Cost accounting concept

Cost Accounting

Cost accounting is that branch of accounting which is concerned with the recording, classifying, analysing, summarising and interpreting of the costs incurred in producing goods or rendering services. Its main purpose is to ascertain the cost of a product or service, control that cost, and provide cost data to management for planning, decision-making and performance evaluation. It uses both historical and predetermined costs and reports mainly to internal management rather than to outsiders.

Limitations of Cost Accounting

1. Based on estimates and conventions: Cost accounting depends on many estimates, such as the estimation of overhead absorption rates, depreciation, and the apportionment of common costs. Since these figures are not exact, the cost ascertained may not be fully accurate, and different bases of apportionment can give different costs for the same product.

2. Not a substitute for financial accounting: Cost accounting does not replace financial accounting. It cannot be used to prepare the profit and loss account and balance sheet required by law, nor does it record all transactions of the business. It only supplements financial accounting, so it cannot give a complete picture of the financial position of the firm.

3. Costly and unsuitable for small concerns: Installing and operating a cost accounting system requires trained staff, additional records and constant supervision. The cost of maintaining the system may exceed the benefits derived from it, especially in small-scale organisations where the volume of operations is low. Hence, it is not practicable for every business.

Other limitations include the possibility of personal bias in cost data, lack of uniformity in cost accounting principles across firms, and the difficulty of applying it to industries producing heterogeneous products.

Two limitations of cost accounting:

1. Lack of uniformity — different firms use different costing methods and techniques, so cost data are not readily comparable between organisations.
2. Costly and complex — installing and maintaining a cost accounting system requires considerable time, money, and expert staff, which may not be feasible for small concerns.

Five advantages of cost accounting:

1. Cost control: Cost accounting records and classifies every element of cost (material, labour, overhead) and compares actual cost with predetermined standard cost. The variances so found point out where and why costs have risen, so management can take corrective action and keep costs under control.

2. Ascertainment of cost and profitability: It provides a reliable method of determining the cost of each job, process or product, and hence the profit made on each. Management knows which products or departments are profitable and which are not, and can act accordingly.

3. Cost reduction: By eliminating waste, idle time, defective work and unnecessary expenses revealed through cost records, cost accounting helps reduce cost per unit permanently without lowering the quality of the product.

4. Valuation of inventory and fixation of selling price: Cost records supply the basis for valuing closing stock of raw material, work-in-progress and finished goods. The cost per unit so obtained also guides management in fixing a selling price that covers cost and yields a reasonable margin of profit.

5. Aids planning, budgeting and decision making: Cost data help in preparing budgets, setting standard costs and choosing between alternatives such as make-or-buy, shut-down or continue, and accept or reject an order. Thus cost accounting supplies the facts on which sound managerial decisions rest.

(Other acceptable points: helps in detecting and preventing frauds and misappropriations, facilitates inter-firm and inter-period comparison, and provides a basis for rewarding efficiency.)

Cost accounting helps in cost control and fixing selling price.

• Cost control: It records and classifies costs, so management can compare actual costs with standard costs and take action to reduce wastage and inefficiency.
• Fixing selling price: It provides reliable cost per unit data, which helps management set a selling price that covers cost and gives a reasonable profit.

Cost accounting is the process of recording, classifying, analyzing, summarizing, and interpreting the costs incurred in the production of goods or services, so that total cost and per-unit cost can be ascertained and controlled.

Cost is the amount of expenditure, or the value of resources sacrificed, incurred in producing and selling a product or rendering a service. In cost accounting, cost means the total of all expenses — material, labour and expenses — incurred to bring a product to its present condition and location. It is the monetary measure of resources used for a specific purpose.

Classification of cost on the basis of element

On the basis of element (the nature of the resources used), cost is classified into direct cost and indirect cost. In detail, there are six elements:

A. Direct cost elements

1. Direct material cost
It is the cost of materials that can be directly identified with and traced to a particular product or job. Such materials become a major part of the finished product. Examples: raw cotton in a textile mill, timber in furniture, leather in shoes, bricks in construction. It is a direct cost and is charged directly to the product.

2. Direct labour cost
It is the cost of wages paid to workers who directly work on the product and whose effort can be identified with a particular job or process. Examples: wages of machine operators, carpenters, weavers and tailors. It is also called direct wages and is charged directly to the product.

3. Direct expenses (chargeable expenses)
These are expenses other than direct material and direct labour that can be directly identified with a particular product, job or process. Examples: hire charges of special machinery for a job, cost of special moulds and designs, royalty paid on production, and fees paid to outside experts for a specific job.

B. Indirect cost elements (overheads)

4. Indirect material cost
It is the cost of materials that cannot be directly identified with or traced to a particular product or job, but are necessary for production or service. Examples: lubricants, oil, grease, cleaning materials, small consumable stores and stationery used in the office. It forms part of overhead.

5. Indirect labour cost
It is the cost of wages paid to workers who do not directly work on the product but assist the production or service process. Examples: wages of supervisors, foremen, storekeepers, maintenance staff, office staff and salesmen. It forms part of overhead.

6. Indirect expenses
These are expenses other than indirect material and indirect labour that cannot be directly identified with a particular product or job. Examples: rent, rates, insurance, depreciation, power and fuel (when not direct), telephone, advertising and carriage outward. It forms part of overhead.

Summing up

$\text{Prime cost} = \text{Direct material} + \text{Direct labour} + \text{Direct expenses}$

$\text{Overhead} = \text{Indirect material} + \text{Indirect labour} + \text{Indirect expenses}$

$\text{Total cost} = \text{Prime cost} + \text{Overhead}$

The first three elements form the prime cost, which is the first and basic element of cost. The last three elements form overhead, which is added to prime cost to arrive at the total cost of a product. Overhead may be further divided into factory/works overhead, office and administrative overhead, and selling and distribution overhead.

Process costing is a method of cost accounting used in industries where production is carried on continuously and the output is homogeneous, under which the total cost of each process or department is accumulated and divided by the number of units produced during the period to obtain the average cost per unit.

Batch costing is a method of costing in which the cost of a batch of identical products (produced together as a lot) is ascertained, and the cost per unit is found by dividing the total batch cost by the number of units in the batch. It is used where goods are produced in distinct batches rather than continuously, e.g. furniture, garments, and components.

Contract costing is the method of costing used when work is done on a separate, large contract (such as building a bridge, road or house) according to the customer's specification, usually at the customer's site and over a long period. A separate account is kept for each contract to find its cost and profit.

Meaning: Cost accounting is the process of recording, classifying, summarising and analysing the costs of producing goods or services, and of presenting this cost information to management for planning, control and decision-making. It is concerned with finding the cost of a product, job or process.

Objectives (any three):

1. Ascertaining cost: to find the cost of each product, job, process or service accurately, so that selling prices can be fixed.
2. Cost control: to control cost by comparing actual cost with budgeted or standard cost and finding the causes of variances.
3. Cost reduction: to find wastage and inefficiency in material, labour and overheads and so lower the cost without lowering quality.
4. Assisting management decisions: to supply cost data for decisions such as make or buy, pricing and tendering.
5. Valuing stock: to provide a sound basis for valuing closing stock of raw materials, work-in-progress and finished goods.

Cost Accounting is the branch of accounting that records, classifies, analyses and allocates the costs incurred in producing goods or rendering services, so that the total cost and per-unit cost of a product or service can be ascertained and controlled.

Difference between Cost Accounting and Financial Accounting

Conclusion: Financial accounting is the general record of the whole business, while cost accounting is a specialised branch that supplies detailed cost information to management for decision-making.