity, and other factors can impact costing calculations. This is where a value add revenue model is an impactful lens to evaluate your business.

A well-designed cost accounting system can be used by decision makers to drive profitability.

Profitability and costing go hand in hand

Misunderstanding of costing can lead to a downward spiral of costing errors and poor business decisions. In a worst-case scenario, a manufacturing company eliminates products that are marginally profitable or even unprofitable, and reallocates the fixed cost covered by those products to the remaining products.

This can lead to the perception that something must be done to improve the profitability of the remaining products. Eventually the business increases prices and loses business due to not being competitive in their market.

How we can help

CLA’s cost accounting consultants have helped thousands of clients put a solid cost accounting system in place, including automation and Power BI tools to perform profitability analysis on current inventory and incoming orders. Whether you’re an established manufacturer or an emerging business, we can provide you with the assistance you need to help strengthen financial outcomes and boost productivity.