Misleading Cost Accounting
Aug. 28, 2000 (Pro2Net) — Previous articles featured on Pro2Net have outlined the problem of using the external accounting structure for managerial cost accounting purposes. These articles also emphasized the importance of separating the financial accounting structure (the external chart of accounts), from the internal accounting structure.
This article details the educational problems that have been developed during the last 50 years because we have only financial accounting and we are trying to include in this general accounting structure questions related to cost accounting.
The very first problem that confuses students is that in studying general accounting, we have learned to have under the classification of Owner's Equity account, two important groups of accounts for our income statement. These groups refer to the expense accounts and the sales revenue accounts. In addition, we have learned how important it is to match our expenses with the corresponding revenues.
But finally, Professors at Stanford, Harvard and other Universities have had to include in their teachings and consequently also in their books, the importance of incorporating a responsibility accounting system into our accounting structure. This responsibility system refers to a dependable and trustworthy information system that each and every responsible person of a department should prepare and use as their budget.
This information and budget refers to all costs that this department has as its departmental operating cost. This means those costs that the department needs to support its activities - be it an administrative or sales activity or a direct production department's activity related to the production of some product.
This includes costs that support the activity of a direct production department. In other words, costs that are necessary to allow the direct laborers to fulfill their assignments. To help these direct workers in their jobs, the department needs to consider additional costs such as salary for the supervisor, indirect wages, rent payments, insurance, phone, production supplies, etc.
In other words, these departmental operating costs refer to the indirect costs the company has. As you will remember, the cost elements that we have in our Internal accounting structure, are basically divided into direct and indirect costs (or variable and fixed costs).
All the indirect operating costs originate in the departments - and each and every department will need and must have these departmental operating costs.
With this new focus on the responsibility accounting system, our universities had to incorporate in their teaching the question of cost related to the departments. That was the moment when the term "overhead" was created.
With this very general designation of overhead, university professors created the idea that a factory would not need to have more than one overhead account. All the big CPA firms were happy to support this idea and instructed large companies to use only one overhead account and summarize all production department's operating costs to this account and establish just one rate for the absorption of these values to the different products of the company. This recommendation to have only one overhead account was a disaster and gave management absolutely wrong information when it came to the production cost.
This overhead account replaced, in the teaching of our universities, the traditional expense accounts. So in the exhibits of Professor Horngren's and Anthony's Cost Accounting books - there was only one overhead account recorded - and no expense accounts were identified.
Another erroneous presentation in these exhibits is the identification of these overhead accounts as general ledger accounts. That means in the chart of accounts of these companies, there were recorded both overhead accounts and expense accounts (in accordance with instructions given by GAAP). This means that the different indirect operating costs of these departments, were recorded both as expense and as overhead.
Because of this misrepresentation of the departmental operating costs and the production costs, Exhibits 1 and 2 in Professor E. Deakin's cost book, are a total mix-up between the responsibility accounting system and production cost accounts. The Nevada instruments company in the exhibit has two direct production departments: one is Assembly and the second is Finishing. But the exhibit shows only one overhead account using the departmental operating costs of these two departments and applying these operating costs with only one rate to the two different production cost accounts.
In addition, the exhibit classifies the Work in Process account as an Inventory account. We all know that the amount of work in process is never controlled as an inventory item. At the end of each month, the work in process amount starts in the afternoon of the last day of the accounting period - and ends the next morning when the new month begins. During this one night nobody will start to control the work in process as an inventory account.
But our university professors had to classify this Work in Process account as an Asset account - and consequently also as an inventory account - because they did not have a special Internal accounting structure.
All these misleading cost accounting procedures were created during the last 30 or more years - simply because nobody had developed a specific chart of accounts for internal accounting.