COST ACCOUNTING: A HISTORY OF INNOVATION

by Cheryl Cunagin and John L. Stancil

From the beginning of commercial activity, merchants have attempted to

determine the profitability of their activities. Rudimentary accounting
principles arose to facilitate this attempt at profit measurement. Luca
Pacioli, a Venetian of the thirteenth century is regarded as the father of
accounting. Pacioli is noted for the development of the double entry
bookkeeping system, known to first-year accounting students as debits and
credits. However, Pacioli is also credited with the origins of cost
accounting. While not focusing on the manufacturing cost aspect, Pacioli
did develop a concern for cash budgeting and variance accounting.(1)

As enterprises began to embark on production activities, a new

extension in the area of accounting was required. This extension was the
development of cost accounting principles for manufacturers. Along with
these new principles came problems that cost accountants wrestle with
today, including problems such as accounting for the overhead incurred in
the production of the product. Absorption costing and its alternative,
variable costing, were developed to fulfill this need, becoming the primary
method of accounting for product costs. Under this approach, a rate is
determined by which a portion of the fixed and variable factory overhead
costs are applied to the cost of each unit. This can be done in one of three
ways: by actual costing, in which actual costs and overhead rates are used;
by normal costing, in which actual material and labor rates are combined
with budgeted overhead rates; or by standard costing, which employs
standard costs for materials, labor, and overhead, with the differences
being charged to variance accounts. With variable costing, fixed factory
overhead is accounted for as an expense of the period, instead of being
charged to the product.

The controversy over the relative merits of these two methods has
extended throughout most of the history of cost accounting. Adding to the
debate is the fact that absorption costing is the only one recognized by the
Financial Accounting Standards Board (FASB) as acceptable for externally-
published financial statements. Absorption costing is also required by the
Internal Revenue Service in tax preparation.

Variable costing makes a distinction between variable and fixed costs.

The distinction permitted by variable costing allows the manager to
understand cost behavior at various levels of production. This better
understanding of cost behavior facilitates internal decision making and is
therefore favored by managers. Thus, both systems will probably continue
to be utilized by their respective constituencies.

The history of absorption costing is closely linked with the history of cost
accounting. Unfortunately, historical documentation about the origins of
cost accounting is limited due to a fire at the headquarters of the National
Association of Accountants (NAA) in 1984. Many irreplaceable documents
were lost in that fire. Richard Vangermeersch, a leading accounting
historian explains that a problem in cost accounting is that many such
accountants feel that they have no past.(2) Much of cost accounting is
largely confined to use for internal decision making. With this lack of public
scrutiny, cost accountants have often developed their own systems and
methods of accounting, unconstrained by the generally accepted
accounting principles (GAAP) of financial (externally-based) accounting.
Lacking conformity and public accountability, cost accounting procedures
have frequently been shrouded under a cloak of corporate secrecy. As a
result, there is a lack of documented cost accounting history.

Certain practices and theories of cost accounting date back to the

fourteenth century. At this time small industrial enterprises started to
produce certain trade items of that era, such as books, woolens, coins, and
wine.(3) The Industrial Revolution brought new developments in cost
accounting systems, but there were no "full-fledged" systems until near the
end of the nineteenth century.(4) Before this time, it was likely that most
manufacturing firms simply modified their accounts to include the factory
charges of direct materials, direct labor and overhead. Usually no sharp
distinction was made between the shop burden (overhead) and the
commercial (selling and administrative) expenses of the firm.(5) Near the
turn of the century, however, cost accountants began to study the overhead
element of cost. At this point, the debate between absorption and variable
costing began. There was a wide diversity of opinions as to whether
overhead assigned to product should be all-inclusive or very limited.(6)

One of the more influential persons during the nineteenth century

speaking for the adoption of absorption costing was Alexander Hamilton
Church, who developed the machine-hour method of allocating and
applying fixed costs such as power, land, and building costs.(7) The
influence of Church and others like him must have weighed heavily for the
adoption of absorption costing, for a National Association of Cost
Accountants (NACA) Bulletin from 1947 states,

Companies excluding direct labor and overhead costs from inventory

apparently do so because bookkeeping systems developed some
years ago did not provide for charging these items to inventories and
any change would now involve numerous difficulties. When certain
 overhead items only are excluded, the reason usually seems to be a
desire to remove fixed charges from inventory and gross profit
figures.(8)

This statement indicates that absorption costing was viewed by many as

the most modern, efficient, and accurate method of accounting for product
costs. There were, however, some dissenters, such as Jonathan N. Harris,
who in 1946 remarked

It is unfortunate that the direct-cost [variable costing] accounting idea

has not yet received general acceptance. If it had come into
widespread use prior to the war, many millions of taxpayers' money
and company funds everywhere might have been saved through
simplification of contract renegotiations, tax returns, countless reports
to the government, and contract-termination claims.(9)

Harris did not get his wish, however, as absorption costing was still the
favored method of accounting for product costs in 1953, when Herman C.
Hersei wrote that variable costing could not be expected to replace the
absorption method that was "satisfactorily serving the needs of most
managements at the present time".(10) While the prevalent feeling was
against variable costing, most systems were not using true absorption
costing. According to H. C. Greer, most manufacturers were using some
form of standard costing. Expenses in excess of standard were being
allocated to a production variance account. This total would ultimately
appear as an addition to cost of goods sold.(11)

Along with these deviations from actual historical absorption costing,

variable costing was growing in acceptance with many manufacturers. In a
1960 survey of approximately four hundred companies in the United States,
The Controllership Foundation reported that twenty-two percent of the
responding companies used direct costing in internal reporting.
Furthermore, the survey showed that two out of three of these companies
had changed from absorption costing in the previous decade.(12) In spite of
this trend, variable costing was not a generally accepted accounting
practice. Absorption costing, in one of its three forms--actual, normal, or
standard--was the preferred method of accounting for product costs.

To this day, absorption costing is the accepted method of inventory

valuation for external reporting purposes. Authors such as Dr. Richard
Vangermeersch are still singing the praises of absorption costing, saying
that the idea of direct costing is "way out of tune with reality."(13) Variable
costing, while increasing in popularity, remains in use only for internal
purposes.(14)
 Alexander Hamilton Church, who died in 1936, was, in many ways a
man ahead of his time. He believed his machine-hour method of allocating
overhead to be a superior method, especially for a capital-intensive firm.
Church's approach was to treat each machine as if it were an assembly-line
worker, resulting in more accurate cost-usage data for each
machine.(15)Allocation of overhead costs on the basis of machine hours has
not received much attention in cost accounting practice until recent years.
As companies installed automated manufacturing facilities, the composition
of product costs changed. Computer integrated manufacturing (CIM) is
distinguished by a lack of assembly line workers (direct manufacturing
labor). Accountants at companies having such installations have begun
accounting for overhead on a machine-hour basis.(16) Direct labor has
ceased to be a separate cost category at many companies.

Church extended his work on a machine-hour allocation basis into the

development of two ideas often taken for granted today in the
manufacturing world. He originated the concepts of production centers and
small jobs.(17) Cost accounting today is heavily dependent on the
production center concept--treating the department, plant, or product as an
independent entity for accounting purposes. The concept of small jobs was
essential to the development of job order costing. Job order costing, along
with process costing, are today's primary methods of accounting for
manufacturing costs. In addition, the small job concept is applicable to the
automated factory of today. Automation cam be used to its fullest potential
in the manufacture of small lots of product, as opposed to large, continuous
productions runs of days gone by.

There were other notable contributions to the foundations of cost

accounting as it is known today. Charles Babbage took the development of
cost accounting systems a step further with his emphasis on integrating the
machine as a part of the management process. In addition, he emphasized
analysis of variance from manufacturing standards. He believed that proper
analysis distinguished a maker from a manufacturer. The manufacturer was
described as one that worked at reducing product cost to the point where
demand could be met, while a maker merely produced prototypes.(18)

Perhaps the last major development in cost accounting systems

emerged from the practice and writing of Stanley Henrici, who has been
described as the father of standard costing systems.(19) With these
systems, the cost manager can determine the cost of the product in a more
uniform manner without large price variations due to swings in production
volume. Standard costing complements variance analysis, enabling the
manager to isolate any problem areas.
 Modifications in cost accounting systems are occurring even today.
Computer integrated manufacturing systems are capable of manufacturing
a product without human intervention, eliminating the need for a direct labor
category. Many companies now classify product cost as direct materials
and overhead, eliminating direct labor altogether.(20) As mentioned, this
development has renewed interest in Church's machine-hour allocation of
overhead, as direct labor often served as the allocation basis in the past.

A second change in the manufacturing environment has created

changes in how cost accountants ply their trade. Just-in-time (JIT)
inventory and production systems are based on the Japanese notion that
inventories are evil. The goal of a JIT system is to have the raw materials
delivered to the plant just in time to begin production. Each stage of
production is completed just in time to move it on to the next stage, and the
product is completed just in time for shipment to the customer.(21) With a
minimum of raw material, work in process, and finished goods inventories
problems regarding inventory valuation and product costing are greatly
simplified. Companies are adapting to this innovation with a variety of
streamlined costing systems.

One of these new costing systems is activity-based costing (ABC).

Under this approach, each manufacturing cost is linked with the activity
creating the cost. For example, the cost of the purchasing department can
be tied to the number of purchase orders prepared. Thus, purchasing
department costs can be allocated based on purchased orders issued for
various departments.

Cost accounting, with its lack of generally accepted accounting

principles, has not had the exposure afforded financial accounting. Its
history is one of innovation, methods devised out of necessity. This is good,
in that innovation occurs unconstrained by some idea of "proper
accounting." Yet, this same feature contributes to the lack of a formal
"History of Cost Accounting." Only the best ideas see the light of public
scrutiny and the true sources of innovations may never be known. Many
modifications or innovations may not be exposed to the public under a
cloak of "corporate security." The history of cost accounting was written,
and continues to be written every day in the factories and offices of
manufacturing America.