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Overview of Cost Accounting

1.1 INTRODUCTION

Cost accounting (CA) has come to occupy a prominent place in a company's management accounting process. In order to develop the best methods to increase a company's profitability and save company's money, CA proves to be a system necessary to the management of the company's affairs.

According to Charles T. Horngren, CA is a quantitative method that accumulates, classifies, summarizes and interprets information for the following three major purposes:

• Operational planning and control
• Special decisions
• Product decisions

According to the Chartered Institute of Management Accountants, London, CA is the process of accounting for costs from the point at which expenditure is incurred with cost units.

John Wilmot, an expert in accounting, summarized the nature of CA as ‘the analyzing, recording, standardizing, forecasting, comparing, reporting and recommending’ and the role of a cost accountant as ‘a historian, news agent and prophet’.

1.2 EVOLUTION OF CA

CA is a form of accounting that developed due to the limitations of financial accounting (FA). FA does not give a clear picture of the operating efficiency of a firm, namely, what should be the price of a product, what is the desired sale, what is the desired profit, whether a product should be manufactured or purchased, and what are the reasons for making profits or incurring losses.

In other words, FA does not reveal the managerial aspects of accounting. It merely provides the historical events in the form of numbers that took place in an organization. This led to the growth of CA.

Formerly, CA was considered a technique for the ascertainment of costs of products or services on the basis of

historical data. Due to changes in the nature of market, controlling cost was considered more important than ascertaining cost. Thus, CA started to be considered more a technique for cost control than one for cost ascertainment. It can be concluded that CA is concerned with recording, classifying and summarizing costs for the determination of costs of products or services; planning, controlling and reducing such costs; and furnishing of information to a company's management for decision making.

In its widest sense, CA embraces the preparation of statistical data, application of cost control methods and ascertainment of the profitability of the activities carried out or planned.

1.2.1 Cost

‘Cost is the amount spent on goods or services received.’

‘Cost represents the resources that have been sacrificed to attain a particular objective.’

‘Cost is the value of economic resources expended as a result of producing or manufacturing.’

1.2.2 Costing

‘Costing is a study of expenses incurred in manufacturing a product and conducting a business.’

‘Costing is a process of analysing and classifying expenses so as to enable the actual cost of any particular process.’

‘Costing is the process of determining the cost of doing something.’

1.2.3 CA

CA is the application of accounting costing principles, methods and techniques in the ascertainment of costs.

CA is the technique and process of ascertainment of costs.

CA involves cost ascertainment, cost presentation and cost control.

1.3 OBJECTIVES OF CA

The ultimate purpose of CA is to ascertain the true cost of every operation. The main objectives of CA are as follows:

1. Ascertainment of cost: It enables the management to ascertain the cost of products, processes, services, etc.
2. Controlling costs: It enables the minimization of cost by comparing the actual costs incurred and the costs estimated.
3. Fixing the selling price: With the help of marginal costing, the prices of a product can be scientifically determined.
4. Determining sales: CA enables the management to determine the sales required to make a desired profit.
5. Matching cost with revenue: CA enables the management to maintain costs and revenues at equilibrium.
6. Profit planning: CA helps the management to plan for future operations in such a way as to maximize the profits.

7. Determining and controlling efficiency: CA involves the study of various operations in manufacturing a product or providing a service. The study facilitates measuring the efficiency of an organization as a whole or department-wise.
8. Facilitating the preparation of financial and other statements: CA enables us to collect information regarding raw material, work in progress and finished goods.
9. Providing a basis for operating policy: CA helps the management to formulate operating policies relating to production, shutting down a unit, replacing machines, etc.

1.4 ADVANTAGES OF CA

As discussed in Section 1.2, the limitations of FA are the chief advantages of CA. The advantages are grouped into four categories. They are as follows:

To the management:

1. In fixing prices
2. In fixing profit
3. In fixing sales
4. In selecting a sales mix
5. In selecting an alternate production pattern
6. In determining the future course of action
7. In fixing remuneration to workers

To the employees:

1. In fixing a sound wage policy
2. In fixing a suitable bonus plan
3. In distinguishing between efficient and inefficient workers
4. In fixing appropriate incentive schemes to employees

To the government:

1. In facilitating the assessment of excise duty
2. In facilitating the assessment of income tax
3. In facilitating the formation of policies regarding industry

To the public:

1. With control over costs, the prices are fair
2. With control over wastage, the quality is better
3. Cause overall growth of industries and employment

1.5 LIMITATIONS OF CA

1. Not applicable to small business concerns: It is generally believed that costing cannot be applied to concerns of small sizes. There is no single method of costing that can be applied to all types of businesses.
2. Expensive: Expenses involved in installing a costing system is disproportionate to the benefits received from it.

3. Not reliable: CA, as against FA, is based on estimates. It is generally believed that decisions made and conclusions drawn based on CA are not reliable.
4. Not an exact science: CA developed because of the limitations of FA. Many theories have also been developed in the light of convention and basic principles. These are not static, but change with time and circumstances. Hence CA is not an exact science, but an approximate science.
5. No Uniform procedures and methods: The procedures and methods of CA followed by different organizations are not uniform and, therefore, they provide different results for the same information.
6. Based on estimation and conventions: In CA, some elements of costs like indirect costs are charged on the basis of estimations. These are the actual costs and they differ from the estimates. Thus, the result derived from CA can be misleading.

1.6 IMPORTANCE OF CA TO BUSINESS CONCERNS

CA helps business houses in the following areas of operations:

1. Control of material cost: Cost of materials usually constitutes a substantial portion of the total cost of a product. CA helps in controlling the cost of materials.
2. Control of labour cost: Labour cost can be controlled when workers complete their work within the standard time limit. Reduction of labour turnover and idle time too help to control labour cost.
3. Control of overheads: Overheads consist of indirect expenses, which are incurred in the factory, office and sales department; they are part of production and sales cost. By keeping a strict check on overheads, a firm can control such expenses.
4. Measuring efficiency: For measuring efficiency, CA department should provide information about standards and actual performance of the activity concerned.
5. Budgeting: Budget preparation is the function of costing department.
6. Price determination: Cost accounts provide information to fix remunerative selling prices for various items of products and services.
7. Expansion: Cost accounts provide estimates of production of various products.
8. Arriving at decisions: Cost accounts help business houses to make the proper decision at the right time.

1.7 ESSENTIALS OF A GOOD CA SYSTEM

The essentials of a good CA system are as follows:

1. A CA system should be practical, simple and tailor-made for the business needs of an enterprise.
2. The data used by the CA system should be accurate.
3. Cooperation and participation of executives at all levels is a must.
4. The expenses incurred in installing the CA system should match the benefits received from it.
5. When a system is introduced, it should not affect the existing ways of obtaining information when they are found to be good.
6. The system should be introduced in a phased manner by developing a proper network within the organization.
7. The management should extend a helping hand in administering and developing the system so that it yields the expected result.

1.8 CA VERSUS FA

Although CA was originally included in FA, the main objectives of both differ. Despite the fact that both follow the double-entry system of accounting, FA believes in treating costs very broadly and the CA in treating costs in detail.

1.8.1 A short summary of the differences between CA and FA

• Purpose

  CA: Provides information in particular

  FA: Provides information in general

• Nature of information

  CA: Data are estimated

  FA: Data are actual

• Transaction

  CA: Deals with internal transactions

  FA: Deals with external transactions

• Valuation of stock

  CA: Stocks are always valued at cost price

  FA: Stocks are valued at cost price or market price whichever is lower

• Accounting period

  CA: Accounts are prepared as and when required

  FA: Accounts are generally prepared annually

• Legal requirement

  CA: Accounts are maintained to meet the requirements of the management

  FA: Accounts are maintained to meet the requirements of Company's Act, 1956 and Income Tax Act, 1962.

CHAPTER SUMMARY

From this chapter you should have understood that CA is only a branch of FA. It not only provides information about the company but also provides the reasons for the data given. The growth of CA is so fast that the fields covered by it keep increasing every day.

EXERCISE FOR YOUR PRACTICE

Objective-Type Questions

I. State whether the following statements are true or false:

1. CA can be used only in a manufacturing concern.
2. CA is a branch of FA.
3. A prosperous business concern does not need a costing system.
4. Cost audit is a part of cost accountancy.
5. CA provides information for ascertaining the financial position as on a particular date.
6. CA helps in the ascertainment of cost beforehand.
7. CA is not needed if prices are beyond the control of the firm.

8. CA will not be necessary if financial accounts provide the necessary analysis.
9. CA is nothing but a post-mortem of past costs.
10. CA is the oldest branch of accounting.

[Ans: 1—false, 2—false, 3—false, 4—true, 5—false, 6—true, 7—false, 8—false, 9—false, 10—false]

II. Choose the correct answer:

1. CA is not applicable to ______
   1. Small business concern
   2. Big business concern
   3. Both a and b
   4. None of above
2. Cost audit is a part of
   1. Financial accountancy
   2. Cost accountancy
   3. Management accountancy
   4. None of above
3. Cost accountancy helps in the ascertainment of
   1. Cost after hand
   2. Cost beforehand
   3. Cost in hand
   4. None of above
4. Reduction of labour turnover and idle time help us to control
   1. Material cost
   2. Standard cost
   3. Labour cost
   4. None of above
5. CA department should provide information about standard and
   1. Ultimate performance
   2. Unestimated performance
   3. Actual performance
   4. None of the above
6. CA can also provide information that may reduce
   1. Overheads
   2. Price
   3. Both a and b
   4. None of above
7. Cost accounts should provide information, which enables the management to fix remunerative
   1. Cost prices
   2. Selling prices
   3. Both a and b
   4. None of these
8. CA helps planning for future operation in such a way as to
   1. Minimize the income
   2. Maximize the profit
   3. Maximize the cost
   4. None of the above
9. The fixed cost is controlled by
   1. Management
   2. External factors
   3. Production department
   4. None of the above
10. Variable cost is controlled by
    1. Production department
    2. Selling department
    3. Both a and b
    4. None of the above

[Ans: 1—a, 2—b, 3—b, 4—c, 5—c, 6—a, 7—b, 8—b, 9—a, 10—a]

DISCUSSION QUESTIONS

Short Answer-Type Questions

1. Define the term cost.
2. What do you mean by costing?
3. Define CA.
4. State the important objectives of CA.
5. State the difference between cost and expense.

Essay-Type Questions

1. What are the advantages of CA? State its limitations.
2. Bring out the importance of CA.
3. What are the factors to be considered before setting up a CA system?
4. What are the essential features of CA?
5. Differentiate between CA and FA.