Introduction to Cost Accounting (made easy)
Relevance of cost accounting
Cost accounting is a subject that is relevant to all forms of Business; be it small, medium, or large ; federal, state or local government; profit or non profit; government agencies or parastatals; military or non military Organizations; all need cost accounting information before making any decisions. They will like to know the estimated or actual cost of production, inventories , services,project, contract, or functions for comparison against their benefits before taking any decisions.
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What is Cost?
Cost may be defined as " the amount of expenditure (actual or notional) incurred on or attributable to a specified thing or activity.
To economist, cost is what must be given up in order to obtain something for example you part with 50 to obtain a notebook; the cost of the note book is the 50. When you sacrifice some resources for example money, machines, and materials in order to execute a project, the cost of the completed project is the total money value of the resources sacrificed for the project.
Accountants , extending the perspective of economists, view cost as the value of Economic resources used in the production of goods, services, income or profit. This shows that accountants is always linking the concept of cost to production, as cost is being incured for the production of goods and services, the generation of revenue or the making of profit. Cost element therefore materials, labour, and expenses are therefore considered and aggregated before arriving at cost of production.
Accounting as a Concept
Accounting is a term derived from 'account' therefore is simply defined as expression of transactions.
Accounting is therefore about giving account of various transactions i.e. explaining the transactions to the satisfaction of interested parties.
American accounting association (AAA) defined as " the process of identifying,measuring and communicating the economic information to permit informed judgements and decisions by users of the information.
Definition of Cost
Cost accounting can be defined as " the process of identifying, analyzing, computing, and reporting cost to management". Another definition is " the establishment of budget, standered costs and actual costs of Operations, processes, activities or products;and the analysis of variances, profitability, or the social use of funds" (technology). Unlike accounting as a whole , cost accounting is a branch, which had the management as the user of its information.
Cost and Financial Accounting Compared
1. Primary users of information:
The users of traditional financial accounting are persons outside the Business entity (i.e shareholders, creditors, government etc). In constrast, cost accounting provides information for managerial purpose only. The content and scope of internal report is a function of the level of management.
2. Unit of measurement:
In Financial Accounting transactions are recorded in monetary terms only . Cost accounting in addition to using monetary units also uses such measures as labour hour, machine hour, kilograms of materials etc as a basis for a particular analysis.
3.Types of Accountanting systems:
In Financial Accounting, journal ledgers and other devices are based on the double entry system in processing financial information. In cost accounting, information flow of data is not restricted to the double entry framework alone but any system that is useful in satisfying the information needs of management may be employed.
4. Frequency of reporting:
The periodicity concept in financial accounting requires that financial statements be prepared and presented at regular time intervals while in cost accounting, reports are prepared whenever they are needed.
5. Measures of data:
Financial accounting provides information from past events of an enterprise for valuation of past performance so the data are historical in nature . In cost accounting, historical and estimated future data can be employed.
6. Types of expenditure analysis:
Financial accounting analysis expenditure according to types of transactions or expenses, that is , under nominal account headings whereas cost accounting pursue the functional or activity analysis so as to find the cost of jobs, processes, and operations.
7. Focal point of analysis:
Traditionally, financial accounting communicates information about the business entity as a whole, that is , financial statements summarises and report upon the transactions of the entire enterprise for example income statement reveals profit and loss in total for the whole business, whereas cost accounting analysis are directed at various segments therefore cost centers, departments, division of the enterprise.
8. Restrictive guide:
Financial accountant is based on general accepted accounting principles and standards that governs the recording, measuring, reporting of financial information. This is in order to protect the interests of various users and to lend credibility to the report while cost accounting records needs not be bound by any of these external restrictions. Cost accounting restrictions is that techniques Accountanting practices must produce information that is relevant and useful to specific management needs.
Cost Terminologies
1. Cost unit
Is a unit of quantity of product or services In relation which cost may be ascertained e.g.
Unit of product: litres of paint, pairs of shoes, caps, tables,tons of cement, contracts etc.
Unit of service: consulting hours, quest night, kilowatt hours, persenger-mile, hospital operation hour etc.
2. Cost centre:
Refers to a location, a person , or an item of equipment in relation to which cost may be ascertained and use for the purpose of cost control.
a. A location may be department, store yard, sales area or a factory.
b. A person may be a sales manager, production manager, personal manager, finance manager or work engineer .
C. An item of equipment may be machine, delivery vehicle, car, truck etc.
The purpose is to aid effective cost control within an organisation by all the cost incurred to the relevant cost center.
3. Cost control
Refers to the ability of management to monitor and supervice expenditure (recurrent and capital). In order to ensure that things are going according to plan and that actual results ( cost incurred) are obtain for comparison against planned results (cost to be incurred) so that appropriate corrective actions may be taken on deviations arising there from, before it is too late.
Before any cost control can be effective, standards or targets of performance must be set against which actual cost can be measured and Compared. This will reveal inefficiency so that appropriate actions could be taken to guard against such occuranace in the future.
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Types of Cost
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Conversion cost:
Cost of converting material into finished goods or semi finished goods i.e. direct materials, direct wages and absorbed production overheads.
Avoiding cost:
Saving in cost as a result of not adopting a given alternative for example advertisement, insurance, donation etc. Only avoidable costs are relevant for dicesion making.
Unavoidable cost:
Those cost that cannot be saved for example depreciation, security cost etc. Unavoidable cost are irrelevant for decisions making.
Sunk cost:
Cost already inccured, and
irrelevant for decision making. It is synonymous with historical or past cost e.g salaries and wages paid, cost of machines already bought.
Relevant cost:
Future cash flow arising as direct consequence of a decision.
Opportunity cost:
Referred to as forgone alternative.
Incremental cost:
Is the difference between cost and revenue for corresponding items under which each alternative is being considered.
Cost Classification
Cost could be classified into various ways according to the need of the user and some of which are explained below:
Classification by nature
Cost unit can be broken down into:
1. Direct material cost
2. Direct labour cost
3. Overheads
Direct material cost:
Is the cost that can be directly and economically traced as an integral part of the final product or services for example cost of flour used in making a loaf of bread.
Direct labour:
Is the cost of labour ( skilled and unskilled) that can be directly identified with final product for example if it takes 4 hours of carpentary work to produce a table, then the 4 hours can be directly 8dentified with the cost of the table. The hourly rate may be 40$ hence the DLC of the table equals to 160$.
Overheads:
Cannot be directly identify with the cost unit in exact amount, but generally incurred in the production of all goods and services. It is therefore, about the cost of indirect materials, indirect labour and other manufacturing, selling and administrative costs. Which can only be apportioned to the final product for absorbtion. There are difficulties in tracing them to a cost unit or even cost center for example rent and rates, electricity bill, water bill, telephone , general management salaries etc.
Classification into Direct and Indirect Costs:
Direct cost:
Direct cost consist of direct materials Labour, direct expenses, which can be directly identified with a job, a product or a service for example;
1. Direct materials: raw materials used for production; parts and assemblies incorporated into finished goods; bricks, timber, cement, used on a contract etc.
2. Direct labour: wages paid to factory workers that are directly related to production, salaries of foremen etc.
3. Direct expenses: expenses inccured directly for a specific job, product or saleble services for example royalties on barrels of crude oil products
Direct materials+ direct labour + direct expenses = prime cost.
Indirect materials:
Materials, labour, and expenses, which cannot be directly identified with the product. Also called overheads, and can be classified into administrative, finance , selling, distribution and production.
Prime cost + overheads = total cost.
Classification into Fixed Variables Cost:
Fixed cost are those cast that will remain unchanged no matter the levels of activity( which can be production level, sales level etc).
Variable cost on the other hand vary proportionately with changes in the level of activity. The higher the level of activity the higher the total variable cost , but the total fixed cost will remain constant, in the short run, despite changes in the level of activity.
Classification into Avoidable and Unavoidable Cost:
Avoidable cost are those that can be avoided or eliminated if an activity is discontinued , whereas unavoidable are those that cannot be eliminated if you stop the activity. Direct cost and variable cost are clearly avoidable cost whereas fixed cost are unavoidable cost.
Classification into full and Marginal cost:
Full is the total cost (TC), mixed cost, semi variable cost or semi fixed cost which reflects the absorbtion of some general overheads costs by the cost unit or cost center. Marginal cost on the other hand represent the additional cost of an extra unit produced. It is the incremental cost of producing an extra unit. Where as full cost is made up of fixed cost and variable cost, marginal cost is about variable cost only.
Classification into Incremental and Sunk Cost:
Incremental cost comprises the additional of making a change such as increasing the vulome of output, changing production methods, changing product mix, or redesigning a product or services. They are the additional cost incurred resulting from a decision to increase production and they are variable in the context of increase output.
Sunk cos on the other hand, comprises all those cost, which are not affected by a decision to increase or decrease a production level. They are past cost, which have been inccured and cannot be changed. They are never relevant for decision in respect of additional cost units to be produced.
Classification into Controllable and u
Uncontrollable:
This books down to responsibility Accounting. Each responsibility center manager should be mindful of cost under his control and be aware of the cost that are controllable by him. Sales department manager, see cost approved to be inccured in his department as controllable, whereas those approved to be inccured by the production dept as uncontrollable by him.
Classification into Joint and Separate Cost:
Joint cost is that cost of processing a single raw materials to produce two or more products. Separate cost on the other hand is the cost of processing the identified product further for it to become consumable or marketable. Joint cost to be apportioned to joint products while a separate cost is to be added to the share of the joint cost of a joint product to arrive at the total production cost of the product.
A single raw material, when processed to the point of split off may produce joint products that can be categorised I to main products and by products. The net realisable value of the by products are to be used in offsetting the joint product before apportionment to the main products.
Note: the cost classification above can be relevent for decision making purpose as well as for cost control and product measurements.
Cost Elements
There are items of cost making up the total of a product or Services. These items to be identified and aggregated as follows:
1. Prime/direct cost: as explained above (materials, labour, and expenses).
2. Factory cost: this is made up of prime cost plus the share of the fixed production overheads cost chargeble to the product or services.
3. Total cost: the sum of factory cost plus the share of selling, admin and distributive overheads expenses attributable to the product or service.
Selling expenses are those inccured in inducing customers to place orders ( advertisement and similar charges).
Distributive expenses are those inccured in getting finished goods to reach the customers for example ware housing, packaging and transportation.
Administrative expenses are those inccured in managing the enterprise for example management cost, accounts, legal and personnel department cost, audit fees and other general admin costs
Selling price:
Total cost plus target profit. Although selling price is not part of the cost element to the seller, it is about the cost of purchase to the buyer.
Target profit 8s to be projected by the management based in its pricing policy.
Principles Applied in Costing
Cost allocation: allocation means to assign a whole item of cost, or of revenue, to a single cost unit, cost center, account or time period.
Also defined as "the allotment of cost that are directly identified with, or inccured by a production or a service cost center.
Cost apportionment: this involves the sharing of indirect cost between two or more cost center or units on the basis of benefit derived by them using relevant basis of apportionment.
Allotment of cost: the procedure of allocation and apportionment of overheads is referred to as allotment of overhead.
Cost/overhead absorption: defined as " a means of attributing overheads to a product or service based on either direct labour hours, direct labour cost or machine hours" (CIMA).
Calculated thus;
Total cost center/ Total unit of base to be used.
Costing Techniques and Methods
Costing techniques:
A technique is set of procedures for achieving stated objectives which do not necessarily constitute a complete system. For example, process costing may be employed as the principal system of cost accounting, but marginal costing may also be used to allow costs to be controlled more effectively and for decision making. Usually, therefore, marginal costing, total absorption costing m, standard costing, budgetary control are regarded as techniques which are imposed on the main system.
Costing method:
This is a method that is used to determine the amount or value of Economic resources used in producing a product or service. They include job costing, batch costing, process costing, services costing, joint product costing etc .
Qualities of good cost accounting information
Cost accounting information is always needed for managerial planning, control and decision making in both private and public sector organisations. For such information to be of relevance, it should be seen to posses certain qualities. The required qualities include:
1. Relevance: the information should be relevance to the users and the purpose for which it is intended.
2. Timeless: the information should be supplied on a timely basis for the purpose for which it is required. It should be made available within the time it is called for. The cost accountant should know when management needs cost accounting information and make it readily available.
3. Reliable/accurate: the information should be accurate and produced in compliance with relevant statutory regulations, professional requirements or managerial guidelines. It is then that the information could be said to be accurate and reliable.
4. Understandable: the information should be simple to understand. The cost accountant has to strike a balance between simplicity and complexity while producing the information.
5. Completeness: the information should fully disclosed what is required. It is not to be released in a piecemeal manner. Incomplete cost accounting information is dangerous to managerial decision making, which is about the future.
6. Objectivity: the information should not be subjective or personal to the provider. It should be the type that would assist management towards achieving Organizations goals. Cost accountant should learn to remove all the subjectivity in the information they give management for planning control and decision making.
7. Comparability: the information should give room for comparative analysis with the information provided in the previous periods. It should enhance inter firm ,intra firm and other forms of comparative analysis.
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