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Cost Accounting

Cost accounting is a process of collecting, analyzing, summarizing and evaluating various alternative courses of action. Its goal is to advise the management on the most appropriate course of action based on the cost efficiency and capability. Cost accounting provides the detailed cost information that management needs to control current operations and plan for the future.

Since managers are making decisions only for their own organization, there is no need for the information to be comparable to similar information from other organizations. Instead, information must be relevant for a particular environment. Cost accounting information is commonly used in financial accounting information, but its primary function is for use by managers to facilitate making decisions.

Unlike the accounting systems that help in the preparation of financial reports periodically, the cost accounting systems and reports are not subject to rules and standards like the Generally Accepted Accounting Principles. As a result, there is wide variety in the cost accounting systems of the different companies and sometimes even in different parts of the same company or organization.

Origins

All types of businesses, whether service, manufacturing or trading, require cost accounting to track their activities. Cost accounting has long been used to help managers understand the costs of running a business. Modern cost accounting originated during the industrial revolution, when the complexities of running a large-scale business led to the development of systems for recording and tracking costs to help business owners and managers make decisions.

In the early industrial age, most of the costs incurred by a business were what modern accountants call “variable costs” because they varied directly with the amount of production. Money was spent on labor, raw materials, power to run a factory, etc. in direct proportion to production. Managers could simply total the variable costs for a product and use this as a rough guide for decision-making processes.

Some costs tend to remain the same even during busy periods, unlike variable costs, which rise and fall with volume of work. Over time, these “fixed costs” have become more important to managers. Examples of fixed costs include the depreciation of plant and equipment, and the cost of departments such as maintenance, tooling, production control, purchasing, quality control; storage and handling, plant supervision and engineering. In the early nineteenth century, these costs were of little importance to most businesses. However, with the growth of railroads, steel and large scale manufacturing, by the late nineteenth century these costs were often more important than the variable cost of a product, and allocating them to a broad range of products lead to bad decision making. Managers must understand fixed costs in order to make decisions about products and pricing.

Cost Accounting vs Financial Accounting

  • Financial accounting aims at finding out results of accounting year in the form of Profit and Loss Account and Balance Sheet. Cost Accounting aims at computing cost of production/service in a scientific manner, facilitate cost control, and cost reduction.
  • Financial accounting reports the results and position of business to government, creditors, investors, and external parties.
  • Cost Accounting is an internal reporting system for an organization’s own management for decision-making.
  • In financial accounting, cost classification based on type of transactions, e.g. salaries, repairs, insurance, stores etc. In cost accounting, classification is basically on the basis of functions, activities, products, process and on internal planning and control and information needs of the organization.
  • Financial accounting aims at presenting ‘true and fair’ view of transactions, profit and loss for a period and Statement of financial position (Balance Sheet) on a given date. It aims at computing ‘true and fair’ view of the cost of production/services offered by the firm.

Elements of cost

Basic cost elements are:

  • Raw materials
  • Labor
  • Indirect expenses/overhead.
  • Material (Material is a very important part of business)
  • Direct material/Indirect material
  • Labor
  • Direct labor/Indirect labor
  • Overhead (Variable/Fixed)
  • Production or works overheads
  • Administration overheads
  • Selling overheads
  • Distribution overheads
  • Maintenance & Repair
  • Supplies
  • Utilities
  • Other Variable Expenses
  • Salaries
  • Occupancy (Rent)
  • Depreciation
  • Other Fixed Expenses

(In some companies, machine cost is segregated from overhead and reported as a separate element)

Classification of costs

Classification of cost means, the grouping of costs according to their common characteristics. The important ways of classification of costs are:

    • By Element: There are three elements of costing i.e. material, labor and expenses.
    • By Nature or Traceability: Direct Costs and Indirect Costs. Direct Costs are directly attributable/traceable to Cost Object. Direct costs are assigned to Cost Object. Indirect Costs are not directly attributable/traceable to Cost Object. Indirect costs are allocated or apportioned to cost objects.
    • By Functions: production, administration, selling and distribution, R&D.
    • By Behavior: fixed, variable, semi-variable. Costs are classified according to their behavior in relation to change in relation to production volume within given period of time. Fixed Costs remain fixed irrespective of changes in the production volume in given period of time. Variable costs change according to volume of production. Semi-variable Costs are partly fixed and partly variable.
    • By control ability: controllable, uncontrollable costs. Controllable costs are those, which can be controlled or influenced by a conscious management action. Uncontrollable costs cannot be controlled or influenced by a conscious management action.
    • By normality: normal costs and abnormal costs. Normal costs arise during routine day-to-day business operations. Abnormal costs arise because of any abnormal activity or event not part of routine business operations. E.g. costs arising of floods, riots, accidents etc.
    • By Time: Historical Costs and Predetermined costs. Historical costs re costs incurred in the past. Predetermined costs are computed in advance on basis of factors affecting cost elements. Example: Standard Costs.
    • By Decision making Costs: These costs are used for managerial decision-making.
      • Marginal Costs: Marginal cost is the change in the aggregate costs due to change in the volume of output by one unit.
      • Differential Costs: This cost is the difference in total cost that will arise from the selection of one alternative to the other.
      • Opportunity Costs: It is the value of benefit sacrificed in favor of an alternative course of action.
      • Relevant Cost: The relevant cost is a cost, which is relevant in various decisions of management.
      • Replacement Cost: This cost is the cost at which existing items of material or fixed assets can be replaced. Thus, this is the cost of replacing existing assets at present or at a future date.
      • Shutdown Cost: These costs are the costs, which are incurred if the operations are shut down and they will disappear if the operations are continued.
      • Capacity Cost: These costs are normally fixed costs. The cost incurred by a company for providing production, administration and selling and distribution capabilities in order to perform various functions.

Other Costs

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