Everything you need to know about cost accounting. Cost Accounting is a branch of accounting, which deals with the accumulation, classification, analysis, recording, allocation, summarization, interpretation, reporting, and control of current and prospective cost. It also includes determination of forecasted future cost and standard cost of products, services, activities, functions, responsibilities etc.
Learn about:-
1. Evolution of Cost Accounting 2. Definitions of Cost Accounting 3. Basic Cost Concept 4. Objectives 5. Elements 6. Nature
7. Classification 8. Principles 9. Purpose 10. Importance 11. Methods 12. Cost Accounting an Aid to Management
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13. Installation 14. Development of Cost Accounting in India 15. Standards for General Cost Accounting Practices 16. Cost Accounting as a Tool of Managerial Planning and Control 17. Advantages 18. Disadvantages.
What is Cost Accounting: Introduction, Definitions, Concepts, Objectives, Elements, Nature, Principles, Purpose, Advantages and Disadvantages
Contents:
- Evolutions of Cost Accounting
- Definitions of Cost Accounting
- Basic Cost Concept of Cost Accounting
- Objectives of Cost Accounting
- Elements of Cost Accounting
- Nature of Cost Accounting
- Cost Classification in Cost Accounting
- Principles of Cost Accounting
- Purpose of Cost Accounting
- Importance of Cost Accounting
- Methods of Cost Accounting
- Cost Accounting an Aid to Management
- Installation of Cost Accounting System
- Development of Cost Accounting System in India
- Standards for General Cost Accounting Practices
- Cost Accounting as a Tool of Managerial Planning and Control
- Advantages of Cost Accounting
- Disadvantages of Cost Accounting
What is Cost Accounting – Introduction and Evolution
The science of Cost Accounting is of recent origin. The idea of Cost Accounting started in the early years of the 20th century, when the concept of large scale production in the factories started growing. It made the traditional accounting system bulky. The new problems in accounting faced by the factories were numerous.
With the increase in the production, different types of costs were found to have different rules on the cost structures of the products. Thus, the variety of expenditures increased and many new items of costs entered the calculations and became vital for taking important decisions by the management.
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Costing is a branch of accounting, which has developed because of the limitations of Financial Accounts. It was developed because of certain needs of management which financial account could not meet. The modern industrial requirements were different and to fulfil these requirements some new methods and principles of accounting became necessary over the old traditional method of financial accounting system. This resulted into the outcome of the “Cost Accounting systems”.
It appears that costing system was first introduced in Robert Loder’s farm accounts in 1610-20. 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. Simultaneously, at New York the National Association of Cost Accountants, now known as National Association of Accountants, was established. Before the Second Word War, standard costing, flexible budgeting, budgetary control and direct costing became popular in the U.K. and the U.S.A.
Before independence there were few Cost Accountants in India and they passed mainly from 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 Fellow, Associate and student members. It has four Regional Offices at Calcutta (H. O.) Delhi, Mumbai, Chennai and several chapter offices.
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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 modem cost management.
The need for the application of cost accounting methods in Indian industries was felt in the beginning of the twentieth century. The development of cost accounting in India started gaining importance after the independence of the country when the Indian Government started laying emphasis on the industrial development of the country. Provisions of cost audit under section 233B of the Companies Act gave impetus to the development of cost accounting in India.
The Vivian Bose Enquiry Commission brought to light the various malpractices prevalent in the manufacturing establishments and it was thought that the audit of financial accounts at the end of the year was insufficient to judge the real efficiency of the working and manufacturing organisations as a result, the concept of cost audit emerged best utilise the resources of the country, and the government was given the power for ordering cost audit under section 233B of the Companies Act, 1956.
What is Cost Accounting – Definitions Provided by Chartered Institute of Management Accountants and Institute of Cost and Management Accounting
Cost Accounting is a branch of accounting, which deals with the accumulation, classification, analysis, recording, allocation, summarization, interpretation, reporting, and control of current and prospective cost. It also includes determination of forecasted future cost and standard cost of products, services, activities, functions, responsibilities etc.
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The Chartered Institute of Management Accountants (CIMA), London, has defined the terms costing, cost accounting and cost accountancy as under:
(i) Costing:
“The technique and process of ascertaining costs.”
(ii) Cost Accounting:
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“The process of accounting for cost from the point at which expenditure is incurred or committed to the establishment of its ultimate relationship with the cost centres and cost units. In its widest uses it embraces the preparation of statistical data, the application of cost control method and ascertainment of the profitability of activities carried out or planned.”
(iii) Cost Accountancy:
“The application of costing and costing and cost accounting principles, methods and techniques to the science, art and practice of cost control and the cost ascertainment of profitability. This includes the presentation of information derived there from for the purpose of managerial decision making.”
From the above definition of cost accountancy, it is clear that the term cost accountancy is more comprehensive and includes ‘costing’ and ‘cost accounting’.
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It may, however, be noted that in common parlance, the terms costing, cost accounting and cost accountancy are used liberally and interchangeably.
C.I.M.A London has defined costing as – “the techniques and processes of ascertaining costs”. According to Wheldon, costing is defined as – “the classifying, recording and appropriate allocation of expenditure for determination of costs, the relation of these costs to sales values and ascertainment of profitability”.
“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.”
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The Institute of Cost and Management Accounting, London (CIMA) 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.”
The Institute of Cost and Works Accountants, U.K. defines “Cost Accounting as the application of costing and cost amounting principles, methods and techniques to the science, art and practice of cost control and ascertainment of profitability. It includes the presentation of information derived therefrom for the purpose of managerial decision-making”. The Institute of Cost and Works Accountants, India defines “Cost Accounting is the technique and process of ascertainment of costs. Cost accounting is the process of accounting for costs, which begins with recording of expenses or the bases on which they are calculated and ends with preparation of statistical data.”
Cost Accounting is defined as the body of concepts, methods and procedures used to measure, analyse or estimate the costs, profitability and performance of individual products, departments and other segments of a company’s operations, for either internal or external use or both, and to report on these questions to the interested parties. Thus, there are three main divisions of cost accounting—cost ascertainment, cost presentation and cost control.
The Institute of Cost and Works Accountants (ICWA) (UK) defines cost accounting as “the process of accounting for cost from the point at which expenditure is incurred or committed to the establishment of its ultimate relationship with cost centers and cost units. In its widest usage it embraces the preparation of statistical data, the application of cost control methods and the ascertainment of the profitability of activities carried out or planned.”
What is Cost Accounting – 5 Basic Cost Concept: Concept of Objectivity, Concept of Time Span, Concept of Relevant Range of Activity and Other Concepts
Cost represents the amount of expenditure (actual or notional) incurred on, or attributable to, a specified thing or cost unit or activity. To average man or woman cost means the amount of money he or she actually pays to get a desired article. ICMA has defined cost as “resources sacrificed or forgone to achieve a specific objective”. The dictionary meaning of cost is “a loss or sacrifice”.
The resources may be either tangible substances (materials or machinery) or services (wages, power, rent or time spent). If the objective is to buy a T. V., then cost is the amount of cash which is to be paid to acquire it. Similarly, the material cost of a product is the expenses incurred in buying, storing and using materials in the product. Again labour cost is the amount of payment made to the operator for time spent on the product at the time of its manufacture. The term ‘cost’ is meaningless without a suffix or a prefix, e.g., material cost, labour cost, fixed cost, process cost, etc. The suffix or prefix explains its nature and limitations.
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Basic Cost Concepts:
1. Concept of Objectivity:
It gives direction to the activities regarding cost finding, cost recording, cost analysing and cost reporting. Cost exercises must be in harmony with objectives. Cost strategies and cost treatments are greatly influenced by objectives.
2. Concept of Time Span:
All assumptions for various cost exercises remain valid for related time span. Fixed cost remains fixed for a particular time span. Time span should be sufficiently long to record the associated cost, labour hours, output and other factors required for analysis. If time span is too small, then cost relating to a particular time span activity may be recorded in another time span activity causing erroneous results.
3. Concept of Relevant Range of Activity:
It refers to the span of volume over which the cost behaviour is likely to remain valid. Various cost exercises work on certain assumptions regarding cost behaviour patterns, which remain valid only within the relevant range of activity. A fixed cost remains fixed only for the relevant range of activity for the period. The relevant range of activity may change with time and it may not be the same between firms and for individual firm.
4. Concept of Materiality:
According to this concept accuracy should be tempered by good judgement provided it does not affect product cost, e.g., certain items of direct cost, which may not be as material as to include in the specific unit of production, may be included in the overhead. Certain decision may be helpful, but benefits may not be material enough on its implementation. Materiality is assessed by considering the nature of company’s activities, competitor’s practices of managerial policies.
5. Concept of Relevant Cost and Benefit:
For evaluating alternative courses of action, only relevant cost and benefit relating to those alternatives should be considered by the management.
(a) Relevant costs and benefits for operating decisions- In operating decisions, emphasis is given on the optimum use of existing capacity. Incremental analysis which works on differential cost and differential revenue is based on this concept. Opportunity cost also emerges from this concept.
(b) Relevance of normal and abnormal cost- Normal cost and abnormal cost, normal working conditions and abnormal working conditions are often used in cost accounting. Normal means anything which is usual or regular, whereas abnormal means anything which is different from normal. Different accounting treatments and strategies are used for normal and abnormal costs as well as for normal and abnormal working conditions.
What is Cost Accounting – Objectives: To Ascertain and Analyse Costs, To Control Cost, To Fix the Selling Price, To Reduce Cost, To Prepare Periodic Statements & a Few Others
The objectives of cost accounting are:
(i) To Ascertain and Analyse Costs:
The primary objective of cost accounting is to ascertain and analyse costs incurred on the production of various products, jobs and services, etc.
(ii) To Control Cost:
Cost accounting has developed various techniques such as standard costing and budgetary control for controlling costs.
(iii) To Fix the Selling Price:
Cost accounting provides reliable data on the basis of which selling prices can be fixed.
(iv) To Reduce Cost:
Of late, the objectives of cost accounting have been extended to reducing costs. Under the cost reduction plan, products, processes, procedures, organisation and methods are continuously scrutinized to improve efficiency and reduce costs. Value analysis, standardization, time and motion study and operations research are important techniques of cost reduction.
(v) To Prepare Periodic Statements:
Under cost accounting system monthly or quarterly cost statements for periodic review of operating results are prepared.
(vi) To Provide Information:
Cost accounting provides useful information for planning and control and for taking various decisions regarding increase in production, installation or replacement of a machine, making or buying of a component, continuing or closing down of a business, etc.
What is Cost Accounting – 4 Major Elements: Material, Labour, Expenses and Overheads
Elements here mean the components of parts of the total cost of a product or service. In other words elements of cost are the items of expenses incurred on a product or service. A cost is composed of three elements they are Material, Labour, Expenses and Overheads
By grouping these elements following divisions of cost are obtained:
1. Prime Cost = Direct Material + Direct Labour + Direct Expenses.
2. Factory / Works Cost = Prime Cost + Factory / Works Overheads.
3. Cost of Production = Factory / Works Cost + Office / Administration Overheads.
4. Cost of Sales or Total Cost = Cost of production + Selling and Distribution Overheads.
Element # 1. Material:
The term material refers to all commodities consumed in the process of manufacture. It can also be used as inventory. The term inventory consist of raw material, work-in-progress and finished goods. Raw materials are the commodities which are consumed in the process of production and they are the basic commodities used for production. Work-in-progress are the commodities which are in the process of production but have not taken a final shape. Finished goods are the manufactured components which are ready for sale.
Materials can be again classified in to direct and indirect. Direct materials are the materials which can be conveniently identified and charged to the product. The examples of direct materials are cloth required to make a shirt, wood in making a table. However in certain cases, though material forms a part of finished product, yet it is not treated as direct material as its value is quite small and it is quite difficult and futile to measure it, such as thread used in a stitching a shirt or a nails used in furniture.
Indirect materials are those materials which cannot be conveniently identified with the cost unit or product. It has less importance as they are relatively less in value. The examples of indirect materials are thread, oil, stationery etc.
Element # 2. Labour:
It is an important element of cost representing the human contribution to production. Labour can be direct or indirect. Direct Labour is that labour which can be conveniently identified wholly a particular job product or process. In other words, direct labour cost consists of wages paid to the workers who are directly engaged in converting raw material into finished products.
Example of direct labour is the wages paid to a worker who makes a shirt. Indirect Labour is that which cannot be conveniently identified with a particular cost unit. In other words indirect labour is one who are not directly engaged in production but only assist the main worker in production. A helper is an example of indirect labour
Element # 3. Expenses:
All costs other than material and labour are termed as expenses. According to CIMA, expenses are defined as “the cost of services provided to an undertaking and the notional cost of the use of owned assets”. Expenses can be again classified into direct and indirect. Direct Expenses are those expenses which can be identified to cost centers or units. These expenses are incurred specifically in connection with a particular job or cost unit. Direct expenses are known as chargeable expenses and a form apart of prime cost.
For example hire charges for purchase of equipments is a direct expense. Indirect Expenses are those which cannot be directly identified with a particular job or process. Example of indirect expenses can be factory rent, repairs and maintenance etc.
Prime Cost:
Prime Cost is the aggregate of direct material, direct labour and direct chargeable expenses. Prime cost is called so because a major portion of the total cost is involved in this cost ranging from 40% – 70%.
Element # 4. Overheads:
Overhead is the total of all indirect costs i.e., indirect material, indirect labour and indirect expenses.
Overheads are again classified into:
i. Factory overheads,
ii. Office overheads, and
iii. Selling and distribution overheads.
i. Factory Overheads:
Factory or Work Overheads are those which are concerned with the manufacturing function.
It includes:
(a) Indirect material such as Cotton waste, lubricants, stationery used in office etc.
(b) Indirect wages such as salary of factory staff, supervision, inspection, work manager’s salary etc. and
(c) Indirect expenses such as factory rent, repairs and maintenance, depreciation on plant and machinery, power, factory lighting c.c.
ii. Office Overheads:
These are the general administrative expenses incurred in formulating polices in the administrative office. These expenses have no connection with production or sales.
Again these overheads can be classified into:
(a) Indirect material like stationery used in general administration, postage, printing etc.
(b) Indirect labour such as salary of office staff, remuneration to directors of the company etc. and
(c) Indirect expenses such as office lighting, depreciation of office equipments, rent of office building, telephone expenses, sundry expenses etc.
iii. Selling and Distribution Overheads:
Selling overheads are incurred to promote the sales and expand the market, where as distribution overheads includes expenses incurred to supply the product from stores to the market.
Selling and Distribution can be again classified into:
(a) Indirect material such as packing material, cost of samples, price list, stationery used in the sales office, oil used for delivery vans etc.
(b) Indirect labour such as salary of sales manager, salary of sales staff, salary of drivers etc.
(c) Indirect expenses such as advertising, rent of warehouse, insurance of goods travelling expenses, carriage outwards, bad debts etc.
What is Cost Accounting – Nature: Cost Accounting is a Separate Discipline, an Art, a Science and a Profession
1. Cost Accounting is a Separate Discipline – Cost Accounting is a recent development in accounting though earlier cost accounting started as a branch of financial accounting but now it has developed as a separate discipline. It consists its own principles, concepts and conventions which has gained its own entity.
2. Cost Accounting is an Art – Cost Accounting is an art as it requires the application of knowledge and skill by the cost accountant. This is required for applying the methods, techniques and principles of Cost Accounting to various management problems like cost ascertainment, cost control, cost reduction etc.
3. Cost Accounting is a Science – It is also a science as it consists of systematic knowledge which a cost accountant must possess. For proper discharge of his duties which includes knowledge of law, practice & procedure, production & material control etc.
4. Cost Accounting is a Profession – Cost Accounting has recently became an important and separate profession. In many countries various professional bodies like the Institute of cost and works accountants of India, the institute of cost & management Accountants in London have increased the awareness of this profession among people.
What is Cost Accounting – Cost Classification: Classification according to Function, Cost Behaviour, Variability, Controllability, Direct and Indirect Cost
Classification is the process of grouping costs according to their common characteristics.
It is the systematic placement on the basis of common features and they are as follows:
1. Functional Classification:
On the basis of functions cost is classified as follows:
(a) Manufacturing Cost:
It also refers to factory cost which begins with supply of raw materials till completion of production. For example materials, wages, power, depreciation on plant and machinery etc.
(b) Administration Cost:
It includes all expenditure incurred in connecting to salaries, audit fees, directors’ remuneration, office expenses or legal expenses.
(c) Selling and Distribution Cost:
Which includes expenses belongs to advertising, salaries of salesman, commission, upkeep and operating charges, showroom rent and rates,
2. Classification According to Cost Behavior and Variability:
On the basis of this, cost is classified as follows:
(a) Fixed Costs:
These costs remains constant irrespective the decrease or increase in volume of production. For example salaries, rent and taxes, insurance, audit fees etc.
(b) Variable Costs:
These costs are fluctuate according to the volume of output or production. For example materials, wages, power, commission to salesman etc.
(c) Semi Variable Costs:
These cost are partly fixed and partly variable. For example indirect labour, general stores, depreciation, repairs and maintenance, supervision, light and power etc.
3. Classification According to Direct and Indirect Costs:
Direct cost refers to the cost which is identified easily with a particular product, process, department or centre etc. Raw materials and labour employed in manufacture of a product. Indirect cost refers to the cost which is incurred for the benefit of cost unit, cost centre and they are not identified easily with particular process, product or department. For example Depreciation on plant and machinery, insurance, rent, power, managerial salaries etc.
4. Classification According to Controllability:
Controllable cost is regulated at a given level of management authority. Variable costs are generally the controllable costs. For example cost of purchase of raw material. Uncontrollable cost cannot be regulated or controlled by the management. For example- salaries and other administration expenses.
What is Cost Accounting – 7 Important Principles of Cost Accounting
1. Cost is charged only after its occurrence. For example, selling costs are charged only to the cost units which have been sold.
2. There should be cause and effect relationship for each item of cost. Each item of cost should justify its cause. For example, common overhead expenses are apportioned on some basis. They are not fully charged to single department.
3. A proper unit of cost should be determined. It is the quantitative measurement of cost ascertainment.
4. Past cost should not be recovered from future cost. A past cost is a cost which could not be recovered. If it is included in future cost, it will distort the future figure.
5. Every business concerns should design its own costing system in accordance with its conditions and problems.
6. Abnormal cost (For example, loss due to fire, theft etc.,) are not included in cost as it is not related to performance of business. For example, worker’s cost of idle time should be excluded while computing job cost. If it is included it will mislead the management.
7. Principle of Double Entry system should be followed to ensure reasonable accuracy in cost sheets, cost ledgers and cost control account.
What is Cost Accounting – The Purpose of Cost Accounts in Cost Accounting
1. To determine the cost of production of each unit, operation, job, process, department or service, and to establish cost standards.
2. To highlight to the management any inefficiencies, and the magnitude of waste, whether of materials, time, expense or in the use of plant and machinery for corrective action (i.e., control of cost).
3. To provide actual cost for comparison with estimates, and for making future estimates, and to help the management in fixing the selling prices of products and services.
4. To provide data, e.g., value of closing stocks of raw materials, work-in-progress and finished goods etc., for preparation of weekly, monthly, quarterly or yearly profit and loss accounts and balance sheets, as desired/for the entire business or a department or a product.
5. To compare actual costs with standard costs and find out sources of economies in production as regards methods, types of equipments, design, output and layout.
6. To formulate, operating policies, e.g.
(i) Whether to make or buy from outside sources; or, utilise idle plant capacity or introduce a new product;
(ii) Determination of cost-volume – profit relationship;
(iii) Whether to stop or continue at a loss, i.e., sell below cost;
(iv) Whether to produce with the existing machine or to replace it by sophisticated and economic ones.
What is Cost Accounting – Importance of Cost Accounting in any Organisation
The importance of cost accounting lies in the fact that for the success of any organisation, it is essential that scarce resources – material, labour and overheads – at its disposal be used in the best possible way. An efficient system of cost accounting ensures that the resources of the enterprise are used in the most efficient manner.
It enables the management to identify the areas of inefficiency and unprofitable activities, minimize material losses and reduce idle time. Cost accounting has become an essential requirement for an enterprise for stability and growth under modern conditions of business.
For the success of an organisation, effective planning, control and proper decision-making are necessary. Cost accounting provides necessary information for planning, control and decision-making. The techniques of budgetary control and standard costing make planning and control possible in an organisation. Cost accounting plays an important role in decision-making process by providing necessary information for viable decision in given circumstances. Now-a-days, cost accounting has become an essential tool of the management.
It provides necessary information for:
1. Planning and control, and
2. Decision-making.
Planning and control are basic functions of management.
Planning involves the deciding of goals of an organisation and the manner in which they are to be achieved.
Control is the process of analysing whether action is being taken as planned, whether results conform to plans and, in case of deviations, taking corrective actions to move along the desired course. Thus in control, the activities of an organisation is conformed to the desired plan of action and feedback about actual results is provided through performance evaluation reports.
Budgets and performance reports constitute significant tools of planning and control. The techniques of budgetary control and standard costing make planning and control possible in an organisation.
Decision-making is the process of selecting a course of action from various possible or available alternatives. Cost accounting plays an important role in the decision-making process. It provides necessary information for a viable decision in given circumstances.
Cost accounting techniques serve the management in taking various decisions such as:
(i) What should be the price of a product in normal and special circumstances?
(ii) Should a component be produced in the factory itself or bought from the market?
(iii) Should the production of a product be given up?
(iv) What priority should be accorded to a product?
(v) Should investment be made in a new product?
(vi) Given a selling price and a cost structure, how much should be produced to earn a desired profit?
What is Cost Accounting – Costing Methods: Job Costing, Contract Costing, Batch Costing, Process Costing, Service Costing, Operation Costing and Multiple Costing
Different industries follow different methods for ascertaining cost of their products. The method to be adopted by business organisations will depend on the nature of the production and the type of output.
The following are the important methods of costing:
Method # 1. Job Costing:
Job costing is concerned with finding the cost of a specific job or work order. This method is followed by those concerns where work is carried on the customer’s request. Under this system a job cost sheet is prepared to find out profit or losses for each job or work order. Duration of the job will be short. Example – Printing job in a printing press, repair job in a garage etc.
Method # 2. Contract Costing:
Contract costing is applied for contract work like construction of dam, building civil engineering contract etc. Each contract or job is treated as separate cost unit for cost ascertainment and control. It is also called “Terminal Costing”. Firms engaged in ship-building, civil engineering for roads, industrial estates and factory construction follow this type of costing.
Method # 3. Batch Costing:
A batch is a group of identical products. Under batch costing a batch of similar products is treated as a separate unit for the purpose of ascertaining cost. The total costs of a batch are divided by the total number of units in a batch to arrive at the costs per unit. This type of costing is generally used in industries like bakery, toy manufacturing etc. Other examples include engineering equipment, drugs and footwear.
Method # 4. Process Costing:
This method is used in industries where production is carried on through different stages or processes before becoming a finished product. Costs are determined separately for each process. The main feature of process costing is that output of one process becomes the raw materials of another process until the final product is obtained. This type of costing is generally used in industries like textile, chemicals, paper, oil refining etc.
Method # 5. Service (Operating) Costing:
This method is used in those industries which render services instead of producing goods. Under this method cost of providing a service is also determined. It is also called service costing. Undertakings such as transport, electricity, gas, hospitals, educational institutions etc., are examples of this type.
Method # 6. Operation Costing:
This is suitable for industries where production is continuous and units are exactly identical to each other. Examples- Mines or drilling, cement works, manufacture of bicycles, ceiling fans etc.
Method # 7. Multiple Costing:
This refers to the combination of two or more of the above-mentioned methods of costing or mix of any methods mentioned above. Where a product comprises many assembled parts or components (as in case of motor car) costs have to be ascertained for each component as well as for the finished product for different components for which different methods of costing may be used.
This composition comes under multiple costing method. It is also known as composite costing. This type of costing is applicable to soft drinks, automobiles and similar products.
What is Cost Accounting – Cost Accounting an Aid to Management: Classification of Cost, Maximum Usage of Scarce Resources, Standards, Budgeting and a Few Others
A good system of cost accounting is an aid to management in the following ways:
1. Classification of Cost – Cost is classified on different basis for the purpose of control, giving information to the management and to compute profitability e.g., imputed cost, historical cost, standard cost etc.
2. Control on Material, Labour and Overheads – There are different techniques to have a control on material e.g., Levels, ABC System, EOQ etc. Labour is controlled through different remuneration plans, overtime, idle time, labour turnover etc. The overheads (indirect expenses) are treated by allocation, absorption & appointment.
3. Maximum Usage of Scarce Resources – Cost accounting system helps the management to utilize the resources more efficiently. It provides the reliable data of cost relating to material, labour and other expenses.
4. Standards and Budgeting – Cost accounting assists management by providing different standards for making estimates for future. With these standards, actual performance is compared and cost is controlled. Besides, different budgets are prepared for a coordinated plan of action for every person in the organisation.
5. Cost Audit – The cost accounting system assists the business in prevention of errors and frauds like price fixation, cost variation, inefficient management, tax assessment and trade disputes. The cost auditor ensures that the cost accounting plan is in accordance with the objectives of management.
6. Various Business Policies and Decisions – Cost accounting helps the business by alternative methods and procedures while making a policy or taking a decision e.g., introduction of new product, problem of product mix, make or buy decisions, key factor, expansion programs, etc.
What is Cost Accounting – Preliminary Considerations Governing the Design and Installation of a Cost Accounting System
All cost accounting systems reflect the same principles and purposes, although their application may vary with circumstances out of necessity. Accordingly, the cost accounting system proposed to be installed should be designed to suit the nature of the business. Further, the system should be simple, and the expenses of operating it should be commensurate with the expected benefits.
The preliminary considerations governing the design and installation of a cost accounting system are:
1. Nature of Business:
The system sought to be designed and introduced, should suit the nature of business. Accordingly, it is necessary to be thoroughly acquainted with the technical aspects and the methods of production. If the business engaged in is the production of goods, it should further be seen whether it produces a single product on a mass scale, or a multi-product concern producing more than one product, or a jobbing type of business, a process type or an assembly unit.
2. Nature of Organisation:
It is equally necessary to study the layout, nature and size of the organisation. Since the system to be designed should suit the organisation, the existing types of authority relationship, the number of layers and the extent of authority and responsibility should also be studied.
3. Methods and Procedures:
The methods of manufacture and the procedures existing for purchase, receipt, storage and issue of materials, the methods of wage payment, computation and payment of wages and of arriving at overheads also deserve careful study.
4. Technical Aspects:
Although the cost accountant is not a technical expert, it is necessary for him to get acquainted with the nature of product, the methods and stages of production, the operations involved, varieties produced and such other technical aspects of the business. Since production efficiency depends upon effective production control, it is equally necessary to know the degree of control exercised over production.
5. Management’s Expectations and Policies:
The cost accounting system to be designed also depends upon management policy and their expectations from the system. If, for instance, the management’s objective of installing a costing system is only to ascertain the cost of each product, the cost accounting system should be simple enough to achieve that objective.
6. Simplicity:
The system to be introduced should be simple and easy to operate. The operating personnel should be capable of understanding the procedures laid down for working the system efficiently.
7. Co-Operation and Support of Personnel:
No system of cost accounting, however carefully designed, can be worked successfully without enlisting the co-operation and support of the personnel involved in the cost accounting process. As such, the system should not be thrust upon them. They should be consulted, their views and suggestions considered, and they should be made cost conscious and drawn into the cost accounting process.
8. Standardisation of Forms:
Accumulation of cost information necessarily involves the maintenance of detailed cost records. Since this entails considerable clerical work, the staff may resent it. It is, therefore, necessary to reduce clerical work to the minimum. Printed forms should be used and they should be standardised as regards size and contents with instructions printed.
9. Accuracy of Data:
It is also necessary to determine the degree of accuracy of data to be supplied by the cost accounting system.
10. Prompt Reporting:
Since a cost accounting system is mainly intended for internal reporting of cost information, cost data should be made available promptly and regularly. It is also necessary that the information supplied should be clear, non-technical and unambiguous. There should be no duplication in reporting the same information.
11. Flexibility:
The costing system should be flexible and capable of adaptation to changing circumstances. It requires periodical scrutiny and change to avoid the danger of becoming obsolete owing to changes and developments in the business.
12. Reconciliation:
Where cost records are maintained independently of financial records, arrangements should be made for regular reconciliation of the trading result as revealed by both the set of books.
13. Cost:
It is equally necessary that the cost of installing a system of cost accounting should be commensurate with the benefits of installation. In other words, the benefits should not outweigh the cost of installation and operation of the costing system.
What may Lead to a Smooth Working?
The above discussion raises a pertinent question as to what should be done to ensure the smooth working of a costing system in an organisation. Some useful guidelines in this regard might be offered thus.
Prerequisites for the Successful Working of a Cost System:
1. Basic Principles:
A system of costing must be practicable. It must be adopted to suit the business, but not the business to suit the system. The business must not be the slave of the system (Bigg). The system should be easy to understand and simple to operate and avoid all unnecessary elaboration.
This will enable the management, the working staff to pick up the system quickly and operate the same without committing avoidable mistakes or omitting necessary details. A costing system should not be more elaborate than what is necessary. It must be elastic and capable of adoption to changing circumstances.
It must facilitate expansion or contraction of business without any difficulty. Finally, it must prove to be a profitable investment. It must produce benefits proportionate to the expenditure involved in installing the system in the long run.
2. Techniques of Control:
To ensure the success of the system, the following techniques of control must be scrupulously followed:
i. Periodical tabulation – Periodical tabulation must be arranged to compare the actual cost data with their corresponding estimates.
ii. Departmentalization – For finding costs accurately, the factory should be divided into production and service departments, followed by proper delegation of authority and responsibility.
iii. Cost studies – Special cost studies and investigations should be made from time to time so that information in cost records may serve as guide for future estimates, quotations and tenders.
iv. Budgeting and standard costing – The techniques of budgeting and standard costing must be freely used to enhance the internal efficiency of an organisation and measure its performance from time to time.
v. Minimum clerical work – To secure greater efficiency, all forms, sheets, vouchers must be of uniform standard. To ensure reliability, every original entry must bear the signature of an authorized person.
vi. Stores and stock control – There must be a proper system of material control ensuring proper records for purchasing, storing, issuing and returning of materials. Likewise, proper control procedures must be established to account for labour and overhead costs.
vii. Prompt cost information – The information relating to costs should be furnished promptly, regularly and systematically. The data must be made available in an understandable form. It should be as detailed as possible so as to leave no room for misinterpretation.
viii. Reconciliation – The cost accounts and the financial accounts should either be interlocked in one integral accounting scheme or be so arranged that the results of the two sets of accounts are reconciled by means of control accounts.
ix. Proper explanation – The system should be carefully explained to management as well as working staff. They must be motivated to take a genuine interest in its adoption and implementation. No attempt should be made to hide facts and figures.
Practical Difficulties in Installation:
Apart from technical problems, the practical difficulties which may arise in connection with the introduction of a cost accounting system are the following:
1. Lack of Support from Management:
In many cases, the costing system is thrust on the managerial personnel, without consulting them and without explaining the benefits of the system. It may also happen that the system introduced may not be supported by the top management, probably because of the expenditure involved. In either case, the system introduced arouses fear and suspicion in the minds of line managers. Consequently, they view the system as an interference in their work, and are likely to resist the same.
The difficulty may be got over by explaining the benefits accruing from the system to all those who would be involved in the cost accounting process and instilling in their minds a sense of co-operation. They should be made cost conscious by being drawn into the process of designing and installation.
2. Resistance from the Accounting Staff:
The accounting staff may offer resistance to the introduction of cost accounting on the ground that their work would increase, or that it is an interference in their routine work of accounting. Their resistance may also be due to their feeling of losing importance with the introduction of cost accounting.
Even this difficulty may easily be overcome by explaining to them the need for cost accounting and assuring, at the same time, that their position would not, in any way, be affected. They should be made to feel that it is absolutely necessary to supplement their accounting work with cost accounting and that the system would neither increase their work nor bring about unemployment, but on the contrary, the system would create more employment opportunities.
3. Non-Co-Operation of Operating Personnel:
The foremen, supervisory staff and operating personnel may also offer resistance to the system due to ignorance and suspicion. As a result, they may not supply the necessary data for the successful working of the cost accounting system.
To overcome this difficulty, it is necessary to properly educate them. They should be made aware of the benefits accruing from the system, and should be made cost conscious by winning their confidence.
4. Shortage of Trained Staff:
At the time of introduction of a suitable system of cost accounting, the concern may experience non-availability or shortage of trained staff to handle the work involved in operating it.
This difficulty need not be an excuse for non-introduction of the system designed. It is necessary to train the existing staff and introduce the system rather slowly, instead of thrusting a complete system upon them irrespective of whether or not they are ready to accept and handle the system.
5. Cost of Installation:
The use of standardised forms necessary for recording and reporting involves additional expenditure which the concern may not afford.
The design of a system and the details of the methods to be employed will vary widely according to the nature of each concern. Accordingly, the system should be designed to suit the concern, and the obtainable results should justify the cost of additional staff and records involved. Cost-benefit analysis should be made to justify the costs involved.
What is Cost Accounting – Development of Cost Accounting System in India
In India the development of cost accounting system is only of recent origin. In pre-independence days there was insignificant industrial development in the country. It was in 1944 that, ‘Indian Institute of Cost and Works’ took birth in the form of company limited by guarantee.
This company would hold examinations and issue the certificates to successful cost accountants. It was in 1959 that ‘Cost and Works Accountants Act ‘was passed by the government of India and ‘the Institute of Cost and Works Accountants of India came into force and commenced its head office at Calcutta. Its function is to promote cost accounting and introduce Cost Accountants of right caliber.
The company’s Act of 1956 amended in 1965 provided for maintenance of cost accounting records and audit thereon. The government has made it compulsory to maintain cost accounts and cost audit thereon for several industries. Cost Accounting is useful in manufacturing of goods or rendering of services. The Cost Accounts is originated as a branch of financial accounting to meet the detailed analytical study of expenditure.
The growth of Cost Accounting could be seen during the First World War i.e., 1914-1919 which was rapid, due to the control on the prices imposed by the Government. The Government entered into the “Cost-Plus” contract systems. Cost plus contract provides for the payment by the customers or the contractee of the actual cost of manufacture or of rendering service plus a stipulated profit.
This necessitated the maintenance of cost records, ascertainment of cost and cost control for a job or service rendered. Due to increase in competition and rapid growth in the international trade, industries became more cost conscious. In 1929, there was a great depression in the economy during which survival of most of the industries became a problem. Hence, cost reduction techniques had to be adopted for survival.
In today’s world of competition, cost consciousness is the key factor for determining the growth of the industrial economy. Ours is a developing country, where we have mixed economy and hence we are having mixed problems. We are facing acute inflation problem, depression in the industries and stagnation in the economy.
Hence, cost reduction has become the need of the hour. Therefore, the industrialists must have a perfect knowledge of costs, so that they can take various decisions regarding planning, pricing, budgeting, policy making of the company regarding fixation of wages etc. Thus, the study of Cost Accounting is of utmost importance in our country because unless we reduce the costs, we cannot survive in the competitive world and have progress of our economy.
What is Cost Accounting – Standards for General Cost Accounting Practices
Some standards based on the recommendations of the Cost Accounting Standards Boards are given below:
1. Consistency- There must be consistency in collection, allocation, classification, interpretation and reporting of costs.
2. Cost period- Cost period should be well defined and applied consistently.
3. Consistency in allocating costs- Each type of cost should be allocated to any cost objective only once and only on one basis.
4. Policy for allocation of direct and indirect cost- There must be a written policy for classifying costs as direct and indirect and this should be applied consistently.
5. Accounting for unallowable cost- Costs unallowable or mutually agreed to be unallowable should be identified and excluded from product or service cost.
6. Cost accounting for disputed items of costs- A business unit should lay down clearly the cost accounting treatment for disputed items of cost, e.g., interest on investment, research and development costs, depreciation on replacement costs, etc., and the policy should be applied consistently.
What is Cost Accounting – Cost Accounting as a Tool of Managerial Planning and Control
Planning is defined as the formulation of objectives as well as programs of operation to achieve these objectives. Objectives and programs are prepared on a long- and short-range basis to provide guidelines for daily operations as well as future activities. The information provided by a cost accounting system is combined with other data and analysed.
Based on its finding, management makes decisions and formulates strategies for the future, affecting areas such as the following:
1. Sales prices and volume
2. Product profitability
3. Purchasing commitments
4. Capital expenditures
5. Plan expansion or contraction feasibility
Control is defined as the continuous comparison of actual performance with programmes, or budgets, prepared by the planning function. Budgets represent the standards of performance. By comparison With actual results, a judgement can be made as to the efficiency of operation, and the profitability of various products. Difference between budgeted (or standard cost) and actual cost call for action on the part of management.
Management must pinpoint the source of the problem. Is it incompetent workers or overpaid labour? Increased prices of raw materials or too much wasted material? Inefficient or obsolete manufacturing processes? Undersized plant? Oversized plant? Unrealistic budget?
These are just some of the questions management must answer in order to achieve and maintain profitability. Success in today’s highly complex and competitive business environment depends on management’s ability to effectively plan and control operations.
Inherent in the planning and control functions of management is the determination of the most efficient methods of implementing an established course of action. Management must work within the restraints imposed by plant size, products manufactured, skills and education of its workers, and nature of the industry.
An infinite number of detailed, theoretically perfect plans could be developed, but many are useless unless their implementation is practical and possible within the existing restraints. In brief, planning is the formulation of objectives and the means to achieve these objectives, while control is the process of review, evaluation and reporting, which monitors the achievement, or lack of achievement of objectives.
What is Cost Accounting – Advantages: Helps in Controlling Cost, Avoids Delay, Centralization of Purchasing, Reveals Losses due to Idle Time and a Few Others
The following are the advantages of cost accounting:
(i) Helps in Controlling Cost – Cost accounting is very helpful in controlling expenditure and minimizing the manufacturing cost of products.
(ii) Relates expenses to their Functions – Cost accounting relates various expenses to their functions and provides an effective tool for control over such expenses.
(iii) Provides useful data about production efficiency – Cost accounting provides useful data not only about product costs but also about production efficiency.
(iv) Avoids delay – It helps the management to initiate action to rectify delays, inefficiencies and wastage. Additionally, it determines normal levels of wastage of materials during storage or in process.
(v) Centralization of purchasing – It facilitates centralized purchasing. This results in economical purchasing.
(vi) Reveals losses due to idle time – Maintenance of time and job records for workers reveals losses incurred due to idle time. Such records assist in taking steps to minimize these losses.
(vii) Provides information about cost inputs/resources – A cost accounting system provides information about the availability of materials, labour and machine capacity. In the absence of such information, proper production plans cannot be drawn up.
(viii) Identifies normal/abnormal losses and gains – Cost accounting entails identifying normal and abnormal losses and gains. This task becomes simpler when standards are set up. Although the setting up of physical standards is primarily the duty of the industrial engineering department, cost accounting also helps a great deal by providing relevant information in this regard.
(ix) Basis for the system of standard costing and budgetary control – Cost accounting lays the basis for the system of standard costing and budgetary control. These two are instrumental in the control of expenditure. Variance analysis and comparison of actual performance with budgets pinpoint areas where economies can be effected.
(x) Helps in the performance appraisal – Cost accounting data help the management in appraising the performance of various units and managers. On the basis of such appraisal the management can encourage the concerned people with suitable rewards and incentives.
(xi) Useful for planning various activities – Cost accounting data are very useful for the management for planning various activities. A wise manager takes finalises various plans only after he has carefully studied the cost implication of various activities.
(xii) Reliable check on accuracy – A system of cost accounting provides an independent and reliable check on the accuracy of financial accounts through reconciliation of profits as ascertained by cost accounts and by financial accounts.
(xiii) Helps in decision-making – Management is assisted in its process of routine and special decision-making by various cost concepts viz., opportunity cost, relevant cost, marginal cost.
(xiv) Useful in day-to-day affairs – The cost department functions as a service department and provides useful and relevant information to various line managers such as a sales manager, production manager, etc., which immensely helps them in their day-to-day affairs.
For example, the cost department, particularly for use of managers, may provide the following statements:
(a) Periodical statements showing the total actual and budgeted costs of each activity.
(b) Statement showing the cost-volume-profit relationship of various products, i.e., marginal cost and contribution of each product towards fixed overheads and profits.
(c) Sales budget showing the sale quantities of various products and also a summary of the total sales.
(d) Details of budgeted selling and distribution costs analysed territory wise and product wise.
(e) Periodical statements comparing actual figures with budgeted figures, classified territory wise and product wise.
(f) Statement showing the analysis of cost variances and sales variances.
(g) Ad hoc statements for pricing purposes or for submitting tenders, etc.
(h) Any other cost statement required by managers for day-to-day decision-making.
What is Cost Accounting – Disadvantages
1. In spite of so many advantages, some people feel that cost accounting is an unnecessary luxury for business establishments. This is not true. Perhaps they feel so because of a few limitations of cost accounting such as: cost accounting is not an exact and foolproof science.
2. Classification of cost into its elements, pricing of material issues on the basis of average or standard costs, etc., apportionment and allocation of joint costs and overheads to joint by-products and cost centres, division of overheads into fixed and variable, division of costs into normal and abnormal, controllable and uncontrollable, etc., are based on conventions, estimation and arbitrariness. The information provided by a cost accountant, therefore, may not necessarily be absolutely true.
3. It may be noted that such limitations are also found in any other system of accounting. Principles and practice of cost accounting are based on sound reasoning and keen common sense. The advantages of cost accounting clearly establish that it is useful and necessary for the success of a modern industrial firm. In spite of the additional cost involved in setting up of a cost accounting system, it provides benefits far in excess of costs it entails.
4. It is not an exact science as it is based on a large number of conventions, estimations and other flexible factors, viz.,-
(i) Classification of cost into its elements,
(ii) Pricing of material issues on the basis of average or standard costs,
(iii) Apportionment and allocation of overhead expenses to cost centres or cost units on arbitrary basis,
(iv) Allocation of joint costs on arbitrary basis,
(v) Division of overhead expenses into fixed and variable,
(vi) Adoption of standard costs and marginal costs,
(vii) Use of predetermined overhead rates, and
(viii) Inclusion or non-inclusion of certain items of expenses.
5. Cost collected for one purpose is unsuitable for another purpose. For example, standard costs are different from actual costs, and costs for pricing in periods of recession are different from costs for pricing in normal circumstances.
6. It provides the base for taking the best decisions but does not give outright solution of the problems.