About Cost Accounting-Introduction
In olden times “the application of costing and cost accounting principles, methods and techniques to the science, art and practice of cost control and ascertainment of profitability of goods or services”. This includes the presentation of information derived there form for helping management to take good business decisions and fulfil the organisational goals. Hence, cost accountancy is the science, art and practice of a cost accountant.
It has been referred to as science, because it is consultancy studying the relationship of reasons and consequences of various factors.
For this the cost accountant should have the knowledge of organization and methods, work study, production, inventory control, operational research, linear programming, etc., besides cost accountancy subjects.
The presentation of data i.e., highlighting the salient features for appropriate action of the higher management is an art.
It is practice as it requires continuous effort of a cost accountant to analyse the evaluate the various alternatives to arrive at a decision which optimises the results.
Modern cost accounting is often called management accounting managers use cost accounting data maximum for settings objectives and controlling the activities of the business.
It is the process of accounting for cost. It begins with recording of income and expenditure and ends with preparation of statistical data.
Hence cost accounting may be referred to as the formal mechanism by which cost of products or services are ascertained with a reasonable degree of accuracy and controlled.
The primary objectives of cost accounting are cost control and cost reduction, determining unit product cost, profit or loss for different product and services, inventory valuation and making employees cost conscious.
CIMA has defined it as “the establishment of budgets, standard costs and actual costs of operations, processes, activities or product; and the analysis of variances, profitability or the social use of funds”.
It is applicable to all types of activities manufacturing and non-manufacturing, in which monetary value is involved.
It performs important functions like (i) fixation and revision of standards; (ii) comparing performance with standards; (iii) introduction of systems; (iv) planning and budgeting; (v) setting index to managerial performance; (vi) protecting interest of investors; (vii) reporting to government; (viii) cost control and cost reduction.]
Wheldon has defined it as “the classifying, recording and appropriate allocation of expenditure for the determination of the costs of products or services, the relation of these costs to sale values and the ascertainment of profitability.
Costs may be found:
Historically, i.e. when it is incurred; or
By using predetermined standards and subsequently analysing between actual cost incurred and the standard cost; and
By using marginal methods of presentation for (a) or (b), differentiating between ‘ variable’ and ‘fixed’ costs can be done using mathematics and integral accounts but cost accounting is the formal mechanism by which costs are ascertained.
EVOLUTION OF COST ACCOUNTING
In 1805 factory cost system was introduced in the U.K and the U.S.A. after the industrial revolution in the eighteenth century. In 1875 several industrialists used the concept of prime cost.
Between 1885 and 1901, several journals of the U.K. and the U.S.A explained the cost concepts and in 1913 a complete text book on cost accounting theory and practice was published by J.L Nicholson from the U.S.A.
The ‘cost-plus’ concept was introduced during the First World War to execute urgent supplies promptly for this there was demand for Cost Accountants and identification of cost elements simultaneously.
In 1919, the Institute of Cost and Works Accountants (U.K.), now known as Chartered Institute of Management Accountants (CIMA), was established.
Before independence there were cost few Cost accountants in India and they passed mainly ICWA (CIMA), U.K. During the Second World War some members of defence services posted at Calcutta took the initiative to form an Indian institute.
The institute of cost and works accountants of India was established at Calcutta immediately after the enactment of the cost and works accountants of India act in 1959.
At present the institute has follow, associate and student members. It has four regional offices at Calcutta (H.O.) Delhi, Mumbai, Chennai and several chapter offices.
In 1968, the government of India introduced selective Cost Audit under section 233-B of Indian companies act, 1956 and framed Cost Accounting Record Rules, 1968.
More persons are now joining this profession. Information technology, Activity-Based Costing (ABC), operational control and performance measurement, etc. are the new concepts of modern cost management.
FINANCIAL ACCOUNTING AND COST ACCOUNTING
In financial accounts, actual transactions of the business are recorded in accordance with established concepts, principles, accounting standards as well as legal requirements, classified and analysed in an orderly manner, so as to prepare profit and loss account or income statement and balance sheet for a selected period of time, indicating the financial position of the business at the end of that period.
The aim of financial accounting is to provide information to the shareholders, investors, financial institutions, government authorities, etc., from which they can assess the profitability, liquidity and solvency of the enterprise.
Moreover, government authorities, e.g., income tax, banks, central excise insurance companies, etc., rely fully on the data provided in the financial statements.
Cost accounting deals with the ascertainment of the cost of a product, service, process or an operation.
The objective of cost accounting is to provide adequate information to departmental managers for optimum utilization of available resources, i.e., material labour and machines etc., and taking timely decisions in solving complex problems like determination of most profitable product mix, fixing mix, preparing quotations, releasing or withdrawal inventory, make or buy decisions, introduction of a new product equipment replacements, discontinuing a less profitable product, processing a by-product etc.
The profit and loss figures derived from financial accounts do not agree as some of the expenditure and incomes recorded in financial books are not considered for product cost, while certain expenditure are included in cost accounts without has been developed by combining cost and financial accounts.
Distinction between Financial and Cost Accounting
|Financial Accounting||Cost Accounting|
|Prepares profit and loss account and balance sheet mainly for external reporting to the shareholders, investors, financial institutions, government authorities and outside parties.||Prepares routine cost reports, special reports and forwards them to the departmental managers for internal control and decision making.|
|Deals with financial transaction of the business.||Deals with product cost and service cost.|
|Records, classifies and analysis monetary transaction according to the nature of expenses.||Records expenditure according to the purpose for which the cost in incurred, e.g. report of loss of material, idle time report, variance report, etc.|
|It is mandatory and structured according to Companies Act, Income-tax Act, etc.||It is mandatory, except those covered by cost audit required u/s 233B of Companies Act, 1956.|
|Values stock at cost or net realisation value whichever is lower.||Values stock at cost.|
|Subject to verification by external auditor.||Cost audit is not mandatory but selective to some particular industries.|
|Prepares profit and loss account and balance sheet annually or at periodic interval and reports aggregate costs.||Develops product or service costs, showing elements wise cost break-up and profitability of each product or service. Prepares cost reports as and when required, i.e., daily, weekly, monthly, etc.|
|Emphasis is not given on the control aspect but on the recording of financial transactions.||Controls with the help of standard costing and budgetary control.|
|Keeps historical records.||Considers both historical and predetermined costs and uses these costs for development of future performance.|
|Shows the profit and loss of the entire business for a particular period.||Shows detailed cost and profit for each product, process, department etc.|
Cost Accounting and Management Accounting
Management accounting is any form of accounting which helps a business to run effectively.
According to Robert S Kaplan it is a system which collects, classifies, summaries, analysis and provides information to managers to take decisions and control internal activities.
Management accounting uses various techniques, e.g. marginal costing, standard costing, budgetary control, cost-volume- profit and break-even analysis, inter-firm comparison, uniform, ratio accounting, fund flow statement, internal audit, operation researches, capital project assessment and control etc.
Financial accounting gives emphasis on internal reporting. The objectives of cost accounting are similar to those of management accounting. Financial accounting is considered as an extension of the management aspects of cost accounting.
Management accounting uses the principles and practices of both financial accounting and cost accounting in the best interest of the business.
Thus, the four essential tasks of management accounting are: (i) cost determination, (ii) cost control, (iii) performance evaluation, and (iv)supplying information for planning and decision-making.
Role of Management Accounting
The role of management accounting may be summarised as follows:
Maintaining cost and financial accounts and preparing respects for routine financial and operational decision-making.
Long-term planning and short-term planning:
Forecasting future business and economic events for making future plans, i.e. long-term plans, strategic management accounting, formulating corporate strategy, market study, etc.
Developing management information system (MIS):
The routine reports as well as reports for long-term decisions-making are forwarded to managers at all levels to take corrective action at the right time. Te management accountant himself also uses these reports for taking important decisions.
The management accountant analysis and prepare reports, e.g. standard costs, budgets, variances analysis and interpretations, cash and fund flow analysis, management of liquidity performance evaluation and responsibility accounting, etc., for control.
Management accountant takes short-term decisions (e.g. optimum product mix, make or buy, lease or buy, pricing, discontinuing a product, etc.) and long-term decisions (e.g. capital budgeting, investment appraisal, project financing, etc.,)and long-term decisions (e.g. capital budgeting, investment appraisal, etc.)
Costing and estimating
Estimating is predetermined cost of carrying out an operation or job or order, required for quoting a price for the job to be done.
Allowances are provided on market prices of material or labours for fluctuation in market conditions. Previously ascertained costs may be used as a guide in fixing prices.
Cost accounts, however, record the actual or standard costs of material, wages and overhead. It is said that “an estimate is an opinion, price, and cost is a fact “.
The Purpose or Use of Cost Accounts
Provide data, e.g. value of closing stock of raw materials, work-in-progress and finished goods etc., for preparation of weekly, monthly, quarterly or yearly profit and loss account and balance sheets, as desired, for the entire business or a department of a product.
Determining the cost of production of each unit, operation, job, process, department or services and to establish cost standards.
To highlight to the management any inefficiencies, and the magnitude of waste, whether of materials, time, expenses or in the use of plant and machinery for corrective action (i.e. control of cost).
To provide actual cost for comparison with estimates, and for making future estimates, and to help the management in fixing the selling price of products and services.
To compare actual costs with standard costs and find out sources of economics in production as regards methods, types of equipments, design, output and layout.
Advantages of Cost Accounting
The advantages of cost accounting are:
It highlights the profitable and unprofitable activities, losses or inefficiencies in any forms and helps management to make optimum utilisation of men, materials and machines by eliminating idle time, under-utilisation of plant capacity, spoilage of materials etc.
It facilitates the preparation of periodical, final accounts accurately with the help of perpetual inventory system of stock control, ABC analysis, level setting, etc.
It establishes more accurate unit costs based on which fair selling prices are fixed. It is helpful during period of depression when prices may have to be fixed below cost.
It provides data-base for use by the government, wage tribunals, trade unions, etc, for solving problems like wage level fixation price fixation, settlement of disputes, payment of dividend, etc.
It helps to form cost centres and responsibility centres to exercise control. It also controls cost with special techniques, e.g. standard costing and budgetary control.
The operation of a system of cost audit in an organization prevents manipulation, fraud and assists in furnishing accurate and reliable cost data to the management and outsides, e.g. the shareholders, the consumers and the government.
It facilitates use of specialised costs reduction techniques, e.g. value analysis, operation researches, cost reduction, management by exception, etc.
It helps management to take short-term decisions, e.g. adding a new product, make or buy replacement of old machinery etc. By using techniques like marginal costing, etc. And also to formulate production and pricing policies and prepare estimates, contracts and tenders.
Unlike financial accounting, which shows profitability of the entire company, it shows the profitability of each product and services.
Cost comparison, in respect of costs of jobs, processes or centre help to control costs. Such comparisons may be made from period to period, of the figures of the same unit or of several units in an industry using uniform costing and inter-firm comparisons methods.
The cost of idle capacity of a concern not working to full capacity can be readily worked out, which enables the management to take appropriate timely action to improve the position.
Value of the closing stock of raw materials, work-in-progress, and finished goods can be readily obtained from the cost records.
It checks the accuracy of the financial accounts by reconciling the two accounts at the end of the accounting period.
Workers are benefited by introduction of incentive plans which results in higher productivity and higher earning for them.
It helps to lower the cost of production and hence the price of products or services.
Limitations of Cost Accounting
It is not exact science as it is based on a large number of conventions, estimations and other flexible factors, viz.
- Classification of cost into elements,
- Pricing of material issues on the basis of average or standard costs,
- Apportionment and allocation of overhead expenses to cost centres or cost units on arbitrary basis,
- Allocation of joint costs on arbitrary costs,
- Division of overhead expenses in to fixed and variable,
- Adoption of standard costs and marginal costs,
- Use of pre-determined overhead rates, and
- Inclusion or non-inclusion of certain items of expenses.]
- Costs collected for one purpose are unsuitable for another purpose. For example, standard costs are different from actual costs, and costs pricing in periods of recession are different from costs for pricing in normal circumstances.
- It provides the base for taking the best decisions but does not give an outright solution to the problems.
Elements of Costs
A manufacturing concern converts raw materials into finished products using labour and certain other services. In order to find the costs of each of these functions, the manufacturing costs is subdivided into three basic elements, viz,
(i.e. the cost of all materials consumed in the process of manufacture up to the primary packing),
(i.e. wages, salaries, bonus, commission, etc. remuneration paid to the employees for conversion of raw materials in to finished products), and
(i.e., the cost of utilities and services provided for the conversion process and the notional cost for using own assets).
Each of these elements is sub-divided in to direct and in-direct cost. Direct costs (i.e. materials, labour and expenses) are costs which can be identified with the product, costs centres, job or services, whereas
Indirect costs (i.e. material, labour and expenses cannot be identified with a given costs objective. Hence, the elements of costs may be summarised as follows:
a. Direct Material:
Material inclusive of component parts, specially purchased or requisitioned for a specific job, order or process.
Materials flowing from one operation or process to another.
Primary packing materials, e.g. cartons, cardboard boxes, etc.
b. Indirect Materials:
Lubricants, grease, small tools, cotton, waste, oils, belt fasteners, work stationery, etc. Some minor materials which from part of production are also considered as indirect material, e.g., cost of glue in cardboard boxes, cost of thread in short making, cost of nails in shoe-making factory.
a. Direct labour:
Workers engaged in altering the condition, conformation and composition of the product.
Inspectors, analysis, etc., exclusively required for such production.
If specifically identified, the wages of foremen, supervisors, clerks engaged in production, the wages of internal transport personnel, etc.
It varies directly in relation to the volume of output.
b. Indirect Labour:
Salaries or wages of foremen, supervisors, inspectors, maintenance labour, clerical staff, indirect labour in drawing and design office, watch and ward, canteen tool room, material handling, medical centre, overtime premium, idle time wages, night shift allowance,, fringe benefits, etc.
a. Direct Expenses:
- Cost of special tools and equipment for a specific job.
- Hiring cost of special tools and equipment for a specific job.
- Maintenance costs of such tools and equipment.
- Cost of patents and royalties.
- Architects, surveyors and consultant’s fees.
- Freight inward on special material.
- Travelling expenses to site.
Experimental costs in connection with model and pilot schemes.
These are also known as chargeable expenses, i.e. those expenses which are directly charged to jobs, products, process, cost centres or cost units. It is a part of prime cost.
b. Indirect Expenses:
Expenses (other than indirect material and labour)
which are not indirectly charged to production, are indirect expenses. Examples of indirect factory expenses or factory overhead are:
- Factory rent, rates and insurance.
- Repairs and maintenance of plants, machinery and buildings, power and fuel, depreciation.
- Sundry expenses, e.g. first aid, rewards for suggestions of welfare etc.
These are appointed or absorbed by cost centres or cost units and not a part of prime cost.
The process of grouping as per their common characteristics, viz., nature of expenses, function, variability, controllability, normality, time direct and indirect costs and decision making. Cost classification as per the nature means grouping of costs under the heads – material, labour and overhead.
This is the common classification. Cost classification is a must for identifying costs with cost centres or cost units for the determination and control of cost.
By nature of expenses:
Here costs are divided under three heads, i.e. material, labour and expenses. Each element can be further subdivided into direct and indirect e.g. materials can be subdivided as raw materials, consumable stores, spare parts, packing materials, oil grease, printing and stationery etc.
Herecosts are divided into manufacturing cost, administration cost, selling cost, distribution cost, research and development cost.
It begins with supplying materials , labour and services and ends with primary packing of finished goods, it includes cost of materials, labour, factory rent, rates, insurance, supervision charges, power and lighting, process fuel, canteens, internal transport, consumable stores, depreciation of plant, sundry expenses (e.g. workers news paper, works welfare. etc.) etc.
This consists of all costs incurred in formulating the policy, directing the organisation and controlling the operations of an undertaking. Such costs do not relate directly to manufacturing, selling, distribution, researches and development activity or function. It includes accounts and personnel office expenses, legal expenses, directors’ remuneration, audit fee, postage, etc.
These are expenses incurred in promoting sales, securing orders and retaining customers. It includes advertising, salaries and commissions of sales manager, training and remuneration of salesmen, cost of preparation of tenders and estimates of special selling projects, rent of showrooms and offices, consumer service before/after sales, cost of samples, demonstration, travel expenses etc.
These are expenses incurred from the time product in completed in the works until it reaches its destination and the reconditioned returned empty package is available for reuse, it includes packing, carriage outwards, maintenance of delivery vehicles, warehouse charges. Loading charges, etc.
Researches and development cost:
It consists of the cost of researching for new or improved products, new ideas or processes by experiment or otherwise and cost of implementing these ideas on a commercial basis. It includes wages and salaries of research staff, payments made to outside research centres, materials used in the research laboratories, etc. Development cost begins from the implementation of the decision to produce a new product or to use a new method and ends with the beginning of the formal production of the product by that method.
It refers to that part of development cost which is incurred in making a trial production run preliminary to formal production, in a new or old factory. In an old factory this cost is considered as researches and development cost. These costs are incurred when a new factory is being established or a newcosts may be charged. These costs are generally considered as deferred revenue expenditure except the portion which has been capitalised and charged to the costs of future production.
By variability or behaviour:
Here costs are classified into fixed, variable and semi-variable/semi-fixed depending upon their behaviour in relation to changes in the volume of output.
These costs do not tend to change in the volume of output, e.g., rent, insurance of factory building, taxes, salary of works manager, depreciation, corporation tax, et. It can be controlled by top management only.
Thesecosts tend to change directly with volume of production e.g, direct material, direct wages, and direct expenses i.e., power consumable stores, packings, carriage outwards, etc. Variable cost per unit remains fixed. Functional managers can control it.
Semi variable/semi –fixed costs:
These costs are partly fixed and partly variable, e.g., electricity charges, telephone expenses, etc. The lowest selling price of an article should cover all direct expenses and variable overheads. During trade depression the selling price may be fixed below the total costs provided it exceeds the direct expenses plus variable overheads. Thus a part of fixed expenses in recovered and loss is minimized.
These costs are classified as controllable cost and uncontrollable cost.
These costs can be influenced by the action of a specified person of an organisation. In a business organisation the heads of each responsibility centre are responsible to control expenses. Costs which they are able to control are called controllable costs, e.g., direct material costs, direct wages, and direct expenses.
These costs remain unaffected by the action of an specified person of an organisation, e.g., fixed costs and allocated and apportioned costs.
In fact, no cost is uncontrollable.
Controllable and uncontrollable costs concepts are related to the authority of a person in the organisation and the time factor involved.
An expenditure which is uncontrollable by one person may be controllable by another. Moreover, and expenditure which cannot be controlled on the short-team basis due to unfavourable circumstances may be control on a long-term basis, when the conditions change.
Here costs are classified as normal cost and abnormal cost.
Normal cost: This is a cost which is normally incurred at a particular level output in the conditions in which that level of output is generally achieved.
Abnormal cost: This is a cost which is not normally incurred at a particular level of output in the conditions in which that level of output is generally achieved.
Based on time: Here costs are classified as historical cost and pre-determined cost.
Historical cost: This is a ‘postmortem’ cost ascertained after its incurrence. It is determined on the basis of actual cost incurred during the period. Such evaluation of cost takes much longer time as it can be prepared only after closing of accounts. It helps in predicting future costs of different alternative actions and selecting a best line of action.
This cost is prepared in advance before the actual operation takes place based on specification, historical cost figures and other factors affecting cost. Thus it is a future cost and may be estimated or standard.
Estimated cost: It is prepared in advance for quoting price before the acceptance of sale orders. It also helps in comparing with actual performance.
Standard cost: When pre-determined cost is found scientifically it becomes standard cost. It consist of setting standards for each elements of cost, comparing standard cost with actual cost incurred, finding out the reasons for variances, fixing responsibility and taking remedial action to avoid its recurrence in future.
Direct and indirect costs: Here costs are classified as direct and indirect cost.
It is incurred for a specific cost unit, process or department and can be directly identified with and allocated to that cost unit process or department. It is also called product cost.
It is incurred for a number of costs units or cost centres. Cost which is apportioned to other cost units on some suitable basis in an indirect cost of that cost unit. Such costs are called over at period and the benefits are also derived within that period and hence they are often called period cost. It cannot be identified with a particular unit of cost.
For example, wages or maintenance department is the direct cost of the maintenance department, whereas it is an indirect cost of production units as it is apportioned to these units on some suitable basis.
Other examples of direct costs are:
The cost of cloth in the shirt, wages of a worker who is directly engaged in production, etc. Again, the costs of consumer able stores, salary of foreman or supervisor, rent of factory, etc. are example of indirect cost.