Cost Accounting Introduction PDF

Animiz and VideoScribe tool for YT S.Y.BBA. - Semester III (Academic Year 2024-25) Faculty of Commerce, The Maharaja Sayajirao University of Baroda Cost Accounting...

Animiz and VideoScribe tool for YT S.Y.BBA. - Semester III (Academic Year 2024-25) Faculty of Commerce, The Maharaja Sayajirao University of Baroda Cost Accounting Unit-I Chapter -1 Cost Accounting Introduction Note: The study material is not exhaustive. These are only guidelines; students are requested to refer the reference books. INTRODUCTION: Financial accounting provides historical information. Its main aim is to record the transactions in books to reveal the results of a concern for a particular period. The financial statements are prepared at the end of the year to know the net result and the financial position of the business. But the management of a concern needs detailed information about the costs incurred during the year for the purpose of planning, cost control and decision making. Cost accounting was developed to fulfill the needs of management for detailed information about the cost. Cost accounting is a mechanism of accounting by means of which costs of services or products or departments or processes are ascertained and controlled in a manufacturing concern. The various deficiencies and limitations of financial accounting gave rise to cost accounting. LIMITATIONS OF FINANCIAL ACCOUNTING: The following deficiencies of financial accounting are the causes for the development of cost accounting. 1. Show only overall performance: Financial accounting fails to disclose the profits or losses associated with specific departments, processes, products, or jobs. It is therefore not possible to know which line of products is profitable or not profitable. Illustration: Profit and Loss account for the year ended 31st March 2003 (Financial Accounting) Particulars Rs. Particulars Rs. To Materials consumed 1,50,000 By Sales 5,00,000 To Direct Wages 1,20,000 To Production Overheads 80,000 To Gross Profit 1,50,000 Total Rs. 5,00,000 Total Rs. 5,00,000 To Operating Expenses 1,00,000 By Gross Profit 1,50,000 To Net Profit 50,000 Total Rs. 1,50,000 Total Rs. 1,50,000 Statement of Income (Cost Accounting) Particulars Products Total Rs. A B C Sales 2,25,000 2,00,000 75,000 5,00,000 Less: Cost of materials consumed 75,000 50,000 25,000 1,50,000 Direct Wages 70,000 30,000 20,000 1,20,000 Production overhead expenses 50,000 20,000 10,000 80,000 Gross Profit 30,000 1,00,000 20,000 1,50,000 Less: Operating Expenses 50,000 30,000 20,000 1,00,000 Net Profit (20,000) 70,000 0 50,000 2. Historical cost reporting: Financial accounting is based on historical costs and does not provide information on anticipated costs. In contrast, cost accounting focuses on ascertaining costs in advance and comparing them with actual costs, enabling investigation of variances and cost control. 3. No Performance appraisal: There is no system of developing norms and standards to appraise the efficiency in the use of material, labor, and other cost by comparing the actual performance with what should have been accomplished during a given period. 4. No Material control system: There is no proper system of control of material, which may result in losses in the form of obsolescence, deterioration, excessive scrape and misappropriation, etc. 5. No labour cost control: There is no system of recording loss of labour time i.e. idle time. Labour cost is not recorded by jobs, processes of departments and as such no system of incentives may be easily used to compensate workers for their above- standard performance. 6. No proper classification of cost: In financial accounting, expenses are not classified into direct and indirect, fixed and variable and controllable and uncontrollable. These classifications have utility of their own. 7. No analysis of losses: Financial accounting does not fully analyse the losses due to idle time, idle plant capacity, inefficient labour, sub-standard materials etc. Thus, the exact causes of the losses are not known. 8. Inadequate information for price fixation: Costs are not available that’s why determination of price of product/ services would not possible. 9. No cost comparison: Comparison is the foundation of modern management control. But financial accounting does not provide data for comparison of cost of different periods, different jobs, or departments or sales territories etc. 10. Fails to supply useful data to management: Financial accounting fails to supply useful data to management for taking various decisions like replacement of labour by machines, introduction of new products, make or buy, selection of the most profitable product mix etc. Financial accounting gives cost data in general. It is like a thermometer which can indicate only the temperature of the body but cannot diagnosis the causes of ill health. EVOLUTION OF COST ACCOUNTING: 1494: Double entry system of accounting is initiated, marking the beginning of modern accounting practices. Industrial Revolution (Late 18th to Early 19th Century): The need for internal operational information and the competitive business environment during the Industrial Revolution acted as catalysts for the development of cost accounting. 1880s: Mass distribution and mass production enterprises adopt internal accounting reporting systems from the railroads, primarily focusing on direct labor and direct material (prime costs). 1880 - 1925: Scientific management movement provides a major impetus to the further development of cost accounting practices. Complex product designs emerge, and multi-activity diversified corporations like Du Pont and General Motors evolve. During World War I and II: The social importance of Cost Accounting grows with the increase in each country’s defense expenditure. Governments in several countries use cost-plus contracts for procurement, where the price paid is the cost of production plus an agreed rate of profit. Prior to Indian Independence: A few Cost Accountants qualified mainly from I.C.M.A. (now CIMA) London, but the profession was relatively small in India. World War II: The need to develop the Cost Accounting profession in India is recognized, and efforts to form an Indian Institute are initiated by members of the Defense Services employed at Kolkata. 1959: The Cost and Works Accountants of India Act is enacted, leading to the establishment of the Institute of Cost and Works Accountants of India (now The Institute of Cost Accountants of India) at Kolkata. 1968: The Government of India introduces Cost Audit under section 233B of the Companies Act, 1956, making Cost Accounting even more significant. Present (Post 2013): Cost Audit is now regulated under Section 148 of the Companies Act, 2013. Cost Accounting, Costing, and Cost Accountancy: These terms are often used interchangeably, but there are differences among them. While they may be used casually, professionals in the field should understand the precise meaning of each term. OBJECTIVES OF COST ACCOUNTING: 1. Ascertain per-unit production cost: Cost accounting aims to determine the cost of production on a per-unit basis, such as cost per kg, cost per meter, cost per liter, etc., to have a clear understanding of cost allocation. 2. Facilitate selling price fixation: Cost accounting helps in determining the cost of production, which in turn enables the management to set appropriate selling prices for products or services. 3. Enable cost control and reduction: Cost accounting plays a crucial role in cost control by developing cost standards or budgets and conducting cost comparisons. It also aids in cost reduction through continuous scrutiny of production methods, employing techniques like value analysis, time and motion study, standardization, and simplification. 4. Analyze profitability at various levels: Cost accounting helps in analyzing the profitability of different divisions, activities, units, products, processes, or departments, providing valuable insights into the organization's financial performance. 5. Identify wastages and inefficiencies: Cost accounting assists in locating wastages, inefficiencies, and gaps in production processes or services, allowing management to take appropriate actions to control and rectify them. 6. Provide data for decision making: One of the primary objectives of cost accounting is to present relevant data to the management, facilitating informed decision-making in various aspects of the business. 7. Prepare cost statements and reports: Cost accounting is responsible for preparing periodical cost statements and reports, presenting them to the management at the right time and in the right format for planning, cost control, and decision-making purposes. 8. Formulate incentive and bonus plans: Cost accounting aids management in formulating and implementing incentive and bonus plans based on productivity and cost-saving measures, promoting employee motivation and efficiency. 9. Assess departmental and process efficiency: Cost accounting allows the study of relative efficiency among different departments, products, processes, or machines, providing opportunities for improvement and optimization. 10. Maximize profit through optimal resource utilization: The ultimate objective of cost accounting is to maximize profits by ensuring optimal utilization of material, labor, machinery, financial resources, and management efforts, leading to improved overall organizational performance. BASIC TERMINOLOGY Cost: cost is a measurement in monetary terms of the amount of resources used for the purpose of production of goods or rendering services. In short, it is the amount of expenditure incurred on a giving thing. The amount of expenditure may be actual or notional. It represents the resources which have been or must be sacrificed to attain a particular objective. Sacrificed may be direct or indirect. Thus, cost is the amount of resources used for something, which must be able to be measured in terms of money. Costing: It is the technique and process of ascertaining cost. Technique: It refers to analyzing and presenting cost to management for planning, cost control and decision making. It refers to the body of principles and rules which are used for ascertaining the cost of manufacturing a product or the cost of rendering a service. Techniques Like Absorption Costing, Marginal Costing, Standard Costing, Budgetary Control & Uniform Costing.  Process: It refers to the allocation, apportionment and absorption of cost-by-cost unit. Cost Accounting: Application of accounting and costing principles methods and techniques in the ascertainment of costs and the analysis of savings and/or excesses as compared with previous experience or with standards. It refers to the process of accounting for costs. It begins with analyzing, classifying and allocating the expenditure for determining the cost of a product. It ends with the preparation of periodical statements and reports for management for planning, cost control and decision making. It refers to a formal mechanism or systematic procedure by means of which cost of production or services are computed. CIMA defines cost accounting as “The establishment of budgets, standard cost and actual costs of operations, processes, activities or products and the analysis of variances, profitability or the social use of funds.” Cost Accountancy: The application of costing and cost accounting principles, methods and technique to the science, art and practice of cost control and the ascertainment of profitability. It includes the presentation of information derived therefrom for the purpose of managerial decision making. Cost Management: Cost management refers to the process of planning and controlling an organization's expenses to ensure that resources are utilized efficiently and effectively to achieve its objectives. It is an essential aspect of financial management and business operations as it helps organizations optimize their spending, maintain profitability, and make informed decisions about resource allocation. COSTING METHODS Over many years, various Cost Accounting Methods have evolved to record the manufacturing costs to suit particular industries. It is the need for the organization to establish a suitable cost accounting system for their business to facilitate the recording and collection of costs; allocation; apportionment and absorption into products and services; analysis and control of costs etc. Whatever the costing method is used, the basic costing principles relating to collection, analysis, allocation, apportionment and absorption is used. The costing methods are broadly categorized into two: (1) Specific order costing, (2) Continuous operation costing. However, the multiple costing method covers application of more than one costing method. The classification of Costing Methods is shown in figure 1. Specific Order Costing Specific Order Costing Methods are used by business organizations which involve in make/assemble/construct or products to individual customers' specific orders. The Specific Order  Costing is further classified into jobs the following: Figure 1. Classification of Costing Methods Costing Methods Continuous Specific Order Multiple Operation Costing Costing Costing Contract Process Operation Service Job Costing Batch Costing Unit Costing Costing Costing Costing Costing Joint and By- product Costing Job Costing: It is applicable where work is undertaken to meet a customer's special requirements and each order is of comparatively short duration. The job costing method is applied in manufacturing concerns where production is carried on demand or order of customers such as machine tool manufacture, printing, general engineering etc. Contract Costing: It is applicable where there is an agreement between contractor and contracted for accomplishment of work or job, which refers to construction work, such as construction of building, bridge, road etc. The construction work is accepted to meet the special requirements of each individual customer and the work is expected to be continued for a long period. Another important feature is that construction work commenced on site and not at the premises of the contractor. Batch Costing: This method is suited in cases where a customer orders certain quantity of identical items or a batch of identical parts or products produced within a concern for replenishing stocks. Batch costing is suitable for industries like the pharmaceutical industry where medicines, injections etc. are prepared in batches, readymade garments etc. Continuous Operation Costing Where organizations which involve in mass production of products, through continuous operations, which will then be sold from stock and will not be produced to the specific requirements of the customers. The important feature of Continuous Operation Costing is that the process involves in production of identical units of output and total costs are divided by number of units produced to give the average cost per unit. The Continuous Operation Costing is classified into the following: Process Costing: It is used to ascertain the cost of each stage of manufacture where material is passed through various operations to obtain a final product or result with by-products in many cases at  different stages. This method is applicable to industries like chemicals, dairy, textiles, paper, sugar etc. Operation Costing: This method is a refinement over process costing as a manufacturing consists of distinct operations. It is therefore called detailed application of process costing. Under this method, costs are collected, accumulated, and ascertained for each of the operations in the manufacturing process separately. This method therefore provides detailed analysis of costs and ensures a high degree of accuracy and control. This method is suitable for industries like engineering, toy making etc. Process costing is used for continuous flow production of standardized products, while operation costing is used for custom-made or made-to-order products with varying specifications. Unit Costing: This method is also called 'single costing' or 'output costing’. It is applicable to the concerns where there is a production of single article on a large scale by a continuous process of manufacture and all the units produced are identical and homogeneous or only a few grades of similar articles. This method is adopted in industries like cement, steel, breweries, TV., radio etc. Service Costing: Service oriented undertakings use service costing for determining the unit and total cost of service provided. Service costing is applicable to the industries like hotels, hospitals, transport undertakings, power generation concerns, canteens etc. Specific Order Costing and Continuous Order Costing: Distinction The major difference between Specific Order Costing and Continuous Operation Costing is that in Specific Order Costing, materials and labour cost are able to directly charge to cost unit and overheads are allocated/apportioned to a cost centre before sharing the costs over cost units. In the case of Continuous Operation Costing, all costs like materials, labour and overheads are allocated or apportioned to cost centres from which these costs are averaged over the cost units produced. Multiple Costing: In case of a complex product, application of more than one costing method is necessary. Hence, it is called multiple costing or composite costing. For instance, up to a particular stage of production, process costing may have to be applied and for the rest of the production stage, job costing may have to be used. Manufacture of motorcar, airplane, television, video etc. provide good examples where multiple costing are to be used. Illustrations: Costing Method Examples Specific Order Costing Job Costing Custom-made furniture, Wedding invitations, Specialized machinery  Contract Costing Construction of a bridge, Building a shopping mall, Highway construction, Dam etc. Batch Costing Production of smartphones in batches, Bottling of beverages, Bakery products, Spare parts, Medicines, Biscuits, Readymade garments etc. Continuous Operation Costing Process Costing Oil refining, Production of paper, Chemical manufacturing, Production of paint, rubber, sugar, plastic, pharmaceutical products etc. Costing Method Examples Operation Assembly line production of automobiles, Manufacturing of electronic Costing devices, Engineering etc. Unit Costing Cement production, Steel manufacturing, Production of computer chips Service Costing Hospital services, Hotel services, Public transportation services, Powerhouse, Canteens, Cinema etc. COST SYSTEMS The important types of costing systems are discussed in brief as follows: Historical Costing: In this type of costing system, the costs are ascertained only after they have been incurred. The main objective of it is to ascertain costs that have been incurred in the past. It is the process of accumulation of costs after they are incurred in a systematic manner. The historical costs are used only for postmortem examination of actual costs incurred and it would be too late to control. The actual figures can be compared only when the standard of performance exists. Absorption Costing: Under the Absorption Costing System all fixed and variable costs are allotted to cost units and total overheads are absorbed according to activity level. In the Absorption Costing System, fixed manufacturing overheads are allocated to products, and these are included in stock valuation. Therefore, valuation of inventories of finished goods and WIP includes manufacturing fixed cost and transferred to next period. Unlike manufacturing fixed overhead, the administrative overhead, selling and distribution overheads are treated as fixed costs and recorded only when they are incurred. Direct Costing: It is a method of costing in which the product is charged with only those costs which vary with volume. Variable or direct costs such as direct material, direct labour and variable manufacturing expenses are examples of costs charged to the product. All indirect costs are charged to Profit and Loss Account of the period in which they arise. Indirect costs are disregarded in inventory valuation. Marginal Costing: Under Marginal Costing, costs are classified into fixed and variable costs. Variable costs are charged to unit cost and the fixed costs attributable to the relevant period is written-off in full against the contribution for that period. Contribution margin indicates the recovery of fixed cost before contributing towards the operational profit. This technique is widely used for internal management purpose for decision making rather than for external reporting. Standard Costing: Under the Standard Costing System, the ascertainment and use of standard costs  and the measurement and analysis of variances is done for control purpose. Standard cost is a predetermined cost which is computed in advance of production on the basis of a specification of all the factors affecting costs and used in Standard Costing. Its main purpose is to provide a base for control through Variance Accounting, for valuation of stock and work-in progress and, in some cases, for fixing selling prices. Uniform Costing: It is not a distinct method of costing. It is the adoption of identical costing principles and procedures by several units of the same industry or several undertakings by mutual agreement. It facilitates valid comparisons between organizations and helps in elimination of inefficiencies. COST ORGANIZATION AND ITS RELATIONSHIP WITH OTHER DEPARTMENTS Cost organization, also known as cost accounting organization, refers to the structure and framework within a company that is responsible for managing cost-related activities. Organization of Cost Accounting Department The organization of the cost accounting department depends upon the size of the concern. In a small and medium-sized concern, the cost accounting department may be set up as a section of the financial accounting system. The cost accountant who is in charge of the cost accounting department may be authorized to report to the chief accountant. In large-sized concern, a separate cost accounting department is established under the supervision of a full-fledged cost accountant. While important functions such as budgeting, cost analysis, etc. are performed by the cost accountant, cost recording, cost reporting and such other functions are performed by cost clerks. The cost accounting department may be organized either on the principle of centralization or decentralization. Under a centralized system, the functions of cost accounting departments relating to all firms belonging to the same industry are performed at a common central place. Under the decentralization system a separate cost accounting department is set up for each and every firm under the supervision of a competent cost accountant. Whatever may be the structure of the cost accounting department in a factory, it is established to serve the following purposes. The key responsibilities of the cost accounting department include: Cost Data Collection: Collecting data on all costs incurred by the company, including direct costs (e.g., raw materials, labor) and indirect costs (e.g., overhead expenses). Cost Analysis: Analyzing cost data to understand cost drivers, cost behavior, and cost trends within the organization. This analysis helps identify areas of inefficiency and opportunities for  cost reduction. Cost Allocation: Allocating indirect costs to products, services, or departments based on appropriate cost drivers. This ensures that costs are properly distributed and assigned to the responsible units. Cost Reporting: Preparing regular cost reports for management, which may include cost variance analysis, cost performance against budgets, and other relevant metrics. Budgeting and Forecasting: Assisting in the budgeting process by providing cost-related data and forecasts to aid in setting financial targets. Decision Support: Providing cost-related information to support various managerial decisions, such as pricing, make-or-buy choices, and resource allocation. Relationship with Other Departments: The cost accounting department has a crucial role in the organization, and it interacts with various other departments to fulfill its functions effectively. Some of the key relationships with other departments include: Production/Operations Department: The cost accounting department works closely with the production or operations department to track and analyze the costs associated with manufacturing goods or delivering services. This collaboration helps in understanding the cost structure and identifying opportunities for cost optimization. Procurement Department: The cost accounting department works with the procurement team to monitor the costs of raw materials and other supplies. Accurate cost data is essential for evaluating supplier performance and negotiating favorable contracts. Finance Department: The finance department and cost accounting department collaborate to ensure that cost data is accurately reflected in the financial statements. They work together to provide insights into cost-related financial metrics, such as cost of goods sold (COGS) and gross margin. Sales and Marketing Department: The cost accounting department may assist the sales and marketing teams in pricing decisions by providing cost data related to products and services. This helps in setting competitive prices while ensuring profitability. Public relation department: It establishes good relations with the public in general and customers, creditors, shareholders, and employees in particular. The cost department provides information concerning price, cost, etc. Legal department: It finds cost department helpful in keeping many affairs of the company in  conformity with the law, specially excise, customs, sales tax and other legislation regarding maintenance of accounts and cost records. Management: The cost accounting department directly supports management by providing them with critical cost-related information required for strategic planning, decision-making, and performance evaluation. INSTALLATION OF COST ACCOUNTING SYSTEM Cost accounting system is a system that accumulates costs, assigns them to cost objects and reports cost information. In addition to this, a proper cost accounting system assists management in the planning and control of the business operations as well as in analyzing product profitability. There are several other advantages of a well-defined costing system in an organization like generating information for decision making, supplying information to the management for internal control, detailed analysis of costs. However, it is necessary that the cost accounting system is properly installed in an organization. The essential elements of such a system is discussed in the previous section. The following factors should be taken into consideration while designing a costing system. 1. Size of the firm - Size of the firm is an extremely important factor in designing a cost accounting system. As the size of the firm and its business grows, the volume and complexity of the cost data also grows. In such situation, the cost accounting system should be capable of supplying such information. 2. Manufacturing Process - Process of manufacturer changes from industry to industry. In some industries, there may be a continuous process of production while in some batch or job type of production may be in operation. A cost accounting system should be such that the manufacturing process is taken into consideration and cost data is collected accordingly. 3. Nature and Number of Products - If a single product is produced, all costs like material, labour and indirect expenses can be directly allocated to that product. But if more than one product is manufactured, the question of allocation and apportionment as well as absorption of indirect expenses (Overheads) arises and hence the cost accounting system should be designed accordingly as more complex data will be required. 4. Management Control Needs - The designing of a cost accounting system in a business organization is guided by the management control requirements. The costing system should supply data to persons at different levels in the organization to take suitable action in their respective areas. 5. Raw Materials - The designing of a cost accounting system in a business is also guided by the raw materials required for the production. The nature of raw materials and the degree of waste  therein influence the designing of the costing system. There are some materials which have a high degree of spoilage. The costing system should be such that identification of spoilage, keeping records of materials, pricing of the issues etc. are taken into consideration. 6. Organization Structure - The structure of the organization also plays a vital role in designing a costing system. The system should correspond to the hierarchy of the organization. 7. External Factors - External factors are also important in the design of a costing system. For example, Cost Accounting Record Rules have been mandatory for certain types of industries. For the sake of compliance of the same, costing system should be designed.