Introduction to Cost Accounting Contents

NATURE AND FUNCTIONS OF COST ACCOUNTING

 What Is “Cost Accounting”?

The Chartered Institute of Management Accountants, in its publication, “Terminology of Management and Financial Accountancy”, defines cost accounting as:

“…. that part of management accounting which establishes budgets and standard costs, and the actual costs of operations, processes, departments or products and the analysis of variances, profitability or social use of funds.”

This involves participation in and with management to ensure that there is effective:

  • Formulation of plans to meet objectives (long-term planning)
  • Formulation of short-term operation plans (budgeting/profit planning) Corrective action to bring future actual transactions into line (financial control) • Recording of actual transactions.

What Cost Accounting Provides for the Organisation

 Additional Financial Information

When cost accounting was first used, its main purpose was to provide additional information concerning the financial operations of an organisation.  For the majority of firms, this is still considered as its main purpose.  It usually implies historical costing and the production of regular detailed statements and statistics.

 Control Information

A more modern concept of cost accounting is that its purpose is to assist management by providing them with control information.

This usually demands more from the cost accountant.  He or she will still produce statistical statements, but will be required to analyse and interpret these statements.  Comparisons will be made with “budgets” and “standards”, and the cost accountant will probably use the exception system of reporting, advising management only where action is required.

 Management Tool

Cost accounting has often been likened to a tool in the hands of management.  Consider what this means:

  • It must be the right tool. The cost accountant, in consultation with management, must agree what information is required and when; the cost of providing it will also have to be taken into consideration.  The question must also be asked, is complete accuracy necessary?  Will an approximation within given limits be of more value, if it can be provided swiftly?

Any system of costing must be tailored to suit the organisation which it serves.  In many cases simple historical cost accounting will be sufficient; in others a more sophisticated system may be necessary.

 

  • The tool must be capable of doing the job. The cost accountant must ensure that the facts and figures produced provide management with the information they require, in an easily assimilated form.

 

Do not forget that manufacturing conditions and markets will change over the years, and the cost accounting system may need to be adapted to suit changing needs.  A new system may need to be designed and introduced.

 

  • It is management who use the tool, and the extent of its success will depend upon the degree of efficiency with which it is used.

Objects of a Cost Accounting System

Different firms will use cost accounting for different purposes.  Nevertheless, every system will involve some of the objectives listed below.

 Cost Control

This will be assisted by:

  • Finding out the cost of each product (or service), process and department – costs must be ascertained in phase with manufacturing activity, enabling remedial action to be taken quickly when it is required.
  • Comparing the costs with budget, standard or past performance figures to indicate the degree of efficiency attained.
  • Analysing the variances from budget and identifying the person or department responsible so that prompt, remedial action may be taken.
  • Disclosing to what extent production facilities are used and indicating the amount and cost of idle and waiting time.
  • Presenting the information suitably to management, in such a form as to guide them in taking any necessary action.

Advice to Management in the Formulation of Policy This will include:

  • Provision of information to assist in the regulation of production and the systematic control of the organisation.
  • Provision of special investigations and reports. These might deal with such matters as:

−       Whether to manufacture a part or to sub-contract another firm.

−          The advisability of installing new machinery. −          The effect of increased or reduced production volumes on profitability.

 Advice on the Effects of Management Policy

This will be disclosed through reports (both regular reports and those following special investigations).

 Estimating and Price Fixing

Figures will be provided from standards or past results as the basis for future estimates.

Cost is an important factor in price fixing, but it is not the only one.  Demand and competitive activity are also crucial.  Therefore a firm’s profitability may depend largely on its ability to control costs in ways described in (a) above.

 COST ACCOUNTING COMPARED WITH FINANCIAL ACCOUNTING

You will be familiar already with the end-products of financial accounting, namely the balance sheet and the profit and loss account.  These are valuable documents for management, the first giving the position of a company or firm at a specific time, the second showing the results of the company’s operations over a specific period of time.  The books of account from which the profit and loss account and balance sheet are derived are also of value, since they provide a record of every transaction.

Despite the value of the financial accounts, it was their inadequacy which gave rise to the introduction of costing and the development of costing techniques.  The financial accounts show primarily external transactions (sales, purchases, borrowing, etc.) and the profit for the organisation as a whole.  Management requires detailed knowledge of the cost of each product or unit, of each department or process to show how the profit was built up and the relative profitability of each section of the business.  Cost accounting has now become an essential factor of every business.

It is of interest that in recent years “integrated accounts” (see later in this study unit) have grown in popularity.  Integrated accounts are merely the combining of the financial and cost accounts into one set of books.  We seem to have come full circle, from the separation of the financial and cost accounts, through the development of costing, to the joining together of the two systems into one integral system.  Of course, in many businesses increasing computerisation has assisted this development.

THE ROLE OF COST ACCOUNTING IN A MANAGEMENT INFORMATION SYSTEM

Product Analysis

Only the very simplest form of organisation does not need a cost accounting system, and even in this case some “cost accounting” would be done, but the simplicity of the business renders a special system unnecessary.

In a more complex organisation, results can be analysed in depth.  The cost of each process or operation which goes to make up the final product can be ascertained, as can the cost of the various “service” departments (stores, tool room, power house, etc.).

Investigating Costs

The cost accountant would not be satisfied merely to ascertain the figures, however.  Perhaps costs can be reduced, and/or revenues, and/or production increased.

The cost accountant will consult the sales manager.  It may be that increases in price will result in a decrease in sales.  Moreover, financial considerations are not the only ones to be borne in mind.

By pursuing such enquiries, the cost accountant is achieving the second function of costing, that is, cost control.  It should be stated here that it is not the cost accountant’s job to make executive decisions, but merely to express the management’s policy in terms of money, and to indicate where efficiency may be increased.

Guiding Management Policy

A most important side to the cost accountant’s work is providing information to management at all levels.  His or her job is to advise management of the financial effects of alternative policies.  He or she is an adviser only; it is for the manager to make policy decisions.  Thus the cost accounting system will justify itself only when the information it produces is used by management.  (Management accountants are part of “Management” and make use of both cost accounting information and financial accounting information for their involvement in management decisions.)

Non-Financial Considerations

Clearly therefore, before management can make decisions, they require information on which to arrive at the decisions and cost accounting information is one part of the required information.  Other matters need to be considered which are frequently of a non-financial nature, however.  These might include:

  • position in the market;
  • environmental considerations;
  • legal constraints;
  • staff qualifications and training needs
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