What is Cost Accounting? An Ice, Water, and Vapor Analogy

By Gary Cokins; Analytics-Based Performance Management LLC, President

       … and Profitability Analytics Center of Excellence (PACE), Director

What is cost accounting? Is it simply a form of accounting for how expenses (e.g., salaries, wages, purchases) are calculated as costs (e.g., products, service-lines, customers)? Is it a method to provide and display visibility and the behavior of costs?

A way to think about cost accounting can be with an analogy from physics and chemistry.

An Ice, Water, and Vapor Analogy

Consider the transformation as the temperature increases for how ice melts into water and then eventually into steam and vapor. Each is comprised of the chemical elements for water (H2O).

Think of ice as resources and their capacity. Resources can be workers or equipment (i.e.; assets). Resources are financial expenses. They are spent like from a bank account check as they are used.

Think of water as what happens to ice as it is “spent”. Think of this as the “work activities” consuming the resources.

Think of vapor and steam, the last stage of the transformation, as the end result or output from the “work activities”.

Activity-Based Costing (ABC)

An activity-based costing (ABC) system is in effect a mathematical model similar to the oxygen transformation. ABC has three “modules”: (1) Resources; (2) Work Activities; and (3) Final Cost Objects.

ABC operates in the reverse direction of the analogy above. Instead of the increasing temperature direction heating the ice to water and then to vapor, imagine the opposite direction with the temperature decreasing from the vapor. In this direction the oxygen vapor begins to condense. Think of rain. Then as the temperature gets colder the water becomes ice. Think as snow.

In cost accounting the process is similar. In module #3 at the bottom as the products are made, the service-lines delivered, and the customers served they require the work activities in module #2. Products must be “made”. Think as recipes or assemblies by workers and machines. Service-lines must be “delivered”.

Next, how do the work activities in module #2 get the energy to work? The answer: from the capacities in the resources in module #1.

Costing is a Consumption View of Accounting

What I just described above about ABC is a “consumption” view of accounting. Starting at the bottom of this “modeling” (module #3), as products are made and service-lines delivered they require work activities (in module #2). The customer triggers the consumption with their purchase.

Next, the work activities (module #2) consume the resources that are the laborer and machine time (in module #1)

Now view the resources in module #1 as the general ledger expenses in the financial systems chart-of-accounts. Costing then models the ice to water to vapor. The expenses are causally traced to the work activity costs in module #2. Next the activity costs are causally traced to products and service-lines in module #3.

Cost Allocations versus Tracing and Assigning

Have you noticed I have not used the term “cost allocation”? This is deliberate. Cost allocations are the bane and misery of accounting! Why? When accountants “allocate” expenses into the calculated costs they take the simple, easy, and convenient path. They use cost allocation factors and bases (think of the denominator in setting rates) like the number of labor or machine hours in manufacturers, amount sales, square feet, or the number of employees in a department.

None of those accurately reflect the “consumption” measures. It is like spreading butter across bread! It violates costing’s universal causality principle that requires a cause-and-effect relationship between an output (module #3) and its source inputs (modules #2 and #1). Yes, those flawed and misleading cost allocations will reconcile in total with zero sum error (to satisfy the auditors), but they are wrong in the parts! As a result the managers and employee team are using deficient cost and thus profit margin information which leads to bad decisions.

Institute of Management Accountants (IMA) Statement of Management Accounting (SMA) on ABC

To learn more about ABC you can read an IMA SMA that I authored on ABC. Its pdf can be downloaded from this link:

https://www.imanet.org//-/media/d5beff30c5864c7383e6ebb61556bab3.ashx?as=1&mh=200&mw=200&hash=E34259B80CE1AC68ED6AB8363D05635AE19BAB91

This graphic displays the three modules in an ABC system’s cost assignment network. The diameters of the arrows are the amount of money passing from the top to bottom module.

Concluding Remarks

Ice, water, and vapor. Resources expenses, work activity costs, and final cost object costs. There are similarities.

Oxygen transforms with changes in temperature. Costs are always calculated from expenses and only accurately by complying with the costing’s causality principle.