Q. “Cost accounting is the branch of Financial Accounting and it has been evolved to do away the limitations of financial accounting and to meet the needs of the management.” Comment.
OR
“The ordinary trading account is a locked storehouse of most valuable information to which a cost system is the key.” Do you agree? Substantiate.
VK
[Ans. The cost Accounting need arouse because of the limitations of financial accounting. As the results of the financial accounts are provided for the whole organisation and that too after the end of the year (which means these results are nothing but the post-mortem of the dead body) and hence these are of very little use to the management in planning and control and decision-making under various conditions. These limitations can be explained as follows:
1. Financial Accounts show only the net results of the business: As we know that financial accounts (i.e. trading account, profit and loss account and baĺance sheet) are prepared at the end of the year and for the whole of the organisation and not the cost or profits of each product or cost centre or cost unit or process or job or batch etc, and hence financial accounts fail to provide day to day information regarding cost of product.
2. Financial Accounts do not make any difference between direct cost and indirect cost: As financial accounts fail to create any difference in direct and indirect expenses for the product, controllable or uncontrollable expenses or variable and non‐variable expenses so financial accounts fail to help in taking effective decision making under crucial circumstances like depression, low demand, competition or make or buy decisions etc.
3. Financial Accounts fail to reveal the weak points of the business: If an organisation is producing different products then it is difficult to analyse which product is profitable or not-profitable and why so? Whether a product, process or centre is running into losses or profit, this information is not revealed.
4. Financial Accounts fail to help in fixation of selling price of a product: As the total cost incurred during the period dividend by total output is the only system of calculating cost of production per unit and that too at the end of the period thus it fails to help in fixation of selling price of the product specifically on the different stages of production of goods and under the various circumstances of business.
5. Financial Accounts fail to provide control on material, labour and other expenses: In financial accounts, the control on cash movement gets very heavy attention in comparison to the material, labour, and other expenses. While the losses of these elements result into increase in cost of production and thus more selling price, resulting into the failure to face competition and thus ultimately paading away from market of the business.
6. Financial Accounts lack to reveal operating efficiency or inefficiency: There is no system which can explain whether the organisation is running efficiently or not. The only judgement is through increase in profits or decrease in profits. But the increase in profits if takes place through controlling the cost of production or through controlling waste of material or wastage of time or by higher productivity of the labour that is what will be having positive effect on the working of the organisation and in that lies the real efficiency and improvement of the organisation. This can be revealed by cost accounting.
7. Financial accounts fail to provide comparison for cost of products: As financial accounts record the transition after the transiction takes place so cost of production cannot be compared with the expected cost or cost of different periods, different jobs, different departments or operations. Without comparison it is difficult to analyse whether the cost are rising or falling and the reasons responsible for this change. Efficiency of a department or of an organisation can be judged by comparison only.
8. Financial Accounts lack in performance appraisal of the organisation: There is no system in financial accounting which can help to judge the various alternatives to improve the performance and working of the different departments, products, markets or methods of production. Thus, the profitability of various alternatives may not be analysed and the organisation may fail to maximise the profits in the available circumstances.
9. Financial Accounts fail to analyse the losses: If during the period there are losses in the undertaking then there is no provision or system to analyse why the losses have taken place and if any reason is assigned then in future it may not be possible to control the same. But cost accounts can help to establish the reason of losses by applying management by exception and responsibility accounting.
10. Financial Accounts fail to keep proper records regarding use of machinery: There is no system in financial accounts which the records of the working hours of the machinery and other factors of production, record regarding idle time and reasons of idle time are kept. Scrap, wastage of material or records, defective and spoiled outputs are not recorded and hence results into wastage of working machine hours.
11. Financial Accounts fail to reveal profits product wise: Which department, cost centre, process is more profitable or less profitable or unprofitable, also this information is not revealed by financial accounts and hence if any of the products or processes is running into loss then it is reducing the overall profits of the whole organisation.
12. Financial Accounts fail in helping decision making: The management has to take the various critical and strategic decisions in the interest of the organization like, make or buy, product mix, change in method of production, change in selling price, change in quality of product and change in material used etc. These all\nAre critical decisions which affect the whole of the organisation’s working and functioning. There must be some system in the accounts on which the management may depend while taking these critical and strategic decisions.]
Thus, we can say that cost accounting has overcome the limitations of financial accounting with the help of techniques like budgeting, marginal costing, standard costing, etc.
OR
(SBP) L.W. Hawkins has rightly said, “The ordinary trading account is a locked storehouse of most valuable information to which a cost system is the key.” It means that a number of valuable information exist in trading account but they can be understood and analysed in a useful manner only with the help of cost system.
Limitations of Financial Accounting OR Need for Cost Accounting: Financial Accounting is considered as the oldest system of accounting. This accounting system is regarded as historical in nature and provides post-mortem of past records. It suffers with various limitations which led to the development of cost accounting. The following are the limitations or deficiencies of financial accounting:
1. Lack of details of materials: Financial accounting failed to provide information about the value and quantity of direct and indirect material used in various jobs, activities or departments the cost and quality of normal and abnormal loss of material, scrap or spoilage of material during the manufacturing process, the share of material cost in the total cost of product or job, etc
2. Lack of Analysis of Labour Cost: Financial accounting only discloses the total amount of wages paid during the year. It fails to provide information as regards to wages paid for specific jobs, activities, department or product. Further, it does not provide information as regard to direct and indirect wages, wages for idle time, over-time, cost for inefficiencies of labour, methods of remunerating labour. etc.
Financial Accounting is silent as regard to number of workers engaged in production and other activities, number of workers engaged on various jobs or departments, number of hours devoted by workers, rate of wages. It also does not provide information whether the increase in number of workers or increase in wage rate has led to corresponding increase in production or output or not.
3. Lack of Classification and Analysis of Overheads: One of the limitation of financial accounting is that it does not provide information as regards to expenses on various overheads department-wise, product-wise or activity-wise. Financial accounting even fails to provide information as regard to expenses on overheads nature-wise viz., variable overheads, semi-varible overheads and fixed overheads for the department, product, job or activity. These overheads are not expressed in financial statements into controllable or non-controllable overheads, basis of apportionment of overheads etc.
4. Lack of Details of Costs and its Elements: Financial accounting lacks in providing information as regards to ascertainment of cost of various products, jobs, activities or services rendered. It fails to provide direct and indirect cost incurred on various activities, cost at various stages of production. It also does not take into account and provide various costs, which are helpful in taking managerial decisions such as opportunity cost or imputed cost, etc.
5. Lack of Complete Information of Costs: Information available from financial statements are considered to be inadequate and meaningless for the purpose of cost control because financial accounting does not record the cost data as required for the purpose of application of various cost control techniques viz., budgetary control or for standard costing. These techniques require information of actual or budgeted cost as regard to each element of cost viz., material, labour and overheads but in quantitative terms and monetary terms for the purpose of comparison of results. Financial accounting system has no provision of laying down standards in regards to material, labour or overheads in order to make actual costs comparable.
6. Difficulty in Fixation of Selling Price: As financial accounting does not ascertain cost of products or activities, hence fixation of selling price of product or activities becomes rather difficult especially in changing market conditions. Various managerial decisions require information as regard to cost and selling price viz., determination of BEP sales, quoting of tender prices, to accept or reject the special offer, fixation of minimum price, fixation of selling price while launching a new product. These decision-making becomes difficult from information provided by financial accounting.
7. Lack of Details of Working of Machines: Financial accounting fails to provide the number of hours worked by a machine and the number of hours it remained idle. No record is kept of the hours worked by different machines in the manufacture of a product or the completion of a job. No proper check is applied to reduce wastage of time and materials occurring at the machines.
8. No Details of Production: In financial accounting, no proper system is adopted to control under-production or over-production. Daily/Montly/Weekly production charts are not prepared and compared with previous periods and budgets.
9. Difficulty in analysing Profitable and Non-Profitable Activities: The financial accounting discloses the overall profit of the concern as a whole. It does not help in analysing the profitable and non-profitable activities, contribution made to profit by each department separately. Suppose, the profit for a year as disclosed by financial books is ₹70,000 but if we analyse this profit department wise, the following position is revealed.
Dept. A +75000 (profit)
Dept. B - 50000 (loss)
Dept. C +25000 (profit)
Total + 70000 (profit)
Now on analysis, the management can either plan to close down Dept. B or to improve its working. This analysis can be done with the help of cost accounting.
10. Limitation in Analysing Efficiency: The efficiency of a department and persons involved can be judged by quantity produced, the quality of products, costs incurred and time saved. Due to lack of proper data, financial accounting does not help in rewarding the efficiency and punishing the inefficiency. The causes of inefficiency cannot be analysed and efficiency improved upon.
11. Lack of Data required for Decision-making: The management has to take crucial decisions at times on several matters, such as, product selling, make or buy, plant installation, closure of departments, product mix, etc. These decisions can be taken on the basis of relevant and adequate data which financial accounting fails to provide in the systematic manner.
It is worth mentioning to quote G.R. Glover and R.C. Williams that “The existence of an accurate system of financial accounts will reveal the general position of a business, but it will not furnish the special detailed information that is derived from an efficient costing system information that is necessary for the internal control and management of a business.”
Hawkins statement can be explained the help of following example.
A company manufactures and sells three products ‘A’, ‘B’ and ‘C’. The Trading and Profit and Loss Account of the company is as follows:
Trading and Profit and Loss Account shows the net profit of the company but the details of various products are locked in this account, which have been opened with the help of the key of the cost account.
Thus, we can say that cost system is an important key for analysis of profit, reduction of cost and increase in efficiency. It has been rightly stated that “Cost accounts are key to economy in manufacture and are indispensable for the intelligent and economical management of a factory.” The key of cost accounting does help in providing the following information:
1. Separate cost of materials for each product or process.
2. Details of normal and abnormal wastage of material.
3. Separate cost of labour for each product or process.
4. Separate calculation of gross profit for each product and service.
5. Separate calculation of net profit for each product or service.
6. Total cost and per unit cost of each product.
7. Detailed analysis of various elements of cost for the calculation of tender price.
8. Information of relative efficiency of plants, machinery, labour and various departments.
