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.






1. Richard Vangermeerach, "Milestones in the History of Management Accounting," in Cost Accounting for the 90's: The Challenge of Technological Change Conference Proceedings, (Montvale: National Association of Accountants, 1986), 77.

2. Ibid., 76.

3. W. E. Thomas, Readings in Cost Accounting. Budgeting. and Control, (Cincinnati, Southwestern, 1960), 3.

4. Ibid., 8.

5. Ibid., 9.

6. Ibid., 10-11.

7. Ibid., 12.

8. Ibid., 22.

9. Ibid., 286.

10. Ibid., 318.

11. Ibid., 330.

12. C. A. Smith and J. G. Ashburne, Financial and Administrative Accounting (New York, McGraw Hill, 1960), 330.

13. Vangermeersch, "Milestones", 76.

14. R. E.Schmiedicke, C. F. Nagy, and E. J. Vanderbeck, Principles of Cost Accounting (Cincinnati, Southwestern, 1988), 449.

15. Horace R. Givens, ed., Biographies of Notable Accountants (New York, Random House, 1983), 1.

16. Robin Cooper, "Does Your Company Need a New Cost System?", Journal of Cost Management (Spring, 1987), 45.

17. Vangermeersch, "Milestones", 77.

18. Ibid.

19. Ibid, 79.

20. Rick Hunt, Linda Garrett, and C. Mike Merz, "Direct Labor Cost Not Always Relevant At H-P," Management Accounting February, 1985, 60.

21. Ibid, 59.