The Business Environment and Concepts (BEC) section of the CPA exam includes a variety of general business topics. The operations management section of the BEC test has a large section devoted to cost accounting topics; hence, many CPA candidates struggle with this material.
But if you’re studying for the CPA exam, don’t lose hope!
Here are some explanations for some of the toughest cost accounting topics on the BEC CPA exam and some tips on how to properly prepare for them!
Four Key Terms On The BEC Exam
To understand the basics of cost accounting, you need to review four key terms that are included on every BEC test. These terms can be confusing, so write the four definitions on a note card so that you can keep the definitions straight in your mind.
You can think of these concepts as two pairs of terms. Direct cost and indirect costs represent one pair, while period costs and product costs are another pair.
Consider the first set below:
- Direct costs: Costs that can be directly traced to a product or service are direct costs. If you manufacture baseball gloves, for example, the leather material used to make the gloves is a direct cost. Material and labor costs are typically direct costs.
- Indirect costs (overhead costs): These costs cannot be directly traced to the product or service produced. As an example, the utility costs incurred to heat and cool the baseball glove factory are indirect costs. The factory must be heated and cooled, regardless of the number of baseball gloves produced. Utility costs, a building lease, and office supplies are common indirect costs.
To compute the total cost of a product or service, each cost is defined as either direct or indirect.
The second pair of terms is period costs and product costs:
- Period costs: Period costs are incurred due to the passage of time. For example, insurance premiums and interest costs for a loan are both defined as period costs.
- Product costs: As the term implies, product costs can be directly traced to the product or service produced. Leather material for baseball gloves, for example, is a product cost, along the labor costs incurred to run sewing machines.
Accountants review costs and label them as either period costs or product costs.
These four terms are important because they help you understand the activities that cause you to incur costs. As an example, increasing production will generate more direct material and direct labor costs, but higher production has no impact on interest paid on a loan.
Finally, each cost can be defined using two of the four definitions. The interest cost on a loan, for example, is an indirect period cost. On the other hand, leather material for baseball gloves is a direct product cost.
Profit Margin, Defined
So why bother using cost accounting at all?
The reason is to calculate the total cost of a product or service so that you can add a profit and come up with a sales price.
Put another way, every cost you incur must be recovered before you can generate a profit. If you don’t know your total costs, your sales price may not be high enough to generate the profit you expect.
Assume, for example, that the total cost of a baseball glove is $60 and that you intend to sell the glove for a $75 sales price. Profit margin is defined as (profit / sales); therefore, your profit margin for the glove is ($15/ $60), or 25%.
What if your total costs are actually $65? If you keep the sales price at $75, your profit is only $10 and your profit margin declines to 15.4%.
That’s why cost accounting is so important and why total costs and profit margin are heavily tested on the BEC CPA Exam.
Why Variance Analysis Is Critical
Every firm should create a formal budget and it must include assumptions about standard (planned) costs, sales, and levels of production. At the end of each month, accountants compare actual results to the budgeted amounts: a process defined as variance analysis.
Variance analysis is critically important because this work helps a business make changes to improve financial results during the year.
If, for example, the price paid for leather material is higher than planned, the baseball glove company will notice a price variance. Assume that management investigates the price variance and determines that the purchasing manager did not negotiate a discount with the company’s leather vendor.
The company can follow up with the vendor and request a price discount based on the quantity of material ordered. Consequently, this change lowers total costs and increases profits.
The BEC test covers a number of variance concepts and the formulas for the variance calculations can be difficult to understand. Generally speaking, variances fall into one of two categories:
- Price variance: The price paid per yard, per pound, or per unit is higher or lower than budgeted. The leather material example above is a material price variance. If the baseball glove company paid a higher labor cost per hour than planned, that would generate a labor rate variance: another form of price variance.
- Quantity variance: A business may also use more of a particular material or service than planned. If the budget calls for 1,000 hours of labor and 1,200 hours are required, the firm has a quantity variance.
To nail down this concept, remember this: Paying a different amount than budgeted, or using a different amount than planned, generates a variance.
Variances can be further defined as favorable or unfavorable. When you think of a favorable variance, think of “better than planned”:
- Favorable variance: If actual costs are less than planned, the cost variance is considered to be favorable. Keep in mind that accountants also budget for sales. If actual sales are higher than planned, the company has a favorable sales variance.
- Unfavorable variance: Actual costs that are higher than planned generate an unfavorable variance. In the same way, producing lower actual sales than planned is an unfavorable variance.
When you’re asked to define a variance as favorable or unfavorable, stop and think: is it a cost variance? If so, are the actual costs higher or lower?
That’s the thought process to use when you answer variance questions!
Cost Drivers And Cost Objects
These two terms seem vague to many CPA candidates, and students find it difficult to understand these concepts:
- A cost driver is an event or activity that causes a business to incur costs. Operating machines for more hours increases repair and maintenance costs, for example. So the number of machines hours is a cost driver for repair and maintenance expenses.
- A cost object, on the other hand, is the product or service produced that causes a business to incur costs. Manufacturing baseball gloves is a cost object that generates both material and labor costs. Essentially, you can think of the cost object as a “sponge” that absorbs costs.
Cost accounting is a subject that is different from financial and managerial accounting, and cost accounting uses different terms that other areas of accounting. For these reasons, CPA candidates may struggle with the BEC test material.
The key is to think through cost accounting questions carefully. While these questions may require more time, you can answer the cost accounting questions correctly and pass the BEC test.
You can do it!