Financial Management & Cost Accounting

Module 8. Costing

Lesson 44
INTRODUCTION TO COST ACCOUNTING

44.1 Introduction

The main goal of an organization is to maximize profit (or functioning in the most efficient manner). To maximize profit, the firm must try to increase its revenues, and at the same time it should control costs. The firm would be much more satisfied when they are actually able to "reduce" their costs. Hence for maximizing the profit and increasing efficiency of a firm, the planning, controlling & reduction of costs is very important.

The effective management of costs can be done only by a systematic approach toward cost.

44.2 Cost

As the entire discussion centers around the term "cost", it is necessary to understand what "cost" means."Cost may be defined as the resources sacrificed or foregone in order to achieve a specific objective."The use of the term " cost ", without a suffix or prefix is also not recommended, for example Direct cost, Indirect cost, Historic cost, Future cost, Additional cost, opportunity cost etc.

44.3 Cost Accounting

Cost accounting is primarily concerned with Recording, classifying and summarizing cost for:-

(a) Determination of costs of products or services

(b) Planning, controlling & reducing such cost and furnishing of information to management for decision making.

Objectives of Cost Accounting

The main objectives of cost accounting are –

(1) Determining Selling Price

As organizations run for profit making, they want their revenues to be greater than costs of goods & services. The cost of manufacturing / producing goods / services gives a base for fixing the selling price of the goods / services.

Several other factors such as demand supply gap, cost of distribution, condition of market etc also play an important role in determining the selling price, but still "Cost" plays the dominating role.

(2) Determining & Controlling Efficiency

Cost accounting involves the study of the underlying operations used in production of a good / service, hence it facilities the measuring of the efficiency of the department or organization as a whole.

Cost accounting also involves preparation of the "Budgeted cost"

(3) Facilitates the preparation of Financial & other Statement.

The third objective of cost accounting is to facilitate & prepare various statements & reports at very short intervals, which are externally useful to the management for efficient running of the business and prompt decision making.

Such statements/reports include frequent review of sales, production, operating costs, daily/weekly/monthly data of units produced, accumulated costs, etc along with their appropriate analysis.

A well developed cost accounting system can provides these statements / reports quickly and without any delay. Hence, it can also facilitate preparation of half-yearly or yearly financial statement.

(4) Provide basis for Operating Policy

A cost accounting involves recording and analyzing various costs, it can give important inputs for taking decisions under particular situation, such as

a. Making or buying from outside suppliers?

b. Own productions or outsourcing?

c. Determination of cost-volume-profit relationship, and hence determining the breakeven point, Margin of safety etc.

d. Continuing with old machinery / equipment or to replace it.

Cost Accounting Vs Financial Accounting:-

It should be emphasized here that financial accounting primarily aims at external reporting to shareholders, lenders, Banks & financial institutions, investors, Government authorities etc and other stakeholders. It is mandatory and prepared as per legal & other requirements.

Cost accounting focuses on cost of product, services etc. It is primarily aimed at internal reporting and the cost accounting reports are provided to managers for effective decision making.

44.4 Methods of Costing & Types of Costing

Methods of costing

Various methods of ascertaining costs are available to suit the business need. But the basic principles are the same in every method. The choice of a particular costing method thus depends on the nature of the business of the concern.

There are two basic methods of costing –

1. specific order or joint costing

2. continuous operation or process costing

All the other methods are either the variation of job or process costing or are just techniques used for a particular purpose under specific conditions. A brief description of each of the methods is as follows:

Job costing

Job costing is the basic costing method applicable to those industries where the work consists of separate contracts, jobs or batches, each of which is authorized by a specific order or contract. The most important feature here is that each job or order can be identified at each stage of production and therefore, costs that can be directly identified with a job or order is charged to that job or order. A share of indirect expenses is also charged to the same. Variations of job costing are contracts costing and batch costing.

Contract costing

It is the form of specific order costing, generally applicable where work is undertaken to customer’s special requirements and each order is of long duration, such as building construction, ship building, structures for bridges, civil construction, etc. The work is usually done outside the factory.

Batch costing

It is that form of specific order costing which applies where similar articles are manufactured in batches either for sale or for use within the undertaking. Costs are collected according to the batch order number and total costs are divided by the total numbers in the batch to arrive at unit cost of each job. The method is applicable to aircraft, toy making, printing industries, etc.

Operation costing – process and services

Process costing method is applicable where goods or services result from a sequence of continuous or repetitive operations or processes and products and products are identical and cannot be segregated. Costs are charged to processes and averaged over the units produced during that period. Like job costing, here also there is no need for maintaining detailed records for each job because the total production consists of identical units. It must be noted that here, the units that are completed during the year are considered. However, this may arise from the following three situations:

1. Uncompleted units of the prior period completed during the current period (shown as work in progress in the beginning)

2. Units started and completed during the current period

3. Units started during the current period but remain uncompleted at the end of the current period, which is shown as work in progress at the end of the year

The work in progress inventory is converted into equivalent complete units based on the stage of completion of their processing.

It should be noted that if the units are lost or spoilt during the processing in any department, such loss is borne by the units complete and remained uncompleted in that department. Thus, the cost of lost units is spread over the remaining units on some equitable basis.

The ascertainment of various costs basically comprises three categories:

a. direct material cost

b. direct labor cost

c. overheads

Examples are food processing, chemicals, dairies, paints, flour, biscuits, etc. Variations of process costing are found in single or output costing, operation costing, departmental costing, as explained below:

Single or output costing

It is used when the production is uniform and identical and a single article is produced. The total production cost is then divided by the number of units produced to get unit or output cost. Examples are mining, breweries, brick making, etc.

Operation costing

It refers to the methods where each operation in each stage of production or process is separately coasted. Thereafter, the cost of finished unit is determined. This is suitable in industries dealing with mass production of repetitive nature like motor cars, cycles, toys, etc.

Departmental costing

It refers to the method of ascertaining the cost of operating a department or cost centre. Total cost of each department is ascertained and divided by the total units produced in that department to arrive at the unit cost. If one product passes through a number of departments for completion, the cost of each department will be picked up and the total unit cost will be aggregate of the unit cost of the department through which the product passes.

Service or operating costing

Operating cost is applicable to service organization that do not makes or sell tangible goods but render services. Examples are transportation companies, hotels, hospitals, schools, electric and gas generation and distribution, etc. Cost of providing and operating a service is ascertained and unit cost is found out by dividing the total cost of units of services rendered. Composite units such as tone-mile, passenger-kilometer, KWH, etc are generally used.

Composite or multiple costing

The manufacture of certain products involves a lot of complexities and therefore, any of the basic methods of job or process costing cannot be used for collecting and presenting product cost. In fact, industries making complex products such as cycles, automobiles, airplanes, radios, etc use a combination of various costing methods and the methods are known as composite or multiple costing.

Techniques of costing

In each of the costing methods, various techniques may be used to ascertain costs depending on the management requirement. These techniques may be grouped as follows:

Absorption costing

It refers to the ascertainment of costs after they have been actually incurred. As per this system, fixed as well as variable costs are allotted to cost units and total overheads are absorbed by actual activity levels. Absorption costing is termed as total costing, since total costs are ultimately allotted to cost units. It is also termed as traditional or historic costing. However, since costs are ascertained after they have been incurred, and substantial time gap exists between the occurrence of the expenditure and reporting of the cost information, it does not help in exercising cost control.

Marginal costing

It refers to a principle whereby variable costs are charged to cost units and the fixed costs attributable to the relevant period is written off in full against the contribution for that period. Contribution is the difference between sales and variable or marginal costs of sales. Marginal costing is also known as direct or variable costing. It is a valuable aid to management in taking important policy decisions, such as product pricing, choosing the product mix, decisions to make or to buy, etc.

Standard costing

It refers to the technique which uses standards for costs and revenues for the purpose of control through variance analysis. Standards are established for each cost element on a scientific basis for the immediate future period, and actual are compared against the standards. Variances from the standards are analyzed, reasons established and corrective action taken to stop the recurrence of inefficient operation. Thus, standard costing is extremely helpful for cost control.

Standard costing is normally used along with budgetary control, which refers to the establishment of budgets relating to responsibilities of executive to the requirements of a policy and the continuous comparison of actual with the budgeted results, either to secure by individual action the objective of that policy or to provide a basis for its revision.

Absorption costing system and marginal or direct costing system can be used in conjunction with standard costing system.

Differential costing

It is defined as a technique used in the preparation of adhoc information in which only costs and income differences between alternative courses of action are taken into consideration. It considers only the additional costs and additional revenues arising out of the decision regarding addition of a project. Similarly, incremental costing technique considers incremental costs and incremental revenue arising out of a decision to change the level of nature of activity.

Uniform costing

It refers to the use by several undertakings of the same costing system, that is, the same basic methods, principles and techniques. This is not a distinct method of costing. This system is applied by a number of units of the same undertaking or several undertakings within the same industry with a view to promote operating efficiency by comparing inter – unit or inter – firm performance data. Trade associations and multinational companies often use this system.