Introduction to cost accounting
MEANING AND SCOPE OF COST ACCOUNTING
Cost accounting is the process of determining and accumulating the cost of product or activity. It is a process of accounting for the incurrence and the control of cost. It also covers classification, analysis, and interpretation of cost. In other words, it is a system of accounting, which provides the information about the ascertainment, and control of costs of products, or services. It measures the operating efficiency of the enterprise. It is an internal aspect of the organisation. Cost Accounting is accounting for cost aimed at providing cost data, statement and reports for the purpose of managerial decision making. The Institute of Cost and Management Accounting, London defines “Cost accounting is the process of accounting from the point at which expenditure is incurred or committed to the establishment of its ultimate relationship with cost centres and cost units. In the widest usage, it embraces the preparation of statistical data, application of cost control methods and the ascertainment of profitability of activities carried out or planned”. Costing includes “the techniques and processes of ascertaining costs.” The ‘Technique’ refers to principles which are applied for ascertaining costs of products, jobs, processes and services. The `process’ refers to day to day routine of determining costs within the method of costing adopted by a business enterprise. Costing involves “the classifying, recording and appropriate allocation of expenditure for the determination of costs of products or services; the relation of these costs to sales value; and the ascertainment of profitability”.
Scope of Cost Accounting
The terms ‘costing’ and ‘cost accounting’ are many times used interchangeably. However, the scope of cost accounting is broader than that of costing. Following functional activities are included in the scope of cost accounting:
1. Cost book-keeping: It involves maintaining complete record of all costs incurred from their incurrence to their charge to departments, products and services. Such recording is preferably done on the basis of double entry system.
2. Cost system: Systems and procedures are devised for proper accounting for costs.
3. Cost ascertainment: Ascertaining cost of products, processes, jobs,services, etc., is the important function of cost accounting. Cost ascertainment becomes the basis of managerial decision making such as pricing, planning and control.
4. Cost Analysis: It involves the process of finding out the causal factors of actual costs varying from the budgeted costs and fixation of responsibility for cost increases.
5. Cost comparisons: Cost accounting also includes comparisons between cost from alternative courses of action such as use of technology for production, cost of making different products and activities, and cost of same product/ service over a period of time.
6. Cost Control: Cost accounting is the utilisation of cost information for exercising control. It involves a detailed examination of each cost in the light of benefit derived from the incurrence of the cost. Thus, we can state that cost is analysed to know whether the current level of costs is satisfactory in the light of standards set in advance.
7. Cost Reports: Presentation of cost is the ultimate function of cost accounting. These reports are primarily for use by the management at different levels. Cost Reports form the basis for planning and control, performance appraisal and managerial decision making.
Objectives of cost accounting
There is a relationship among information needs of management, cost accounting objectives, and techniques and tools used for analysis in cost accounting. Cost accounting has the following main objectives to serve:
1. Determining selling price,
2. Controlling cost
3. Providing information for decision-making
4. Ascertaining costing profit
5. Facilitating preparation of financial and other statements.
1. Determining selling price The objective of determining the cost of products is of main importance in cost accounting. The total product cost and cost per unit of product are important in deciding selling price of product. Cost accounting provides information regarding the cost to make and sell product or services. Other factors such as the quality of product, the condition of the market, the area of distribution, the quantity which can be supplied etc., are also to be given consideration by the management before deciding the selling price, but the cost of product plays a major role.
2. Controlling cost Cost accounting helps in attaining aim of controlling cost by using various techniques such as Budgetary Control, Standard costing, and inventory control. Each item of cost [viz. material, labour, and expense] is budgeted at the beginning of the period and actual expenses incurred are compared with the budget. This increases the efficiency of the enterprise.
3. Providing information for decision-making Cost accounting helps the management in providing information for managerial decisions for formulating operative policies. These policies relate to the following matters: (i) Determination of cost-volume-profit relationship. (ii) Make or buy a component (iii) Shut down or continue operation at a loss (iv) Continuing with the existing machinery or replacing them by improved and economical machines.
4. Ascertaining costing profit Cost accounting helps in ascertaining the costing profit or loss of any activity on an objective basis by matching cost with the revenue of the activity.
5. Facilitating preparation of financial and other statements Cost accounting helps to produce statements at short intervals as the management may require. The financial statements are prepared generally once a year or half year to meet the needs of the management. In order to operate the business at high efficiency, it is essential for management to have a review of production, sales and operating results. Cost accounting provides daily, weekly or monthly statements of units produced, accumulated cost with analysis. Cost accounting system provides immediate information regarding stock of raw material, semifinished and finished goods. This helps in preparation of financial statements.
DIFFERENCE BETWEEN FINANCIAL ACCOUNTING AND COST ACCOUNTING
Importance of Cost accounting
The limitation of financial accounting has made the management to realise the importance of cost accounting. The importance of cost accounting are as follows:
1. Importance to Management Cost accounting provides invaluable help to management. It is difficult to indicate where the work of cost accountant ends and managerial control begins. The advantages are as follows :
Helps in ascertainment of cost : Cost accounting helps the management in the ascertainment of cost of process, product, Job, contract, activity, etc., by using different techniques such as Job costing and Process costing.
Aids in Price fixation : By using demand and supply, activities of competitors, market condition to a great extent, also determine the price of product and cost to the producer does play an important role. The producer can take necessary help from his costing records.
Helps in Cost reduction : Cost can be reduced in the long-run when cost reduction programme and improved methods are tried to reduce costs.
Elimination of wastage : As it is possible to know the cost of product at every stage, it becomes possible to check the forms of waste, such as time and expenses etc., are in the use of machine equipment and material.
Helps in identifying unprofitable activities :With the help of cost accounting the unprofitable activities are identified, so that the necessary correct action may be taken.
Helps in checking the accuracy of financial account : Cost accounting helps in checking the accuracy of financial account with the help of reconciliation of the profit as per financial accounts with the profit as per cost account.
Helps in fixing selling Prices : It helps the management in fixing selling prices of product by providing detailed cost information.
Helps in Inventory Control : Cost furnishes control which management requires in respect of stock of material, work in progress and finished goods.
Helps in estimate : Costing records provide a reliable basis upon which tender and estimates may be prepared.
2. Importance to Employees ; Worker and employees have an interest in which they are employed. An efficient costing system benefits employees through incentives plan in their enterprise, etc. As a result both the productivity and earning capacity increases.
3. Cost accounting and creditors : Suppliers, investor’s financial institution and other moneylenders have a stake in the success of the business concern and therefore are benefited by installation of an efficient costing system. They can base their judgement about the profitability and prospects of the enterprise upon the studies and reports submitted by the cost accountant.
4. Importance to National Economy : An efficient costing system benefits national economy by stepping up the government revenue by achieving higher production. The overall economic developments of a country take place due to efficiency of production.
5. Data Base for operating policy : Cost Accounting offers a thoroughly analysed cost data which forms the basis of formulating policy regarding day to day business, such as:
(a) Whether to make or buy decisions from outside?
(b) Whether to shut down or continue producing and selling at below cost?
(c) Whether to repair an old plant or to replace it?
LIMITATIONS OF COST ACCOUNTING
Like other branches of accounting, cost accounting is not an exact science but is an art which has developed through theories and accounting practices based on reasoning and common sense. These practices are not static but changing with time. Cost accounting lacks a uniform procedure. There is no stereotyped system of cost accounting applicable to all industries. There are widely recognised cost concepts but understood and applied differently by different industries. Cost accounting can be used only by big enterprises. The limitations of cost accounting are as follows:
It is expensive because analysis, allocation and absorption of overheads require considerable amount of additional work.
The results shown by cost accounts differ from those shown by financial accounts. Preparation of reconciliation statements frequently is necessary to verify their accuracy. This leads to unnecessary increase in workload.
It is unnecessary because it involves duplication of work. Some industrial units are functioning efficiently without any costing system.
Costing system itself does not control costs. If the management is alert and efficient, it can control cost without the help of the cost accounting. Therefore it is unnecessary.
Cost accounting is the process of determining and accumulating the cost of product or activity. It is a process of accounting for the incurrence and the control of cost. It also covers classification, analysis, and interpretation of cost. In other words, it is a system of accounting, which provides the information about the ascertainment, and control of costs of products, or services. It measures the operating efficiency of the enterprise. It is an internal aspect of the organisation. Cost Accounting is accounting for cost aimed at providing cost data, statement and reports for the purpose of managerial decision making. The Institute of Cost and Management Accounting, London defines “Cost accounting is the process of accounting from the point at which expenditure is incurred or committed to the establishment of its ultimate relationship with cost centres and cost units. In the widest usage, it embraces the preparation of statistical data, application of cost control methods and the ascertainment of profitability of activities carried out or planned”. Costing includes “the techniques and processes of ascertaining costs.” The ‘Technique’ refers to principles which are applied for ascertaining costs of products, jobs, processes and services. The `process’ refers to day to day routine of determining costs within the method of costing adopted by a business enterprise. Costing involves “the classifying, recording and appropriate allocation of expenditure for the determination of costs of products or services; the relation of these costs to sales value; and the ascertainment of profitability”.
Concepts of Cost Accounting
Following are the main concepts of cost accounting:
Cost
There is a cost involved to purchase or produce anything. Costs may be different for the same product, depending upon the stages of completion. The cost changes according to the stage a product is in, for example, raw material, work in progress, finished goods, etc. The cost of a product cannot be perfect and it may vary for the same product depending upon different constraints and situations of production and market.
Expenses
Some costs are actual, such as raw material cost, freight cost, labor cost, etc. Some expenses are attributable to cost. To earn revenue, some expenses are incurred like rent, salary, insurance, selling & distribution cost, etc. Some expenses are variable, some are semi-variable, and some of fixed nature.
Loss
Expenses are incurred to obtain something and losses are incurred without any compensation. They add to the cost of product or services without any value addition to it.
Cost Center
Cost center refers to a particular area of activity and there may be multiple cost centers in an organization. Every cost center adds some cost to the product and every cost center is responsible for all its activity and cost. A cost center may also be called a department or a sub-department. There are three types of cost centers:
- Personal and Impersonal Cost Centers - A group of persons in an organization responsible as a whole for a group activity is called a personal cost center. In case of impersonal call center, the activities are done with the help of plant and machinery.
- Operation and Process Cost Centers - The same kind of activity is done in an operation department. In a process cost center, as the name suggests, different kinds of processes are involved.
- Product and Service Cost Centers - A department where all activities refer to product is called a product department. When the centers render their services to a product department for its smooth functioning, they are called service cost centers.
Profit Center
Profit centers are inclusive of cost centers as well as revenue activities. Profit centers set targets for cost centers and delegates responsibilities to cost centers. Profit centers adopt policies to achieve such targets. Profit centers play a vital role in an organization.
Cost Drivers
Cost of any product depends upon cost drivers. There may be different types of cost drivers such as number of units or types of products required to produce. If there is any change in cost driver, the cost of product changes automatically.
Conversion Cost
The cost required to convert raw material into product is called as conversion cost. It includes labor, direct expenses, and overhead.
Carrying Costs
Carrying cost represents the cost to maintain inventory, lock up cost of inventory, store rent, and store operation expenses.
Out of Stock Cost
Sometimes loss is incurred due to shortage of stock such as loss in sale, loss of goodwill of a business or idle machine. It is called out of stock cost.
Contribution Margin
Contribution margin is the difference between sale price and variable cost.
Ordering Costs
Ordering costs represent the cost to place an order, up to to stage until the material is included as inventory.
Development Cost
To develop new product, improve existing product, and improved method in producing a product called development cost.
Policy Cost
The cost incurred to implement a new policy in addition to regular policy is called policy cost.
Idle Facilities Cost and Idle Capacity Cost
If available facilities remain idle and some loss incurred due to it, it is called idle facilities cost. If capacity is unused due to repair, shut down or any other reason, it is called capacity cost.
Expired Cost
When the cost is fully consumed and no future monetary value could be measured, it is called expired cost. Expired cost relates to current cost. Suppose the expenses incurred in an accounting period do not have any future value, then it is called an expired cost.
Incremental Revenue
Incremental revenue implies the difference in revenues between two alternatives. While assessing the profitability of a proposed alternative, incremental revenues are compared with incremental costs.
Added Value
Added value means value addition to any product. Value addition of the product may be due to some process on product or to make the product available or there may be other reasons; but it also includes the profit share on it.
Urgent Cost
There are some expenses that are to be incurred on an immediate basis. Delaying such expenses may result in loss to business. These expenses are called urgent cost. Urgent costs are not be postponed.
Postponable Cost
Without avoiding any expenses, if we are able to defer some expenses to future, then it is called a postponable cost.
Pre-production Cost
The cost incurred before commencing formal production or at the time of formation of new establishment or project is called pre-production cost. Some of these costs are of capital nature and some of these are called deferred revenue expenditure.
Research Cost
Research costs are incurred to discover a new product or to improve an existing product, method, or process.
Training Cost
The costs incurred on teaching, training, apprentice of staff or worker inside or outside the business premise to improve their skills is called training cost.
Scope of Cost Accounting
The terms ‘costing’ and ‘cost accounting’ are many times used interchangeably. However, the scope of cost accounting is broader than that of costing. Following functional activities are included in the scope of cost accounting:
1. Cost book-keeping: It involves maintaining complete record of all costs incurred from their incurrence to their charge to departments, products and services. Such recording is preferably done on the basis of double entry system.
2. Cost system: Systems and procedures are devised for proper accounting for costs.
3. Cost ascertainment: Ascertaining cost of products, processes, jobs,services, etc., is the important function of cost accounting. Cost ascertainment becomes the basis of managerial decision making such as pricing, planning and control.
4. Cost Analysis: It involves the process of finding out the causal factors of actual costs varying from the budgeted costs and fixation of responsibility for cost increases.
5. Cost comparisons: Cost accounting also includes comparisons between cost from alternative courses of action such as use of technology for production, cost of making different products and activities, and cost of same product/ service over a period of time.
6. Cost Control: Cost accounting is the utilisation of cost information for exercising control. It involves a detailed examination of each cost in the light of benefit derived from the incurrence of the cost. Thus, we can state that cost is analysed to know whether the current level of costs is satisfactory in the light of standards set in advance.
7. Cost Reports: Presentation of cost is the ultimate function of cost accounting. These reports are primarily for use by the management at different levels. Cost Reports form the basis for planning and control, performance appraisal and managerial decision making.
Objectives of cost accounting
There is a relationship among information needs of management, cost accounting objectives, and techniques and tools used for analysis in cost accounting. Cost accounting has the following main objectives to serve:
1. Determining selling price,
2. Controlling cost
3. Providing information for decision-making
4. Ascertaining costing profit
5. Facilitating preparation of financial and other statements.
1. Determining selling price The objective of determining the cost of products is of main importance in cost accounting. The total product cost and cost per unit of product are important in deciding selling price of product. Cost accounting provides information regarding the cost to make and sell product or services. Other factors such as the quality of product, the condition of the market, the area of distribution, the quantity which can be supplied etc., are also to be given consideration by the management before deciding the selling price, but the cost of product plays a major role.
2. Controlling cost Cost accounting helps in attaining aim of controlling cost by using various techniques such as Budgetary Control, Standard costing, and inventory control. Each item of cost [viz. material, labour, and expense] is budgeted at the beginning of the period and actual expenses incurred are compared with the budget. This increases the efficiency of the enterprise.
3. Providing information for decision-making Cost accounting helps the management in providing information for managerial decisions for formulating operative policies. These policies relate to the following matters: (i) Determination of cost-volume-profit relationship. (ii) Make or buy a component (iii) Shut down or continue operation at a loss (iv) Continuing with the existing machinery or replacing them by improved and economical machines.
4. Ascertaining costing profit Cost accounting helps in ascertaining the costing profit or loss of any activity on an objective basis by matching cost with the revenue of the activity.
5. Facilitating preparation of financial and other statements Cost accounting helps to produce statements at short intervals as the management may require. The financial statements are prepared generally once a year or half year to meet the needs of the management. In order to operate the business at high efficiency, it is essential for management to have a review of production, sales and operating results. Cost accounting provides daily, weekly or monthly statements of units produced, accumulated cost with analysis. Cost accounting system provides immediate information regarding stock of raw material, semifinished and finished goods. This helps in preparation of financial statements.
DIFFERENCE BETWEEN FINANCIAL ACCOUNTING AND COST ACCOUNTING
Both cost accounting and financial accounting help the management formulate and control organization policies. Financial management gives an overall picture of profit or loss and costing provides detailed product-wise analysis.
No doubt, the purpose of both is same; but still there is a lot of difference in financial accounting and cost accounting. For example, if a company is dealing in 10 types of products, financial accounting provides information of all the products in totality under different categories of expense heads such as cost of material, cost of labor, freight charges, direct expenses, and indirect expenses. In contrast, cost accounting gives details of each overhead product-wise, such as much material, labor, direct and indirect expenses are consumed in each unit. With the help of costing, we get product-wise cost, selling price, and profitability.
The following table broadly covers the most important differences between financial accounting and cost accounting.
| Point of Differences | Financial Accounting | Cost Accounting |
|---|---|---|
| Meaning | Recoding of transactions is part of financial accounting. We make financial statements through these transactions. With the help of financial statements, we analyze the profitability and financial position of a company. | Cost accounting is used to calculate cost of the product and also helpful in controlling cost. In cost accounting, we study about variable costs, fixed costs, semi-fixed costs, overheads and capital cost. |
| Purpose | Purpose of the financial statement is to show correct financial position of the organization. | To calculate cost of each unit of product on the basis of which we can take accurate decisions. |
| Recording | Estimation in recording of financial transactions is not used. It is based on actual transactions only. | In cost accounting, we book actual transactions and compare it with the estimation. Hence costing is based on the estimation of cost as well as on the recording of actual transactions. |
| Controlling | Correctness of transaction is important without taking care of cost control. | Cost accounting done with the purpose of control over cost with the help of costing tools like standard costing and budgetary control. |
| Period | Period of reporting of financial accounting is at the end of financial year. | Reporting under cost accounting is done as per the requirement of management or as-and-when-required basis. |
| Reporting | In financial accounting, costs are recorded broadly. | In cost accounting, minute reporting of cost is done per-unit wise. |
| Fixation of Selling Price | Fixation of selling price is not an objective of financial accounting. | Cost accounting provides sufficient information, which is helpful in determining selling price. |
| Relative Efficiency | Relative efficiency of workers, plant, and machinery cannot be determined under it. | Valuable information about efficiency is provided by cost accountant. |
| Valuation of Inventory | Valuation basis is ‘cost or market price whichever is less’ | Cost accounting always considers the cost price of inventories. |
| Process | Journal entries, ledger accounts, trial balance, and financial statements | Cost of sale of product(s), addition of margin and determination of selling price of the product. |
Importance of Cost accounting
The limitation of financial accounting has made the management to realise the importance of cost accounting. The importance of cost accounting are as follows:
1. Importance to Management Cost accounting provides invaluable help to management. It is difficult to indicate where the work of cost accountant ends and managerial control begins. The advantages are as follows :
Helps in ascertainment of cost : Cost accounting helps the management in the ascertainment of cost of process, product, Job, contract, activity, etc., by using different techniques such as Job costing and Process costing.
Aids in Price fixation : By using demand and supply, activities of competitors, market condition to a great extent, also determine the price of product and cost to the producer does play an important role. The producer can take necessary help from his costing records.
Helps in Cost reduction : Cost can be reduced in the long-run when cost reduction programme and improved methods are tried to reduce costs.
Elimination of wastage : As it is possible to know the cost of product at every stage, it becomes possible to check the forms of waste, such as time and expenses etc., are in the use of machine equipment and material.
Helps in identifying unprofitable activities :With the help of cost accounting the unprofitable activities are identified, so that the necessary correct action may be taken.
Helps in checking the accuracy of financial account : Cost accounting helps in checking the accuracy of financial account with the help of reconciliation of the profit as per financial accounts with the profit as per cost account.
Helps in fixing selling Prices : It helps the management in fixing selling prices of product by providing detailed cost information.
Helps in Inventory Control : Cost furnishes control which management requires in respect of stock of material, work in progress and finished goods.
Helps in estimate : Costing records provide a reliable basis upon which tender and estimates may be prepared.
2. Importance to Employees ; Worker and employees have an interest in which they are employed. An efficient costing system benefits employees through incentives plan in their enterprise, etc. As a result both the productivity and earning capacity increases.
3. Cost accounting and creditors : Suppliers, investor’s financial institution and other moneylenders have a stake in the success of the business concern and therefore are benefited by installation of an efficient costing system. They can base their judgement about the profitability and prospects of the enterprise upon the studies and reports submitted by the cost accountant.
4. Importance to National Economy : An efficient costing system benefits national economy by stepping up the government revenue by achieving higher production. The overall economic developments of a country take place due to efficiency of production.
5. Data Base for operating policy : Cost Accounting offers a thoroughly analysed cost data which forms the basis of formulating policy regarding day to day business, such as:
(a) Whether to make or buy decisions from outside?
(b) Whether to shut down or continue producing and selling at below cost?
(c) Whether to repair an old plant or to replace it?
LIMITATIONS OF COST ACCOUNTING
Like other branches of accounting, cost accounting is not an exact science but is an art which has developed through theories and accounting practices based on reasoning and common sense. These practices are not static but changing with time. Cost accounting lacks a uniform procedure. There is no stereotyped system of cost accounting applicable to all industries. There are widely recognised cost concepts but understood and applied differently by different industries. Cost accounting can be used only by big enterprises. The limitations of cost accounting are as follows:
It is expensive because analysis, allocation and absorption of overheads require considerable amount of additional work.
The results shown by cost accounts differ from those shown by financial accounts. Preparation of reconciliation statements frequently is necessary to verify their accuracy. This leads to unnecessary increase in workload.
It is unnecessary because it involves duplication of work. Some industrial units are functioning efficiently without any costing system.
Costing system itself does not control costs. If the management is alert and efficient, it can control cost without the help of the cost accounting. Therefore it is unnecessary.
Explained so well. please keep us updated with such stuffs. This has been helpful for all of us in terms of financial decision. If anyone is interested in accounting costs do visit our website.
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