cost accounting foundations - jones & bartlett learning · how does cost accounting differ from...

Part I provides the reader with a solid founda-tion in the essentials of cost accounting. Thechapters in this section introduce costing andcost definitions. Various approaches to prod-uct costing and cost allocation are discussed.Breakeven analysis is also covered in this sec-tion, as are techniques for making nonroutinedecisions.

Chapter 1 introduces the distinctionsamong financial, managerial, and cost ac-counting. The chapter discusses the use ofcost accounting for planning, control, andnonroutine decision making. The role of costaccounting for inventory costing and incomedetermination is also introduced. The chapterstresses the importance of several particularissues in cost accounting: the role of humanbeings; the need to develop cost informationnot only for reporting, but also for manage-ment control; and the benefit/cost philosophyregarding the generation of cost information.

Chapter 2 defines basic cost accounting con-cepts including full costs; average costs; cost ob-jectives; direct and indirect costs; and fixed,variable, marginal, total, and joint costs. Theseconcepts are then applied to marginal cost pric-ing and to the issue of departmental costingversus product-line costing.

Chapter 3 discusses product costing ingreater detail. Job-order and process costing

are explained and contrasted. The chapteralso discusses standard costing systems andmicrocosting.

Chapter 4 addresses the complex issue ofcost allocation. The reasons and guidelines forallocating costs are explained. Cost allocationtechniques are discussed, including cost poolsand cost bases. This chapter also reviews theinstitutional cost report, with a discussion ofhow cost allocation relates to standard costingand microcosting. The difficulties of allocat-ing of joint costs are considered. The chapterends with a discussion of the relative merits ofratio of cost to charges (RCC) costing versusrelative value unit (RVU) costing.

Next, Chapter 5 discusses the issue of de-veloping cost information for nonroutine de-cisions. It considers the identification ofalternative approaches for accomplishing aspecific objective and the issue of relevantcosts, and provides a number of examples.

Chapter 6, the last chapter in this section,addresses cost-volume-profit analysis. Therelationship between fixed costs and volumeis stressed. The discussion of breakevenanalysis provides a number of examples ofcost-volume-profit analysis. The chapterends with a discussion of the breakevenanalysis technique and examines its underly-ing assumptions.

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Part I

Cost Accounting Foundations

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3

CHAPTER 1

Introduction to Cost Accounting

GOALS OF THIS CHAPTER

1. Describe the purpose of cost accounting.2. Distinguish among financial, managerial, and cost accounting.3. Explain the use of cost accounting for planning and control, nonroutine decisions, inven-

tory valuation and income determination, managed care contract negotiation and over-sight, and required external reports.

4. Discuss the conflict between generating cost data for reporting versus for managementplanning, decision making, and control.

5. List several key characteristics of a good cost accounting system, and describe some diffi-culties in designing such a system.

6. Explain the importance of human motivation in cost accounting.

KEY APPLICATION QUESTIONS

1. How does cost accounting differ from financial accounting?2. Why is cost information important for my organization?3. In what ways will my organization use the information from a cost accounting system?

KEY TERMS USED IN THIS CHAPTER

Accounting; capitation; congruent goals; control; cost accounting; cost accounting system; costmeasurement; cost reimbursement; cost reporting; divergent goals; financial accounting; incen-tives; income determination; inventory valuation; managed care organization; managerial ac-counting; Medicare Cost Report; nonroutine decisions; period costs; planning; product costs;profitability analysis; strategic planning.

Note: Key terms appear in boldface italics when first used in the chapter. All key terms are defined in theGlossary.

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4 CHAPTER 1 INTRODUCTION TO COST ACCOUNTING

FinancialAccounting

ManagerialAccounting

Cost Accounting

Accounting

Figure 1–1 Position of Cost Accounting withinthe Larger Realm of Accounting

THE PURPOSE OF COSTACCOUNTING

From a narrow perspective, cost accounting isan element of financial management that gen-erates information about the costs of an organ-ization and its components. As such, costaccounting is a subset of accounting in general;accounting generates financial information fordecision making. From a broader perspective,cost accounting encompasses the developmentand provision of a wide range of financial infor-mation that is useful to managers in their orga-nizational roles. This book takes that broaderperspective.

The prime reason for undertaking any infor-mation-generating activity is so that an effectivedecision can be made. In fact, there is little rea-son to generate information other than to use itin a decision-making process. Even if the userof financial information does nothing after re-ceiving it, the user may well have used the infor-mation to help decide that no action wasrequired at that time. Often, the tools of cost ac-counting can be better understood if one firstconsiders the types of decisions that might bemade using the information.

Financial Accounting vs. Managerial andCost Accounting

Accounting is often subdivided into twomajor categories: (1) financial accountingand (2) managerial accounting. This subdivi-sion aligns itself with the two major classes ofusers of accounting information: (1) externalusers and (2) internal users.

Financial accounting provides informationprimarily for individuals or entities who areoutside of, or external to, the organization.These include banks, suppliers, in some casesowners, the government, and a range of oth-ers interested in the finances of a particularorganization.

Information is conveyed to these users pri-marily by a set of financial statements, in par-ticular the operating statement (or income oractivity statement or statement of revenuesand expenses), the balance sheet (or statementof financial position), the cashflow statement,and the statement of changes in net assets (orstatement of changes in owner’s equity).These financial statements often must followprescribed and somewhat uniform presenta-tion formats as required by the AmericanInstitute of Certified Public Accountants(AICPA), various levels of government, andother bodies such as the American HospitalAssociation.

Internal users of financial information arethe employees who manage the organization.Internal managers need a broad range of fi-nancial information to run the organization ef-fectively. Managerial accounting generatesany financial information that can help man-agers make decisions. Statements generatedfor internal use can take any form that man-agement feels will communicate necessary oruseful information. They have no mandatedformat and can vary greatly from organizationto organization.

Figure 1–1 illustrates the position of costaccounting within the larger realm of ac-counting. Cost accounting is often consideredto be synonymous with managerial account-

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The Purpose of Cost Accounting 5

ing, but that is not a completely accurate por-trayal. Cost accounting includes all of mana-gerial accounting, but it also focuses oncertain elements of financial accounting thatare closely related to cost measurement andcost reporting. For example, generating ahospital cost report for Medicare is techni-cally part of financial accounting, since thereport is generated for an external user, theCenters for Medicare and Medicaid Services(CMS), which administers the Medicare pro-gram. However, because a Medicare CostReport focuses largely on the calculation ofcosts, it is properly a part of cost accountingas well.

This book explains the tools of cost ac-counting so that they can be used for both in-ternal management applications and externalpurposes. The reader should bear in mind thatoften the distinction between the two is hazyat best. Reports generated for external usersmay become valuable documents for use bymanagers. However, caution is required. Re-ports generated for external users often haveto comply with mandates from the externalusers. For example, the government may reg-ulate specific treatment of certain types ofcosts. Although that treatment may be appro-priate for external users, it might be mislead-ing for internal managers. The Medicare CostReport is a good example. Many health careorganizations must comply with reportingregulations in preparing this report, but thatdoes not mean that the report must be usedinternally. There may be alternative ap-proaches to determining costs that would givethe managers more useful information for thedecisions they must make.

Cost accounting information is useful formanagers in a number of areas. These includethe management of department-level costs,pricing decisions in negotiations with man-aged care organizations (MCOs), strategicplanning, and profitability analysis. The re-mainder of this section focuses more generally

on the use of cost accounting for planning andcontrol, nonroutine decisions, inventory val-uation and income determination, managedcare contract negotiation and oversight, andpreparation of required external reports.

Planning and Control

One of the primary purposes for collectingcost accounting information is to allow man-agers to better plan and control the opera-tions of the organization. The planningprocess ensures that the organization has theopportunity to determine its maximum poten-tial. The control process then ensures that theorganization has the opportunity to achievethat potential.

Planning means that the managers of theorganization think through the implications oftheir actions before they act. For example,should the organization undertake a newservice? Planning allows the managers to an-ticipate whether the new service is likely tomake or lose money. By planning ahead, ad-vantageous opportunities can be undertakenand problematic ones avoided.

Decisions will not always be based solelyon the accounting information generated. Anorganization might decide to proceed with anew service even if cost accounting informa-tion indicates that the service will likely lose$100,000 per year. There may be overriding,societal issues that make the service stillworthwhile. The health benefits to the com-munity may be so great that the organizationdecides to proceed even at a loss of $100,000.

However, that does not mean that the costinformation was not used in the decision. Mostlikely, the information was used in two ways.First, the information was used to determinethe size of the loss so a decision could be madewhether to offer the service. If the projectionhad been a $1 million or $10 million loss peryear, the organization might have decidedagainst the project, despite its health benefits.

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Second, the calculation allowed managementto know how much of a loss would need to besubsidized by other sources. The managers cannow make plans to have an excess of $100,000per year generated from other activities.

If such an excess is not generated, then theorganization risks insolvency. However, theorganization has not proceeded to implementthe service without any information at all, justbecause it is an important health service forthe community. The calculation of cost infor-mation has provided the starting point for thebroader planning the organization must do tosubsidize the new service and remain finan-cially stable.

Will the plans actually work? That de-pends largely on how well the employees ofthe organization work to control operationsand keep to the plan. Sometimes things willhappen that the organization cannot control;for example, prices of supplies may rise. How-ever, that does not mean that the organiza-tion should abdicate responsibility forcontrol. Managers must work to keep the ac-tivities of the organization under control. Ifuncontrollable events occur, management cantake actions to respond to those events. Itmay be necessary to alter the original plan.The tools that allow managers to control on-going activities and to respond effectivelywhen either controllable or uncontrollableevents occur make up the control elements ofcost accounting.

Nonroutine Decisions

Most organizations generate a substantialamount of routine information for runningthe organization on a day-to-day basis. Costaccounting, however, also provides the toolsfor making the nonroutine decisions thatmanagers face from time to time.

The question of whether to add or delete ahealth care service, or whether to expand ahealth care facility, can have significant finan-

cial implications for the organization. The rou-tine information generated as part of theeveryday accounting process may not be ade-quate for the manager to make such decisions.The cost accounting tools provided in this bookare designed to offer the reader the conceptualbasis to generate the information needed tomake correct decisions in these cases.

Inventory Valuation and IncomeDetermination

In many industries, inventory is a significantpart of the production process. As manufac-turing firms produce their goods, some costsare treated as expenses in the year the prod-uct is made ( period costs), whereas othercosts are not considered expenses until theproduct is sold ( product costs). The timing ofwhen costs are treated as expenses has a po-tentially dramatic impact on the value of theinventory asset on the balance sheet as wellas on the net income (excess of revenuesover expenses) reported on the incomestatement.

This is an example of cost accounting’scrossover between financial and managerialaccounting. The examination of the costs ofproduction is clearly related to managerial ac-counting. The determination of inventory andexpense values for creation of financial state-ments is part of financial accounting. Both el-ements are part of cost accounting.

Inventory valuation and income determina-tion receive substantial attention in most costaccounting texts, but inventory is a relativelyminor asset for most health care organizations.The primary issues related to inventory valua-tion and income determination concern inven-tory that is transformed in the manufacturingprocess from a raw material into a finishedgood. Such manufacturing transformation isextremely uncommon in the area of healthcare services, and therefore is not a majorfocus in this book.

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Costs for Reporting vs. Costs for Management Planning and Control 7

Managed Care Contract Negotiation andOversight

The provision of health care in the 1990s wasdominated by a focus on cost control and therapid growth of managed care. While healthcare organizations need to be able to relatepayment with cost of care for all types of pay-ers, this need is significantly more important inthe case of managed care.

Unlike other payers, MCOs typically nego-tiate payment rates and/or payment mecha-nisms with health care providers. In thesimplest negotiation, the MCO tries to negoti-ate a discounted price for a particular service.In this case, cost accounting provides the toolsnecessary for providers to know how low theycan go. Increasingly, MCOs are negotiatingcomplex payment mechanisms in which thepayment to the provider is set at a fixedamount regardless of the individual patient’ssubsequent use of services. In this situation(typically referred to as capitation), theprovider is faced with the need to know boththe potential/likely use of services and the costof those services. A good cost accounting sys-tem can identify the cost of the services andassist in identifying the likely mix of servicesto be used.

Once a provider has entered into a man-aged care contract, cost accounting becomesan integral component of monitoring that con-tract. One must remember that the contractwas based on negotiation of the unknown. Inorder for the provider to know how to pro-ceed in the future (both with the existing con-tract and with any subsequent managed carecontracts), knowing the actual use of servicesand the cost of those services becomes vital.

Required External Reports

As noted earlier, many health care organiza-tions have regulatory and contractual report-ing requirements related to cost information.

These requirements have significant impacton the types of cost information generated bythe organizations. As one considers the vari-ous approaches to cost accounting, one mustbalance the information between its strict in-ternal uses to enable the manager to run theorganization more efficiently and its externaluses to create the desired cost information forreporting purposes.

COSTS FOR REPORTING VS. COSTSFOR MANAGEMENT PLANNINGAND CONTROL

The roles of cost accounting for external re-porting and for planning and control do not al-ways work comfortably side by side. Often, themandated need for external reports predomi-nates the accounting process, leaving man-agers with inadequate information.

Managers frequently complain of problemsthat are symptomatic of cost accounting sys-tems that are designed for reporting purposesrather than for managerial use. For example,in many health care organizations, suppliesand purchased labor services do not show upon departmental expense reports for themonth used, but rather one or two monthsthereafter. The lag may not be consistent frommonth to month or from one type of item toanother. Without a special study, there is noway to tell how much of a month’s usage wasincluded in the actual figure reported.

Reporting costs as an expense for a monthother than the month the resource was actu-ally consumed creates problems. Managerstry to determine whether they used an appro-priate amount of resources for the numberand type of patients treated. However, if theycannot match a month’s expense report withthe resources consumed in that month, thenthey cannot accurately compare resource con-sumption to patient volume and mix. This cansubstantially impair the ability of managers tocontrol costs.

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Financial managers usually have a justifica-tion for why things are done in a way that maynot be most responsive to the managerialneeds of department heads. Health care costaccounting developed with a focus on gather-ing information for cost reimbursement (anexternal reporting function) rather than formanagement. Yet, the main job of the man-agers is to run the organization efficiently andeffectively. External reporting is an ancillaryfunction.

In this era when efficiency and cost-effec-tiveness are more of a concern than ever be-fore, it is vital to examine closely the variouselements of the organization’s cost accountingsystems. Even the most routine and mundanereports should be considered. Do they pro-vide the information that a manager needs tomake effective decisions and to control theoperations of the health care organization, orare they designed for the convenience of ex-ternal reporting? If they are for external re-porting, then a thorough revision of suchreports may be in order.

GOOD COST ACCOUNTINGSYSTEMS

There has been a growing lack of satisfactionwith the costing systems that health care or-ganizations have used over the last severaldecades. As a result, the last several yearshave been a bonanza for health care consult-ants, especially in the hospital field. A widevariety of cost accounting systems have beeninstalled, ranging from relatively modest incost to multimillion dollar systems. Yet, it isnot clear that these new systems have been to-tally satisfactory or even more satisfactorythan the systems they replaced. Horror storiesof millions of dollars spent on systems that donot work properly are becoming more andmore common.

Perhaps one reason for these failures is thatsome cost accounting systems are expected todo more than they possibly can. It is difficult for

any one system to serve the conflicting needs ofallocating costs for external reporting, deter-mining incremental costs for negotiating anddecision making, and determining productcosts for productivity measurement and costcontrol. While there has been a great focus onreplacing cost accounting systems, perhaps partof the solution is to view and install new prod-uct costing systems that would perform as sup-plementary systems rather than replacements.

Another possible reason for problems withnew systems is that cost accounting systemsare being developed and installed without ad-equate specification. A “good cost accountingsystem” is difficult to define, because differenthealth care organizations have different infor-mation needs. A good cost accounting systemis one that is based on a knowledge of what in-formation is needed, why it is needed, andwhat will be done with it once it is available.

Benefit /Cost Philosophy of CostInformation

We can set a minimum standard for a goodcost accounting system. It should generate in-formation that is more valuable than the costof the system itself. This rule of thumb has al-ways been a part of health care costingsystems. Accuracy in cost measurement is de-sired, but must be balanced against the cost ofacquiring the information.

Given the intense financial constraints facedby most health care providers, it is difficult tohave enough resources—human and com-puter—to meet all the needs of a good cost ac-counting system. For any additional moneyspent on cost accounting one must be able toshow a return on the investment.

Clearly, substantial amounts of money areat stake. If a health care organization usesnew information to discover that a productline loses a lot of money, and it can eliminatethat product line, then the new information isquite valuable. But the same information dis-covered about an integral service that cannot

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The Human Element in Cost Accounting 9

possibly be eliminated if the organization is tocontinue to exist is much less valuable.

It costs money to generate cost accountinginformation. The more complex the informa-tion, the more costly it is. Often, managers de-sire to use extremely accurate accountinginformation for making decisions. From anidealistic point of view, that makes perfectsense; from a pragmatic point of view, it is notalways a sensible option.

When one decides to generate cost infor-mation, the benefit of the information to begenerated should be weighed against the costof the information. Sometimes an approxima-tion, which is much less expensive to makethan an exact calculation, will be perfectly suf-ficient for making a reasonable decision.

Wise use of the limited resources of an or-ganization calls for choosing the least expen-sive adequate data for making a decision.When one decides whether to generate infor-mation, one should always consider what lesscostly information alternatives exist. Often,the less costly alternatives require substan-tially less time and effort; in general, oneshould tend toward using these. More costlyalternatives should be used only when theirextra benefits exceed their additional costs.

THE HUMAN ELEMENT IN COSTACCOUNTING

Students of cost accounting often expect thefocus to be on numbers: “How much doessomething cost?” However, the primary focusof cost accounting is on people. The measure-ment of numbers is secondary. People are theessential ingredient in any organization; theyare what makes things work. Unless we con-sider people, there is no way to collect cost in-formation and, more important, no way tocontrol costs.

Determining costs can be a totally absorb-ing task. One risk in cost accounting is that wetend to lose touch with the various human be-ings who are involved in the different parts of

the process. If we do not closely consider theindividual people involved in the cost ac-counting process, we may calculate costs accu-rately, but make things more expensive thanthey should be because employees are spend-ing more than is necessary. If the focus is lesson detail and accuracy, and more on why peo-ple act in a way that causes unnecessaryspending, we may be able to improve effi-ciency and lower total costs.

People who work within the health care in-dustry often do so because of their underlyingaltruism. They want to help society. They wantto help individuals. However, that does notmean that the goals of individuals working forhealth care organizations are completely thesame as those of their organizations. For exam-ple, most employees of a health care organiza-tion would prefer a substantially larger salarythan they are currently receiving. The organi-zation might prefer lower salaries than it is cur-rently paying. These divergent goals must berecognized by the organization (Figure 1–2).

One recurring theme throughout this bookis that managers must consider not only costcalculations, but also the incentives and moti-vations of the people working for the healthcare organization. In cost accounting, werecord the results of actions people take. Un-derstanding their motivations and likely re-sponses to incentives is essential to the design

Figure 1–2 Divergent Goals. Source: Reprintedfrom Budgeting Concepts for Nurse Managers, Sec-ond Edition, by S.A. Finkler, p. 43, with permissionof W.B. Saunders, © 1992.

DIVERGENT GOALS

Organization Individual

Low SalariesSmall StaffSmall Offices

High SalaryLarge StaffLarge Offices

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Figure 1–3 Congruent Goals. Source: Reprintedfrom Budgeting Concepts for Nurse Managers, Sec-ond Edition, by S.A. Finkler, p. 44, with permissionof W.B. Saunders, © 1992.

CONGRUENT GOALS

Organization Individual

Incentive Effect

of an effective cost accounting system. It isnecessary for the interests of the individual tobe brought together with, or to become con-gruent goals with, those of the organization(Figure 1–3). Individuals are more likely toact consistently in the organization’s best in-terests if a system of incentives is in place. Thecost accounting system can help establish aframework of incentives.

In recording the cost outcomes, individualperformance must be carefully judged. If em-ployees are not competent or do not work hard,a signal of failure may be warranted. However,if a manager is both competent and hard work-ing, the cost accounting system should not indi-cate poor performance by the individual, evenif actual costs exceed expectations. Such an in-dication is more likely to be discouraging thanit is to provide the individual with an incentive

to work even harder. When people work hardand fail, they often question why they workedso hard. Thus, we must be extremely judiciousin the design of cost accounting tools for evalu-ation. Understanding their likely impact on theindividuals who work for the organization is acritical element of management.

SUGGESTED READING

Anderson, L., and D. Clancy. 1998. Cost account-ing. 2d ed. Houston: Dame Publications.

Barfield, J., et al. 2002. Cost accounting: Traditionand innovations. 5th ed. Minneapolis: WestPublishing.

Cooper, R., and R.S. Kaplan. 1998. The design ofcost management systems: Text, cases, and read-ings. 2nd ed. Englewood Cliffs, NJ: Prentice-Hall, Inc.

Hansen, D., and M. Mowen. 2005. Cost manage-ment: Accounting & control. Cincinnati: South-Western Publishing.

Horngren, C.T., et al. 2006. Cost accounting: Amanagerial emphasis. 12th ed. Englewood Cliffs,NJ: Prentice-Hall, Inc.

Jayson, S. September 1992. Focus on people notcosts. Management Accounting: 28–33.

Shuck, R. December 1997. A comprehensive ap-proach to analyzing capitated contracts. Cost andQuality Quarterly Journal 3, no. 4: 47–50.

Thibadoux, G.M., et al. September 1997. Costsunder capitation. Medical Group ManagementJournal 44, no. 5: 95–100.

Tselepsis, J.N. May 1989. Refined cost accountingproduces better information. Healthcare Finan-cial Management: 26–28, 30, 34.

EXERCISES

Questions for Discussion1. Describe the conflict between the use of

cost accounting to generate information forreporting and its use to generate informa-tion for management.

2. In order to design a good cost accountingsystem, what do you need to know?

3. How can cost accounting aid in the negotia-tion of managed care contracts?

4. What is the relationship between motiva-tion and incentives and cost accounting?

5. Distinguish between financial and manage-rial accounting. Where does cost account-ing come in?

6. What are some examples of nonroutinedecisions?

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Exercises 11

7. Would you contend that one good cost ac-counting system is the best approach, orthat there should perhaps be several sys-tems, each addressing different needs?

8. What is the prime reason for collecting costaccounting information?

9. True or false: One should always developthe best cost accounting system possible,which generates the most accurate informa-tion. Why or why not?

10. Distinguish between planning and control.

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