Cost Accounting: Branch of Financial Accounting and Key to Valuable Information

 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.

Codification of overheads: Meaning and Methods.

 Q. What do you mean by codification of overheads? Discuss the various methods of codification. 

Ans. Meaning of Codification of overheads: When the collected overheads are grouped according to their class it is known as classification of overheads. Each group or class is given a code number to help in maintaining mechanised accounting and secrecy in the system. This code allotment procedure is known as codification. Codification may be done by any of the following methods:

(i) Numbers

(ii) Alphabets

(iii) Combination of numbers and alphabets

(iv) Symbols

Methods of Codification: The various methods of codification are as follow:

(1) Numerical Numbers: Under this method the various groups are alloted numerical numbers so that one group of overhead may represent one standing order number. As for example 

No. 1 to 20 Indirect Material 

       21 to 30 Indirect Labour

       31 to 37 Idle Time

       38 to 43 Overtime 

       44 to 50 Insurance 

       51 to 54 Rent

       55 to 70 Depreciation 

       51 Rent of factory

       52 Rent of Office Building 

       53 Rent of Warehouse 

       54 Rent of Branch Office

(2) Alphabets: Under this method, alphabets are alloted to each overhead. These alphabets help in memory and identification of overheads. For example, 

PO – Power

RE – Repair

DE – Depreciation 

CA – Carriage

MA – Maintenance 

(3) Combination of Alphabets and Numericals: Under this method both of the above methods are combined into one. Under this method, alphabet stands for head of expenses and number shows further analysis of expenses. As for example,

RE1 = Repair to factory building

RE2 = Repair to office building 

RE3 – Repair to warehouse 

RE4 – Repair to vehicle

RE5 – Repair to furniture 

Again repair to furniture can be divided into further code number.

RE5.1 – Repair to factory furniture 

RE5.2 – Repair to office furniture 

RE5.3 – Repair to warehouse furniture and so on.

(4) Symbols: This method is used in those concerns which are working under mechanised system with punched card accounting. The nine digit punched card is divided into four parts.

00/000/00/00

The first part of two digits represents class of overhead i.e., fixed or variable. The second part of three digits represents head of overhead (i.e. idle time etc.), the third part of two digits signifies analysis of expenses (i.e. waiting for material). The fourth part of two digits represents the cost centre (i.e. assembly shop).

   For example symbol 10/120/01/07

Stands for 10 for variable cost, 120 for idle time, 01 for waiting of material, 07 for assembly shop.

Code.                       Stands

10/120/01/07.        Variable/Idle Time/Waiting for material/Assembly Shop

Cost Accounting: fundamental principles and functions

 Q. Define cost accounting. Explain the fundamental principles and functions of cost accounting.

VK

Ans. Meaning of Cost Accounting: Cost Accounting refers to the process of accounting for costs incurred in manufacturing, trading or services rendering types of businesses. Hence, cost accounting is the most systematic and scientific branch of accounting that deals with identification, analysis, recording, summarizing and communication of current and prespective cost. 

Cost Accounting is a branch of accounting which deals with accumulation (collection), classification, recording, analysis, interpretation, reporting and control of current and prospective costs. It explains the cost of production of a product or a service according to its components per unit as well as total. Cost accounting is a specialised branch of accounting which involves classification, accumulation, analysis, assignment and control of cost. The rules and principles of cost accounting have developed over a period of time by experience. The cost accounting need arouse because of the limitation of financial accounting.

Cost Accounting is the classifying, recording and appropriate allocation of expenditure for the determination of the costs of products and services and for the presentation of suitably arranged data for the purpose of control and guidance of management. It includes the calculation of cost of every product, job, section, department, process, service. It is the method of accounting for cost. 

Fundamental Principles of Cost Accounting: The following are the main principles of cost accounting:

1. A Cost should be related to its cause: A cost should be related as closely as possible to its cause for recovering the cost of product, job, process or cost centre. The effect of cost of an item on the various products, departments or processes should be established before it is charged to that product or cost centre. The cost are collected and analysed according to their nature and are to be allocated or apportioned on the basis of cause relationship. For example, rent of the factory building should be charged from all the production departments on the basis of the area occupied by each production department. 

2. A Cost should be Charged only after its Incurrence: While calculating the cost of individual units those costs which have been incurred (actually or nationally) should be taken into account. As for example selling overheads should be charged only to those units which have been sold and all those units which are still in stock should not be charged with selling overheads. Similarly normal loss should be only absorbed by those units in which it has taken place and not in those units which are yet to be produced.

3. Abnormal Cost should be Excluded from Costing: A loss due to accident, fire, theft, riots, negligence is the abnormal loss. Abnormal losses should not be charged to the production cost as these are not related to production. The inclusion of abnormal loss in the cost of production would distort cost figures ans mislead the management as to the working results of the undertaking. For this reason only normal cost incidental to production is charged to product, job or cost centre and not the abnormal losses or abnormal cost. This is the reason abnormal losses are transferred to costing profit and loss account. 

4. Past Costs are not charged to Future Periods: A past cost means a cost from which no more benefit is to accrue. A cost item which was incurred in the year 2015 is not to be charged from the cost of production from the product of the year 2016. It will unnecessary distort the cost of production and it may lead to wrong decision by the management regarding the product, cost centre or efficiency of the department. But if there is an item of expenditure in the past, the benefit of which will accure in the future, then it should be charged in future period as a deffered revenue expenditure as for example expenditure on advertisement. The items of past cost if remain uncharged from the product of that period then it should be transferred to costing profit and loss account with a note stating reason. 

5. The concept of Conservatism has no place in Cost Accounting: Cost accounts should be prepared with facts without any biasness or with a secret purpose. The closing stock is valued at cost price or market price, whichever is less in financial accounts while in cost accounts stock is valued at cost only. There is no creation of secret reserve in cost accounts as in the case of financial accounts. If principle of conservation is asopted in cost accounting then the cost of production will not be comparable and purposeful. 

6. Principle of Double Entry should not be Applied in Cost Accounting: The cost ledgers and other cost control accounts are kept on double entry principles. Costing, however requires a greater use of cost sheets and cost statements for the purpose of cost ascertainment, cost control and reporting to management.

Functions/Objectives of Cost Accounting: The main objectives of cost accounting may be:

1. To Ascertain Cost: With the help of cost accounting cost per unit of a product, job or process is calculated. For calculating cost of the product or service various methods like unit costing, contract costing, job costing etc. are applied. The technique of ascertaining the cost is known as costing. 

2. Cost Control: Cost Control is reducing the cost of production by controlling the wastage of material, labour and other expenses. Cost control helps to improve the efficiency of organisation as a whole. For cost control bugetary control, standard costing and responsibility accounting are the main tools applied by the management.

3. Determination of Selling Price: Cost accounting has the main object to help in fixation of selling price of the product or service not only in normal condition but also under various stressing market conditions. To fix the selling price various factors like cost of production, market situation, business cycle, govt. policies, competition, change in fashion, income level of the people do play their role. Cost accounts helps to provide necessary information to take decisions under conditions like depression, export, or exploring the new market etc. Minimum selling price can be decided with the availability of proper cost data.

4. Ascertainment of Profitability: Profitability means capacity to earn profits of a department, section, product, job or a process or service. This capacity can be judged with the help of cost data provided by cost accounting. The expected profits are compared with the actual profits to know the reasons of difference, if any. This helps to analyse the efficiency of each segment of the organisation as well as the whole of the organisation. Before introduction of a new product, design, method, machine or operating Market profitability analysis helps to set targets and performance measurement. Thus, the object of cost accounting is to measure the profitability of the activities carried out or planned. Profit making capacity should be established.

5. Provides a base for setting business policies: Cost accounting helps to provide accurate cost information. These cost data help the management in taking short-term and long-term business policies to be followed. Cost accounts help in various decision making processes which may be very crucial to the organisation like: 

(a) To introduce new product or new method of production or to explore a new market.

(b) How to use idle capacity if there remains any?

(c) Deciding the sales mix to maximise the profits or to maximise the use of available factors of production.

(d) Make or buy decision regarding a product 

(e) Exporting goods in a foreign market even at below the cost of production or not.

(f) Closing down the plant or to contribute production even in losses.

(g) Replacement of old machinery with the new model or not. 

6. Inter-firm Comparison: Cost accounting helps in making comparisons of cost or of profits of one firm with other firm operating in the same industry. For the inter-firm comparison there should be the application of uniform costing system within that industry. 

7. Control on Wastage: Cost accounting can explain the source of wastage in the statement of cost (i.e. material, labour and other expenses) and thus can save the national factors of production.

8. Minimum Capital in Stocks: Cost accounting through various techniques like various levels of stock, analysis of slow moving material, continuous stock taking can decide the objective to minimise the investment of capital in stocks of raw material, work-in-progress or finished goods.

9. Effective Information System: The objective of cost accounting is to prepare regular reports regarding material, labour and other expenses and to communicate those reports at the effective level of management to make them effective. 

10. Internal Audit System: The objective of cost accounting is to develop internal audit system which may help in effective working of different departments of the organisation.

SBP

Ans. MEANING OF COST ACCOUNTING: Cost Accounting is a specialised branch of general accounting in which detailed and systematic information related to cost of goods and services are maintained in such a way as to obtain detailed information about total and per unit cost and guidance for the analysis and control of cost.

Add definition here.

Conclusively, cost accounting may be defined as the body of concepts, methods, techniques and procedures used to compute, analyse or estimate the costs, profitability and performance of individual products, services or departments and other segments of an enterprise.

FUNDAMENTAL PRINCIPLES OF COSTING

The fundamental principles of costing are as follows:

1. Cost is related to its cause. A cost is related as closely as possible to its cause. Rent of the factory, for instance cannot be charged to office expenses, repairing charges of a machine cannot be charged to some other machine, and in the same way, a foreman's salary cannot be charged to one single unit, if many more units are produced in a department supervised by that foreman. The reason in all the above cases is that the cost is related to its cause.

2. Cost is charged after it is incurred. If a cost is not incurred either actually or notionally, it cannot be charged to a cost centre. For instance, a cost unit is not charged with selling costs while it is still under manufacture in the factory, as selling costs would occur only when the cost unit is finished in the factory and is sold. Similarly, normal loss or wastage is to be borne by the units of which it is a loss or wastage. Such a loss is not imposed on those units which are yet to pass the point of loss.

3. Abnormal costs are excluded from costing. A cost to meet the loss caused by'fire, riot, theft or accident is an abnormal cost. This cost is not charged to production as it is not related to production part. The presence of abnormal cost in costing would only distort cost figures and mislead the management for the purposes of cost control and decision-making. Similarly such financial expenses as have little or no relationship with costing, are also considered abnormal and are not charged to costing.

4. Past costs are not charged to future periods. A past cost is one from which no more benefit is to accrue. If, however, a past cost is such the benefit of which is to accrue in a future period also, as for instance, advertisement expense being treated as deferred revenue expenditure, then it is not a past cost and it can be charged during the period of benefit.

5. The concept of conservatism has no place in costing. The closing stock in financial accounting is valued at cost price or the market price, whichever is less, but in costing, the closing inventory and stocks are valued at cost only. There is a value attached to the concept of conservatism in financial accounting but it is not so in costing. Cost statements are required to be prepared so as to state facts with no known bias. If, however, a contingency is to be taken into consideration in cost accounting, it should be so stated and shown distinctly.

6. Accounting for cost is based on Double-entry Principle. The Cost ledgers and other cost control accounts are kept on the double-entry principle-the same principle which is adopted so exhaustively in financial accounting. Costing, however, requires a greater use of cost-sheets and cost statements for the purpose of cost ascertainment, cost control and guidance to management.

FUNCTIONS OR OBJECTS OF COST ACCOUNTING

The main functions or objects of cost accounting are as follows :

1. Cost ascertainment. The primary objective of cost accounting is to determine the cost of production of every unit, job, operation, process, department or service. The technique of ascertaining cost is known as 'Costing. In order to determine cost, all the expenses are accumulated, classified and analysed. It not only determines the cost at completion stage but also determines cost at various stages of production.

2. Cost control. Cost control is one of the important functions of cost accounting. To measure the efficiency of the organisation or of the cost centres, the various operations involved in the manufacture of products are to be carefully studied. Budgets and standards for the consumption of materials, use of labour, and for expending the overhead are to be set and compared with the actual performances. The variances arising out of the comparison so made tell the tale whether the cost is within control or not.

3. Cost reduction: Cost reduction refers to real or genuine savings through permanent reduction in cost of a product or service without impairing the quality and affecting its purpose for which it was intended to be used. In the competitive market situations, it is utmost important for the organisations to look for activities and search for new technology through research and development activities that can reduce the cost of a product. Cost reduction can be attainable in almost all the areas of business activities. The area covered for cost reduction are like product design, plant layout, production methods, material substitution, reduction in wastages, innovation marketing strategies, purchasing and material control etc.

4. Ascertainment of profitability: It is the object of cost accounting to ascertain the profit making capacity of that activity planned or being carried out and to compare the actual profits made with their profitabilities. Difference is analysed and efforts are made to earn the maximum profit as per capacity.

 

5. Determination of selling price: The supply price or the tender price of a product depends upon its total cost plus a margin of profit which the businessman wants to make depending upon the inter-play of factors of demand and supply. Cost accounting provides detailed information about the composition of total cost for the determination of the selling price. It also provides information to decide the extent to which the prices can be reduced to meet the challenge arising out of competition, by differentiating the costs into variable and fixed cost. Similarly, in the event of depression or recession, the cost accountant can guide as to which expenses can be curtailed, to reduce the cost of production and thus to decide the minimum selling price.

6. Providing a basis for business policy and decision-making. The objective of cost. account- ing is to help the management in the formulation of business policy and in decision-making. The gross-profit analysis, the cost-volume-profit relationship, the break-even point of sales, and the differential costing method, etc., help the management in profit-planning and in deciding crucial matters like (a) introduction or discontinuance of a product; (b) utilization of idle plant capacity; (c) selection of most profitable sales-mix; (d) dumping of goods in a foreign market at a cheaper price; (e) make or buy; (f) purchase of new plant or continuance with the old plant at the cost of heavy repairs, etc.

7. Compliance to statutory requirements: The Central Government, under Section 209(1) (d) of the Companies Act, has made it compulsory for 47 industries to maintain cost accounts. Thus, compliance to statutory requirements is also one of the objectives of cost accounting.

Define cost accounting. Explain the fundamental principles and functions of cost accounting.