What is cost accounting? Definition, Types and Facts



What is cost accounting? Definition, Types and Facts

Accounting can no longer be considered a mere language of business. The need for maintaining the financial chastity of business operations, ensuring the reliability of recorded experience resulting from these operations and conducting a frank appraisal of such experiences has made accounting a prime activity along with such other activities as marketing, production and finance. Accounting may be broadly classified into two categories – accounting which is meant to serve all parties external to the operating responsibility of the firms and the accounting, which is designed to serve internal parties to take care of the operational needs of the firm.

The first category, which is conventionally referred to as “financial accounting”, looks to the interest of those who have primarily a financial stake in the organization’s affairs – creditors, investors, employees etc. On the other hand, the second category of accounting is primarily concerned with providing information relating to the conduct of the various aspects of a business like cost or profit associated with some portions of business operations to the internal parties’ viz., management.

This category of accounting is divided into “management accounting” and “cost accounting”. This section deals with cost accounting.

Cost: Cost is a foregoing, measured in monetary terms, incurred or potentially to be incurred to achieve a specific objective. Cost can be termed as the amount of resources given up in exchange for some goods or services.

Costing: The technique and process of ascertaining costs is known as Costing.

Cost Accountancy: Cost Accountancy includes, Costing and Cost Accounting. Cost Accountancy is the application of costing and cost accounting principles, methods and techniques to the science, art and practice of cost control and the ascertainment of profitability.

Read on: Cost:Meaning, Types and Importance

Read on:  What are the different types of Cost Accounting? (Overview)

Meaning of Cost Accounting

Cost accounting developed as an advanced phase of accounting science and is trying to make up the deficiencies of financial accounts. It is essentially a creation of the twentieth century.

Cost accounting accounts for the costs of a product, a service or an operation. It is concerned with actual costs incurred and the estimation of future costs. Cost accounting is a conscious and rational procedure used by accountants for accumulating costs and relating such costs to specific products or departments for effective management action. Cost accounting through its marginal costing technique helps the management in profit planning and through it’s another technique i.e. standard costing facilitates cost control. In short, cost accounting is a management information system which analyses past, present and future data to provide the basis for managerial decision making.

Read on: Cost:Meaning, Types and Importance

Read on:  What are the different types of Cost Accounting? (Overview)

Nature and Characteristics of Cost Accounting

The nature and main characteristics of cost accounting are as follows:

(i) Specialized Branch of Accounting: Cost accounting is a specialized branch of accounting which covers collection, classification, recording, apportionment, determination and control of cost. Though it is based on double entry system but has its own concepts and conventions also.

(ii) Art and Science Both: Cost accounting is a science because it has its own principles and rules, which are followed on regular basis and in a systematic manner. It is also an art because its principles and techniques are used in solving the business problems through cost data.

(iii) Recognized as a Profession: As cost accounting is a specialized branch of knowledge, it is recognized as a profession also. The Institute of Cost and Works Accountants of India provides Professional assistance to cost accountants and frames the rules for their professional and approach.

(iv) Determination of various Components of Total Cost: It ascertains cost of products and services through the process of accumulation, classification, analysis and recording.

The elements of cost include

(a) material

(b) labour

(c) expenses.

The main function of this system is to determine total cost and cost per unit. It also determines the cost of incomplete work or job in case if the work remains uncompleted.

(v) Application of Statistical Data of Computing Profit and Cost: The extensive use of system involves application of statistical data, control methods and techniques and determining profitability. The statistical data are helpful in preparation of cost sheet, cost statement, various cost accounts and are used for the purpose of cost comparison.

(vi) Helpful to Management: This system provides information and measures for control and guidance for various levels of management.

Read on:  What are the different types of Cost Accounting? (Overview)


Types of Costs

1. Fixed costs are costs that don't vary depending on the level of production. These are usually things like the mortgage or lease payment on a building or a piece of equipment that is depreciated at a fixed monthly rate. An increase or decrease in production levels would cause no change in these costs.

2. Variable costs are costs tied to a company's level of production. For example, a floral shop ramping up its floral arrangement inventory for Valentine's Day will incur higher costs when it purchases an increased number of flowers from the local nursery or garden center.

3. Operating costs are costs associated with the day-to-day operations of a business. These costs can be either fixed or variable depending on the unique situation.

4. Direct costs are costs specifically related to producing a product. If a coffee roaster spends five hours roasting coffee, the direct costs of the finished product include the labor hours of the roaster and the cost of the coffee beans.

5. Indirect costs are costs that cannot be directly linked to a product. In the coffee roaster example, the energy cost to heat the roaster would be indirect because it is inexact and difficult to trace to individual products.

Read on: Cost:Meaning, Types and Importance

Read on:  What are the different types of Cost Accounting? (Overview)


Scope of Cost Accounting

The scope of cost accounting is very broad. An organization having an effective cost accounting system helps the management in performance of their responsibilities in an efficient and effective manner. In brief, cost accounting covers the following aspects:

a. Classification of Cost: The cost classification is the process of grouping costs according to their characteristics. In this context the cost can be classified according to elements, functions, nature, controllability, normality and relevance to decision-making.

b. Cost Recording: After cost classification, cost transactions are recorded in various ledger accounts.

c. Cost Allocation: It includes allotment of whole items of cost to cost centres or cost units according to pre-determined basis.

d. Cost Determination: It is also called as „cost measurement‟ and it means computation of cost of individual products, services, departments or other segments of an enterprises. It can be done by preparing cost sheet or statement of cost. Production account can also be prepared for this purpose.

e. Cost Control: It is an important aspect of cost accounting and for this purpose various techniques such as standard costing, budgetary control, inventory control, quality control, etc. can be adopted.

f. Cost Comparison: It refers to comparison of current cost with previous cost or cost of similar other concerns.

g. Cost Reporting: It means communication of cost data on regular basis which may be used by management for decision-making or which are made available to government or some outside agencies.

h. Cost Reduction: It means permanent and genuine reduction in per unit cost of produced or services rendered.

i. Cost Analysis: It involves the estimation of relationship between costs and various determinants of costs.

j. Cost Audit: It means an examination of the appropriateness of the cost accounting system adopted by the business and effectiveness of its implementation.

Read on:  What are the different types of Cost Accounting? (Overview)


Function of Cost Accounting

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

a. 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 analyzed. It not only determines the cost at completion stage but also determines cost at various stages of production.

b. Cost control: Cost control is one of the important functions of cost accounting. To measure the efficiency of the organization 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 actual performances. The variances arising out of the comparison so made tell the tale whether the cost is within control or not.

c. 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 organizations 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 wastage, innovation marketing strategies, purchasing and material control etc.

d. 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 profit abilities. Difference is analyzed and efforts are made to earn the maximum profit as per capacity.

e. 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.

f. Providing a basis for business policy and decision-making: The objective of cost accounting 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 of heavy repairs, etc.

g. 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.

Cost Centre- Any unit of cost accounting selected with a view to accumulating all cost under that unit is known as Cost Centre. The unit may be a product, service, division, department, section, a group of plant and machinery, a group of employees of several units. E.g. production department, service department.

Classification of Cost Centre- Process cost center, Production cost center, Service cost centre, Impersonal cost center, Personal cost centre and Operation cost centre.

Distinction between Financial Accounting and Cost Accounting

Though there is much common ground between financial accounting and cost accounting and though in fact cost accounting is an outgrowth of financial accounting yet the emphasis differs.

Firstly financial accounting is more attached with reporting the results of business to persons other than internal management – government, creditors, investors, researchers, etc. Cost accounting is an internal reporting system for an organization’s own management for decision making.

Secondly financial accounting data is historical in nature and its periodicity of reporting is much wider. Cost accounting is more concerned with short-term planning and its reporting period much lesser than financial accounting. It not only deals with historic data but also is futuristic in approach. Thirdly, in financial accounting the major emphasis in cost classification is based on the type of transaction e.g. Salaries, repairs, insurance, stores, etc. But in cost accounting the major emphasis is on functions, activities, products, processes and on internal planning and control and information needs of the organisation.


Utility of Cost Accounting

A properly installed cost accounting system will help the management in the following ways:

1- The analysis of profitability of individual products, services or jobs.

2- The analysis of profitability of different departments or operations.

3- It locates differences between actual results and expected results.

4- It will assist in setting the prices so as to cover costs and generate an acceptable level of profit.

5- Cost accounting data generally serves as a base to which the tools and techniques of management accounting can be applied to make it more purposeful and management oriented.

6- The effect on profits of increase or decrease in output or shutdown of a product line or department can be analyzed by adoption of efficient cost accounting system.


Distinction between Costing and Cost Accounting

Costing is the technique and process of ascertaining costs. It tries to find out the cost of doing something, i.e., the cost of manufacturing an article, rendering a service, or performing a function. Cost accounting is a broader term, in that it tries to determine the costs through a formal system of accounting (unlike costing which can be performed even through informal means). Stated precisely, cost accounting is a formal mechanism by means of which costs of products and services are ascertained and controlled. The institute of cost and management accountants, U.K. defines cost accounting as: the 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, thus, includes three things:

1. Cost Ascertainment: finding out the specific and precise total and unit costs of products and services.

2. Cost Presentation: reporting cost data to various levels of management with a view to facilitate decision making.

3. Cost Control: this consists of estimating costs for production and activities for the future, and keeping them within proper limits. Budgets and standards are employed for this purpose.

Cost accounting also aims at cost reduction, i.e., achieving a permanent and real reduction in cost by improving the standards. Cost accountancy is a comprehensive term that implies the `application of costing and cost accounting principles, methods and techniques to the science, art and practice of cost control‟. It seeks to control costs and ascertain the profitability of business operations.

Classification of Cost In the process of cost accounting, costs are arranged and rearranged in various classifications. The term „classification‟ refers to the process of grouping costs according to their common characteristics. The different bases of cost classification are:

1. by nature or elements (materials, labour and overheads)

2. by time (historical, pre-determined)

3. by traceability to the product (direct, indirect)

4. by association with the product (product, period)

5. by changes in activity or volume (fixed, variable, semi-variable)

6. by function (manufacturing, administrative, selling, research and development, preproduction)

7. by relationship with the accounting period (capital, revenue)

8. by controllability (controllable, non-controllable)

9. By analytical/decision-making purpose (opportunity, sunk, differential, joint, common, imputed, out-of-pocket, marginal, uniform, replacement)

10. by other reasons (conversion, traceable, normal, avoidable, unavoidable, and total).


Elements of Cost

The elements of costs are the essential part of the cost.

There are broadly three elements of cost, as explained below:

(A) Material

The substance from which the produce is made is called material. It can be direct as well as indirect.

I) Direct Material: it refers to those materials which become an integral part of the final product and can be easily traceable to specific physical units. Direct materials, thus, include:

1. All materials specifically purchased for a particular job or process.

2. Components purchased or produced.

3. Primary packing materials (e.g., carton, wrapping, card-board boxes etc.).

4. Material passing from one process to another.

II) Indirect Material: all materials which are used for purpose ancillary to the business and which cannot conveniently be assigned to specific physical units are known as `indirect materials‟. Oil, grease, consumable stores, printing and stationery material etc. are a few examples of indirect


(B) Labour

In order to convert materials into finished products, human effort is required. Such human effort

is known as labour. Labour can be direct as well as indirect.

I) Direct Labour: It is defined as the wages paid to workers who are engaged in the production process and whose time can be conveniently and economically traceable to specific physical units. When a concern does not produce but instead renders a service, the term direct labour or wages refers to the cost of wages paid to those who directly carry out the service, e.g., wages paid to driver, conductor etc. Of a bus in transport service.

II) Indirect Labour: Labour employed for the purpose of carrying out tasks Incidental to goods produced or services provided is called indirect labour or indirect wages. In short, wages which cannot be directly identified with a job, process or operation, are generally treated as indirect wages. Examples of indirect labour are: wages of store-keepers, foremen, supervisors, inspectors, internal transport men etc.

(C) Expenses

Expenses may be direct or indirect.

I) Direct Expenses: These are expenses which can be directly, conveniently and wholly identifiable with a job, process or operation. Direct expenses are also known as chargeable expenses or productive expenses. Examples of such expenses are: cost of special layout, design or drawings, hire of special machinery required for a particular contract, maintenance cost of special tools needed for a contract job, etc.

II) Indirect Expenses: Expenses which cannot be charged to production directly and which are neither indirect materials nor indirect wages are known as indirect expenses. Examples are rent, rates and taxes, insurance, depreciation, repairs and maintenance, power, lighting and heating etc.

The above elements of cost may be shown as follows:

Element of cost

a. Direct/indirect Materials

b. Direct/indirect labour

c. Direct/indirect expenses

1. Overheads

The term overheads includes, indirect material, indirect labour and indirect expenses, explained in the preceding paragraphs. Overheads may be incurred in the factory, office or selling and distribution departments/ divisions in an undertaking.

Thus overheads may be of three types: factory overheads, office and administrative overheads and selling and distribution overheads.

This classification of overheads may be shown thus:

Classification of Overheads


Direct Overheads

Factory Overheads - Indirect

Office Overheads - Indirect

Selling and distribution Overheads - Indirect

2. Cost Classification by Time

On the basis of the time of computing costs, they can be classified into historical and predetermined costs.

I) Historical Costs: These costs are computed after they are incurred. Such costs are available only after the production of a particular thing is over.

II) Pre-Determined Costs: These costs are computed in advance of production on the basis of a specification of all factors influencing cost. Such costs may be:

1. Estimated costs: estimated costs are based on a lot of guess work. They try to ascertain what the costs will be based on certain factors. They are less accurate as only past experience is taken into account primarily, while computing them.

2. Standard costs: standard costs is a pre-determined cost based on a technical estimate for material, labour and other expenses for a selected period of time and for a prescribed set of working conditions. It is more scientific in nature and the object is to find out what the costs should be.

3. Cost Classification by Traceability

As explained previously, costs which can be easily traceable to a product are called direct costs. Indirect costs cannot be traced to a product or activity. They are common to several products (e.g., salary of a factory manager, supervisor etc.) And they have to be apportioned to different products on some suitable basis. Indirect costs are also called `overheads‟.

4. Cost Classification by Association with Product

Costs can also be classified (on the basis of their association with products) as product costs and period costs.

1. Product Costs: product costs are traceable to the product and include direct material, direct labour and manufacturing overheads. In other words, product cost is equivalent to factory cost.

2. Period Costs: period costs are charged to the period in which they are incurred and are treated as expenses. They are incurred on the basis of time, e.g., rent, salaries, insurance etc. They cannot be directly assigned to a product, as they are incurred for several products at a time (generally).

5. Cost Classification by Activity/Volume

Costs are also classified into fixed, variable and semi-variable on the basis of variability of cost in the volume of production.

1. Fixed Cost: Fixed cost is a cost which tends to be unaffected by variations in volume of output. Fixed cost mainly depends on the passage of time and does not vary directly with the volume of output. It is also called period cost, e.g., rent, insurance, depreciation of buildings etc. It must be noted here that fixed costs remain fixed up to a certain level only. These costs may also vary after a certain production level.

2. Semi-Variable Cost: These costs are partly fixed and partly variable. Because of the variable element, they fluctuate with volume and because of the fixed element; they do not change in direct proportion to output. Semi-variable or semi-fixed costs change in the same direction as that of the output but not in the same proportion. For example, the expenditure on maintenance is to a great extent fixed if the output does not change significantly. Where, however, the production rises beyond a certain limit, further expenditure on maintenance will be necessary although the increase in the expenditure will not be in proportion to the rise in output. Other examples in this regard are: depreciation, telephone rent, repairs etc.

3. Variable Cost: Cost which tends to vary directly with volume of outputs is called `variable cost‟. It is a direct cost. It includes direct material, direct labour, direct expenses etc. It should be noted here that the variable cost per unit is constant but the total cost changes corresponding to the levels of output. It is always expressed in terms of units, not in terms of time.

6. Cost Classification by Function

On the basis of the functions carried out in a manufacturing concern, Costs can be classified into four categories:

1. Manufacturing/Production Cost: it is the cost of operating the manufacturing division of an enterprise. It is defined as the cost of the sequence of operations which begin with supplying materials, services and ends with the primary packing of the product.

2. Administrative/Office Cost: it is the cost of formulating the policy, directing the organization and controlling the operations of an undertaking, which is not directly related to production, selling, distribution, research or development. Administration cost, thus, includes all office expenses: remuneration paid to managers, directors, legal expenses, depreciation of office premises etc.

3. Selling Cost: selling cost is the cost of seeking to create and stimulate demand e.g., advertisements, show room expenses, sales promotion expenses, discounts to distributors, free repair and servicing expenses, etc.

4. Distribution Cost: it is the cost of the sequence of operations which begins with making the packed product, available for despatch and ends with making the reconditioned returned empty package, if any, available for re-use. Thus, distribution cost includes all those expenses concerned with dispatching and delivering finished products to customers, e.g., warehouse rent, depreciation of delivery vehicles, special packing, loading expenses, carriage outward, salaries of dispatch clerks, repairing of empties for re-use, etc.

5. Research and Development Cost: It is the cost of discovering new ideas, processes, and products by experiment and implementing such results on a commercial basis.

6. Pre-Production Cost: Expenses incurred before a factory is started and expenses involved in introducing a new product are preproduction costs. They are treated as deferred revenue expenditure and charged to the cost of future production on some suitable basis.

7. Cost Classification by Relationship with Controllability

On the basis of controllability, costs can be classified as controllable or uncontrollable.

1. Controllable Cost: A cost which can be influenced by the action of a specified member of an undertaking is a controllable cost, e.g., direct materials, direct labour etc.

2. Uncontrollable Cost: A cost which cannot be influenced by the action of a specified member of an undertaking is an uncontrollable cost, e.g., rent, rates, taxes, salary, insurance etc. The term controllable cost is often used in relation to variable cost and the term uncontrollable cost in relation to fixed cost. It should be noted here that a controllable cost can be controlled by a person at a given organization level only. Sometimes two or more individuals may be involved in controlling such a cost.

8. Cost Classification by Decision-Making Purpose

Costs may be classified on the basis of decision-making purposes for which they are put to use, in the following ways:

1. Opportunity Cost: It is the value of the benefit sacrificed in favour of choosing a particular alternative or action. It is the cost of the best alternative foregone. If an owned building, for example, is proposed to be used for a new project, the likely revenue which the building could fetch, when rented out, is the opportunity cost which should be considered while evaluating the profitability of the project.

2. Sunk Cost: A cost which was incurred or sunk in the past and is not relevant for decision making is a sunk cost. It is only historical in nature and is irrelevant for decision-making. It may also be defined as the difference between the purchase price of an asset and its salvage value.

3. Differential Cost: The difference in total costs between two alternatives is called as differential cost. In case the choice of an alternative results in increase in total cost, such increase in costs is called `incremental cost‟. If the choice results in decrease in total costs, the resulting decrease is known as decremental cost.

4. Joint Cost: Whenever two or more products are produced out of one and the same raw material or process, the cost of material purchased and the processing are called joint costs. Technically speaking, joint cost is that cost which is common to the processing of joint products or byproducts upto the point of split-off or separation.

5. Common Cost: Common cost is a cost which is incurred for more than one product, job territory or any other specific costing object. It cannot be treated to individual products and, hence, apportioned on some suitable basis.

6. Imputed Cost: This type of cost is neither spent nor recorded in the books of account. These costs are not actually incurred (hence known as hypothetical or notional costs) but are considered while making a decision. For example, in accounting, interest and rent are recognized only as expenditure when they are actually paid. But in costing, they are charged on a notional basis while ascertaining the cost of a product.

7. Out-Of-Pocket Cost: It is the cost which involves current or future expenditure outlay, based on managerial decisions. For example a company has its own trucks for transporting goods from one place to another. It seeks to replace these by employing public carriers of goods. While making this decision, management can ignore depreciation, but not the out-of-pocket costs in the present situation, i.e., fuel, salary to drivers and maintenance paid in cash.

8. Marginal Cost: It is the aggregate of variable costs, i.e., prime cost plus variable overheads.

9. Replacement Cost: It is the cost of replacing a material or asset in the current market.


How does cost accounting differ from traditional accounting methods?

In contrast to general accounting or financial accounting, the cost accounting method is an internally-focused, firm-specific system used to implement cost controls. Cost accounting can be much more flexible and specific, particularly when it comes to the subdivision of costs and inventory valuation. Cost accounting methods and techniques will vary from firm to firm and can become quite complex.

Why is cost accounting used?

Cost accounting is helpful because it can identify where a company is spending its money, how much it earns, and where money is being lost. Cost accounting aims to report, analyze, and lead to the improvement of internal cost controls and efficiency. Even though companies cannot use cost accounting figures in their financial statements or for tax purposes, they are crucial for internal controls.

What types of costs go into cost accounting?

These will vary from industry to industry and firm to firm, however certain cost categories will typically be included (some of which may overlap), such as: direct costs; indirect costs; variable costs; fixed costs; and operating costs.

What are some advantages of cost accounting?

Since cost accounting methods are developed by and tailored to a specific firm, they are highly customizable and adaptable. Managers appreciate cost accounting because it can be adapted, tinkered with, and implemented according to the changing needs of the business. Unlike the Financial Accounting Standards Board (FASB)-driven financial accounting, cost accounting need only concern itself with insider eyes and internal purposes. Management can analyze information based on criteria that it specifically values, which guides how prices are set, resources are distributed, capital is raised, and risks are assumed. 

What are some drawbacks of cost accounting?

Cost accounting systems and the techniques that are used with them can have a high start-up cost to develop and implement. Training accounting staff and managers on esoteric and often complex systems takes time and effort, and mistakes may be made early on. Higher-skilled accountants and auditors are likely to charge more for their services when evaluating a cost accounting system than a standardized one like GAAP.

Read on: Cost:Meaning, Types and Importance



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