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Cost accounting: Detailed explanation.

Cost Accounting

Cost accounting refers to a branch of accounting and it is used by business organisations for ages. This particular branch of accounting is the best way for every kind of non-profit and profit making organisations to track their costs and the activities for which such costs are incurred by them.

Cost accounting uses to deal with the evaluation of the cost of a product or service a company offered. It computes the cost of a product or service by considering every factor contributing to the process of producing such product or service which include the factor related to manufacturing or production and administrative.

Cost accounting system is aimed to help a company’s management to fix up the final price of a product or service it produces and to control the cost associated with the production of such product or service. Moreover, it pinpoints every sort of wastage, defects, and leakages during a company’s manufacturing process as well as its marketing processes.

Cost accounting is a highly significant and advantageous companion of traditional financial accounting system. This accounting system involves the establishment of actual cost or standard cost of operations, different types of budgets along with classification, recording, and allocation of business related expenditure.

Origin

Before the emergence of industrial revolution, business organisations were small in size and they are characterized by simple exchanges between organizations and individuals. In that period of time, accurate bookkeeping was needed but cost accounting was not so much vital. Over the years businesses become complex due to their distinct operating activities which evoked the need for cost accounting.

The industrial revolution age has resulted in the development of large scale organisations and businesses and these organisations were much dynamic and complex than previous. Such dynamic and complex nature of businesses instigated the invention of a new brand of accounting which is called cost accounting.

So the concept of cost accounting originated and evolved due to the industrial revolution to help businessmen to track their business related expenses and costs by keeping a record for the same. Prior to the golden era of industrialization, costs and expenses of a business are categorized as variable costs which include cost of material, labor, overhead and other variable costs.

However, at the time when industrialization came into existence, businesses had a number of ‘fixed costs’ that are not directly associated with the manufacturing or production of products or services. These fixed costs consist of expenses related to rent, storage costs, depreciation, insurance cost and more. As steel industry, railroads and some other large industries were developed, the understanding of the fixed costs of businesses became vital.

Allocation of these fixed costs became significant to the business owners and managers for their business oriented decision making, product development, and pricing. Such increasing importance of understanding fixed costs, allocating the same in an appropriate manner, and considering these cost elements in decision making have originated the concept of modern cost accounting.

Evolution

In today’s world, the business environment becomes very dynamic as well as complex. A company must have the ability to navigate the complex business factors that arise from the external business environment as the threat of new entrants, competition, uncertainty, risks, and some other uncontrollable external factors. All these external business environment factors create complexities and difficulties for companies to continue their business operations smoothly and to expand their business.

Before the industrial revolution, when the organisations were small in size and scale, the external business environment was not that much complex as it is now. In order to conduct business operation successfully by mitigating all the complex external factors effectively, the modern business organisations require lots of processes and input which invoked the idea of cost accounting to come into existence.

Over the times and as per the increasing complexities in business activities, only conventional financial accounting becomes insufficient for effective management of large and medium scale organisations. The need for improving the management system and business activities of large and medium size companies has provoked the evolution of cost accounting system. In the past few decades, this newly evolved branch of accounting has come through rapid growth and evolution in the present business world.

A number of new techniques and procedures were developed in order to refine the cost accounting system and to make it most useful for companies. The main idea behind the development of cost accounting system was to refuse the backlogs of the conventional accounting system i.e. financial accounting system. Financial accounting is not able to enhance a company’s efficiency and cost control system. Thus, for enhancing operational efficiency of companies, and improving their cost control mechanism cost accounting system developed. With time some scientific methods and standards are formulated to increase the effectiveness and usefulness of cost accounting system.

Definition and Objectives

Cost accounting is an accounting process which is for recording all types of costs incurred by a company or organisation for conducting their business operations in such a way which can assist in improving its management. It is a process of collecting, classifying, recording, analysing, summarising, and then, allocation of costs those areassociated with the operational processes of an organisation, and then developing a set of actions for controlling those costs.

It is a method of accounting that aims towards capturing the costs of a company’s production process by assessing the input costs related to each step of the company’s production process and fixed costs like depreciation of tangible assets, amortisation of intangible assets. With the application of cost accounting mechanism, a company become able to measure different types of costs first and then record them individually and after that compare between the input and output (actual) results to aid its management to measure its financial performance.

This particular accounting concept is involved with the determination of costs of production (products), processes, projects, and more for reporting the same in the financial statements of a company with correct amounts. It also involved in assisting a company’s management in its planning and controlling and preparing specific and relevant financial analyses which assist in decision making in the best manner.

A vital part of this accounting system involves unit cost of products for reporting the COGS (cost of goods sold) of the manufacturer’s income statement and inventory cost in the balance sheet. Cost accounting uses to assist management to set business plans as well as to control the entire business through preparing budgets for operations, transfer pricing, standard costing, and reporting on variance, etc.

It also helps the management in preparing capital budget for the company in relation to business expansion. It includes some special analyses like cost behaviour analysis, CVP (cost-volume-profit) analysis, decisions related to make or buy, final selling prices of products, and more. The root of cost accounting system is found in manufacturing companies though it has extended its arms to service providing companies also.

For instance, a bank uses cost accounting for determining the processing cost associated with its customers’ deposits and/or checks, cost of maintaining the account, servicing costs related to mortgage loans, processing cost for international or domestic fund transfers and more. This, in turn, provides guidance to the management of the bank in setting the proper price for the various services it provides to the customers or clients.

The objectives of the cost accounting system are to ascertain per unit cost of different types of products a manufacturing company uses to manufacture, to provide correct cost analysis of business operations along with different cost elements in relation to the regular operating activities of a business concern. It is also aimed to disclose the sources of production related wastages such as wastage of raw materials, time, and fund.

All the production and distribution related wastages from raw material purchase to placing the final product to market are required to be analysed by every manufacturing company and cost accounting system is the best option to do so. Another objective of cost accounting system is to provide requisite data and information to the management of a company as guidance to set the best possible price for the final product.

Furthermore, this particular accounting system’s another objective is to ascertain profitability attached to each product and service produced by a company and advise the management regarding the way to maximise such profitability.

Advantages of cost accounting

The process of cost accounting led a company to collect and interpret information for determining how it earns and utilizes funds while conducting its regular business operations. This accounting system provides lots of actionable information in comparison to the financial accounting system. The advantages a company uses to get for using cost accounting system are as follows:

Advantages of Cost Accounting

Helpful in price fixation

In some cases, a company is capable of fixing up the final price for the products it tends to sell in the market as per the cost incurred for producing such products. Here, it becomes difficult to fix a product’s final price properly if proper cost figures are unavailable. If the final price of a product is fixed without using proper costing information, then quoted or final price of such product might be too low or high compared to the actual production cost of that product.

If the final price of a product stands higher than the production cost then a company losses its customers and of it stands lower than production cost then the company faces loss. Cost accounting system reveals the exact price to be charged from customers that would be profitable for the manufacturing company. Manufacturing companies using cost accounting system used to get accurate information about the costs incurred for manufacturing a product or service they deliver to customers.

Detect profitable as well as unprofitable business activities

This accounting system detects profit generating business activities that are required to be continued by a company to stay profitable in the market. Besides this, it also detects the unprofitable or loss making business activities of a company that is responsible for creating negative pressure on the company’s profitability and helps the management to eliminate such activities.

Guide in price reduction

In some situations like slump or depression, it becomes very important for a company to reduce the final price of its products, even below the products’ actual total cost. In this situation, properly ascertained costs guide the management of a company to reduce the final price of products to cope up with the situation

Adaptable in nature

Managers use to appreciate the cost accounting system because it is easy to adapt, and implemented in accordance with the changing needs and demands of a business. Unlike the static financial accounting system, driven by the Financial Accounting Standards Board (FASB), the cost accounting system is only concerned with internal purposes and internal eyes of a company’s management board.

Assist in proper planning and decision making

Cost accounting system helps the management to set financial budgets, conduct variance analysis both of which are very important for making proper business plans. It facilitates the management by providing them detailed information regarding available labour and machine capacity and in this way it helps in setting proper work plan so that no department remains idle or no one is overworked. It assists in preparing annual financial budget and capital budget which are very significant for proper fund allocation and business expansion. It guides management to make decisions regarding the use of labour and machine for production by indicating the profitability of using both of these of any one of these for production

Assist in controlling expenditure

Cost accounting is useful for controlling expenditure as it helps to measure every single cost related to production and detects excess expenditure. By indicating the unprofitable business activities this system of accounting helps management to eliminate those actions or modify the same to transform it into profitable actions. Timely detection of unprofitable activities helps to control overall cost of production from getting increased.

Ease labour costs monitoring and controlling

Labour costs of a company are easy to monitor as well as control if a company applies cost accounting system. Proper monitoring and controlling of labour costs assist the management to determine productivity and efficiency of a company’s labour force which is important while estimating marginal productivity of each employee. It also helps management to make decision on how to enhance individual labour productivity to increase the overall productivity of a company.

Disadvantages of Cost Accounting

Alongside the various advantages of cost accounting system there are some disadvantages of using this accounting system. The limitations of cost accounting system are given below:
Lack of uniformity: This particular accounting system does not include a uniform process. It often makes different cost accountants to generate separate results from the same data and information. Due to such limitation, the results of cost accounting are used as estimates only.

Costly: For small and medium scale business organisations, the application of cost accounting system is costly as it needs a completely separate set up for accounting. For large companies, this accounting system is not hard to implement but it puts negative pressure on their profits.
Complex: This accounting system is quite complex to apply in comparison to financial accounting system as it requires lots of work on the front end, along with some constant adjustments for improvements. Segregation of different types of cost elements by considering their nature is also responsible for making this system complex than other accounting systems.
Reliance on experienced and highly-skilled professionals: The application of cost accounting system requires highly-skilled professional accountants and auditors. It creates dependency on the cost accountants heavily and led a company to bear extra cost for hiring cost accountants. After the implementation of cost accounting system, employees required to get extra training as well as must gain the capability to cooperate with the data input sufficiently. Non-cooperation of employees found responsible for rendering ineffective cost accounting system which is otherwise found as a beautifully constructed accounting system.

What is cost accounting?
What is cost accounting?

Impact of Cost Accounting on a Company’s Success

Cost accounting system helps a company to control its all kind of cost associated with production and marketing of products or services it delivers. Every organisation aims to reduce its operating costs to increase its profitability and cost reduction is one of the main targets to fulfil by the organisations to stay in the market profitably. The more a company becomes able to control its costs the great it becomes able to invest in innovation and modification of products and in other activities such as marketing and business expansion. The information and data provided by cost accounting system include all types of costs associated with manufacturing a product or delivering a service. Such information is utilized by a company’s management while making decisions on pricing, budgeting, product mix, and others to support a company’s operational and financial objectives. Cost accounting significantly helps a company to control its business expenditure. It assists management of a company to set operational and capital budgets which help to make long-term strategic decisions to achieve long-term organisational goals in a successful manner.

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