In the Classroom
Winning Numbers: Cost Accounting Decisions Can Turn a Profit into a Loss
A hospital that performs double bypass surgeries might choose to allocate its overhead costs per patient. Or, it could choose to allocate costs by the type of surgery — in which case, all bypass surgeries would be lumped together. The second method is perfectly legal, and would save money on paperwork. But only the first method would show the variation in costs from patient to patient — an essential piece of information for a manager trying to keep costs in line.
"From a financial accounting perspective, it’s not a big deal which choice you make, but for your company, it’s a big deal," says Wharton Professor Chris Ittner during a recent session of Finance and Accounting for the Non-Financial Manager.
If you don’t allocate overhead right, what you think you’re making could be completely wrong.
–Chris Ittner, Ernst & Young Professor of Accounting; Faculty member, Finance and Accounting for the Non-Financial Manager
In one case, a company refigured its overhead costs using a more detailed allocation method, and discovered the gross margin on one of its products was negative 4 percent instead of 42 percent.
"If it turns out that the reality of how you actually do work is different from how you allocate it, [your reported profitability] is probably all messed up," Ittner says. "If you don’t allocate overhead right, what you think you’re making could be completely wrong."
How Profitable Are We?
Allocating overhead is just one of the crucial decisions about cost accounting that Ittner discusses in the program. For companies both large and small, decisions about whether to expand the business, keep treading water, or scale back usually boil down to numbers in the accounting reports. After all, the figures are supposed to make it clear: Is the firm losing money? How profitable is this new product? Should we really buy this company?
It is a mistake, however, to simply rely on the company’s externally-driven financial accounting reports to make such decisions, Ittner says. Depending on how they’re recorded, costs associated with unsold inventory, unfinished jobs, advertising, and day-to-day operations can temporarily skew a company’s results. "If you let me pick your cost accounting methods, I can dramatically change reported profits in the short term."
Indirect (or Overhead) Costs
One of the key issues in cost accounting is where to record indirect costs (also known as overhead), Ittner says. Direct costs are those that can be traced directly to a specific cost object, such as material and supplies used to make a product or provide a service. Accounting for the costs is straightforward.
Indirect costs are costs of doing business that aren’t easily traced back to a specific job or project. Overhead might include the hospital’s costs of a heart-lung machine used for a variety of different types of operations, an advertising campaign that promotes more than one product, or the salary of a plant manager.
Even distinguishing between the two types of costs isn’t cut and dry. "Depending on what decision you’re making, the things that fall into the overhead versus direct cost categories could change," says Ittner.
A bank, for example, may need to decide whether to eliminate mortgage processing from one of its branches, or close the branch entirely. In the first case, costs for heating the building and paying the security guard would fall into the overhead category, while the salaries for the loan officers would be direct costs. In the second case, however, all costs would be considered direct costs, because they can all be traced back to the cost of operating the branch. These assumptions might lead to very different decisions about profitability.
Companies also have to determine how to allocate (or charge) overhead costs to products or services when determining their reported costs. Since the definition of indirect costs is costs that cannot be directly attributed to products or services, the allocation process is somewhat arbitrary, but is required for accounting purposes. The company could choose to charge overhead costs on the amount of time the job runs on the machine, for example. So the company would divide its total overhead costs for the year by the total number of machine hours to derive a "rate per machine hour." This rate would then be used to determine overhead costs. Alternatively, the company could charge overhead based on the number of labor hours used to make the product. If one product used a lot of labor while another used an automated process with little labor, the choice between allocating based on labor or machine hours would have a huge impact on reported profitability for the two products.
Although cost accounting may at times seem arbitrary, the assumptions on which it is based can help to guide the company’s most important decisions. This is why, Ittner points out, managers cannot afford to leave all the number crunching to the accounting department.
"A lot of times, any one of these cost accounting numbers won’t actually give you the numbers you need for decision purposes," says Ittner. "All it can tell you is where to start looking. But the important thing for a manager is to understand the extent to which you can rely on your organization’s accounting system at all when you begin making your decision."
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