What are the purposes of costing?

A cost accounting system or costing system is a set of rules, methods and techniques used to estimate the resources consumed to achieve specific goals.

Costing systems report numbers that indicate the manner in which particular products, services or customers use the resources of an organization. They are at the core of costs-benefits analyses and thus provide information guiding resource allocation and process optimization. They are also used for asset valuation. However, for reasons I will develop as we progress in this chapter, they can rarely serve all three purposes simultaneously.

Resource allocation

The pursuit of any goal requires consuming resources. Unfortunately, resources are limited and as a consequence, what some people consume to achieve some goals becomes unavailable to others to achieve other goals. In such a context, two questions are a source of major economic, ethical and political challenges: 1) is a specific goal worth the resources required for its achievement? 2) is there no better use for the resources it takes? The simplicity of these two questions is deceptive because answering them is extremely difficult. Indeed, it requires knowing both the value of the goal and the value of the resources consumed for its achievement.

Economists explain how market efficiency ensures that the price of a product or service reflects its true value, i.e. what people are willing to sacrifice for it. But many markets are not efficient1, and everything which has value is not necessarily exchanged on a market in the first place. Therefore, what some goals are worth is not always obvious and becomes the object of intense political debates, even wars.

As for the resources consumed to make a product or provide a service, they are not that easy to estimate either. Some resources consumed to achieve a goal are easy to associate to its achievement. For instance, it is not difficult to assert that the raw materials incorporated in a product or the labor time which was specifically dedicated to making that product are resources consumed to make that product. But what about the materials wasted in the process? What about the depreciation of an equipment used to make the product, but also used to make other products? What about the time of the company’s financial accountant who does not make products, but without whom the company would not be allowed to operate and therefore could not make the products? What about the health of workers subjected to unsafe working conditions? And what about the ecological damage resulting from the production of the energy consumed to heat a factory where many products are made?

As these examples suggest, what is really consumed to achieve a goal, its “true cost”, can be very difficult to assess accurately and exhaustively. But this assessment is crucial to avoid wasting resources on less valuable endeavors and diverting them away from the most valuable one. Costing is a set of techniques specifically designed to address this challenge:

Process optimization

A well designed cost system also helps managers make the best possible use of resources once they have been allocated just by providing a good representation of resource flows within the organization. First, making managers aware of the resources they consume to achieve specific objectives gives them an incentive to avoid waste. Second, costing provides the means to compare the efficiency of different practices or different units and thus allows benchmarking and orient sourcing decisions. Third, well designed cost systems also show managers how they can control costs by managing their causes. Costing information can therefore motivate and orient efforts to improve process efficiency.

Asset valuation

Finally, a cost accounting system is also necessary to value the inventory in the balance sheet, the costs of goods sold in the income statement, or long-term assets which are produced by the company for itself (e.g. self-produced equipment or intangible assets like patents). When a cost accounting system is designed for that purpose, it has to comply with International Accounting Standards or Generally Accepted Accounting Principles. This means that some design choices are dictated by financial reporting requirements.

In this chapter, I will systematically present first the set of options complying with financial reporting standards, assuming first that the cost system we design is for asset valuation. I will then also discuss other options we can consider when we disconnect costing from financial reporting, and explain how these alternative design choices would yield more useful information to guide resource allocation. These will highlight why costing is not appropriate for managerial decision making when it is driven by the financial accounting requirements and explain why we will introduce other techniques in subsequent chapters.

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  1. On that note, for markets to be really efficient, future generations would have to be able to purchase resources today so that they are still available for them in the future. Since this is impossible, we could argue that there is no efficient market and thus markets cannot assign value.↩︎