Cost Accounting

Cost accounting Definition: Cost accounting is the accounting method for ensuring cost-effectiveness by
accumulating, organizing, recording, calculating, analyzing and assessing the overall expenses incurred
on a product, process or project, etc. It is mostly used in industrial units or factories where the goods are
manufactured.

Unlike financial accounting, cost accounting is a broader perspective to review and control the
performance of the industries by the management. To know more about the different types of expenses
incurred in operating a business, one must be aware of the cost classification.

Related Terminology (Cost, Costing & Cost accountancy)

There are specific terminologies which though have a different meaning but are usually used as
a substitution for cost accounting. The three of these are as follows:

Cost: Cost refers to any expense or sacrifice made to develop a product or service. As far as
manufacturing units or industries are concerned, the three significant elements of cost are material, labour
and overheads. These are further bifurcated into two categories each, i.e. direct and indirect. The cost can
also be identified by its variability as the fixed cost, variable cost and semi-variable cost.

Costing: Costing is the technique and method used for calculating the cost of a product or service.

Cost Accountancy: Cost accountancy is a systematic process of applying the costing, as well as cost
accounting methods in business activities. It ensures cost control and reduction.
Concept of Costs

It is a commonly accepted fact that physical inputs or resources are important for enhancing production. We,
however, tend to miss out on the financial aspect of this rule. Some of the most important decisions
pertaining to business often relate to the cost of production, instead of physical resources themselves. Hence,
it is important for producers to understand cost analysis. Let’s understand the general concept of costs for
that.

Concept of Costs

In order to understand the general concept of costs, it is important to know the following types of costs:

1. Accounting costs and Economic costs (in terms of Treatment)

2. Outlay costs and Opportunity costs (in terms of the Nature of Expenses)

3. Direct/Traceable costs and Indirect/Untraceable costs (in terms of Traceability)

4. Incremental costs and Sunk costs (in terms of the Purpose)

5. Private costs and Social costs (in terms of Payers)

6. Fixed costs and Variable costs (in terms of Variability)

Concept of Costs in terms of Treatment

1. Accounting costs: Accounting costs are those for which the entrepreneur pays direct cash for procuring
resources for production. These include costs of the price paid for raw materials and machines, wages paid to
workers, electricity charges, the cost incurred in hiring or purchasing a building or plot, etc. Accounting costs
are treated as expenses. Chartered accountants record them in financial statements.

2. Economic costs: There are certain costs that accounting costs disregard. These include money which the
entrepreneur forgoes but would have earned had he invested his time, efforts and investments in other
ventures. For example, the entrepreneur would have earned an income had he sold his services to others
instead of working on his own business

Similarly, potential returns on the capital he employed in his business instead of giving it to others, the output
generated by his resources which he could have used for others’ benefits, etc. are other examples
of economic costs.

Economic costs help the entrepreneur calculate supernormal profits, i.e. profits he would earn above the
normal profits by investing in ventures other than his.
Concept of Costs in terms of the Nature of Expenses

1. Outlay costs: The actual expenses incurred by the entrepreneur in employing inputs are called
outlay costs. These include costs on payment of wages, rent, electricity or fuel charges, raw materials, etc.
We have to treat them are general expenses for the business.

2. Opportunity costs: Opportunity costs are incomes from the next best alternative that is foregone when
the entrepreneur makes certain choices.

For example, the entrepreneur could have earned a salary had he worked for others instead of spending time
on his own business. These costs calculate the missed opportunity and calculate income that we can earn by
following some other policy.

Concept of Costs in terms of Traceability

1. Direct costs: Direct costs are related to a specific process or product. They are also called traceable costs
as we can directly trace them to a particular activity, product or process.

They can vary with changes in the activity or product. Examples of direct costs include manufacturing costs
relating to production, customer acquisition costs pertaining to sales, etc.

2. Indirect costs: Indirect costs, or untraceable costs, are those which do not directly relate to a specific
activity or component of the business. For example, an increase in charges of electricity or taxes payable on
income. Although we cannot trace indirect costs, they are important because they affect overall profitability.

Concept of Costs in terms of the Purpose

1. Incremental costs: These costs are incurred when the business makes a policy decision. For example,
change of product line, acquisition of new customers, upgrade of machinery to increase output are
incremental costs.

2. Sunk costs: Suck costs are costs which the entrepreneur has already incurred and he cannot recover them
again now. These include money spent on advertising, conducting research, and acquiring machinery.

Concept of Costs in terms of Payers

1. Private costs: These costs are incurred by the business in furtherance of its own objectives. Entrepreneurs
spend them for their own private and business interests. For example, costs of manufacturing, production,
sale, advertising, etc.

2. Social costs: As the name suggests, it is the society that bears social costs for private interests and
expenses of the business. These include social resources for which the firm does not incur expenses, like
atmosphere, water resources and environmental pollution.
Concept of Costs in terms of Variability

1. Fixed costs: Fixed costs are those which do not change with the volume of output. The business incurs
them regardless of their level of production. Examples of these include payment of rent, taxes, interest on a
loan, etc.

2. Variable costs: These costs will vary depending upon the output that the business generates. Less
production will cost fewer expenses, and vice versa, the business will pay more when its production is
greater. Expenses on the purchase of raw material and payment of wages are examples of variable costs.

Scope of Cost Accounting

Cost accounting is being widely applied by the production units to modify the process and maximize the
profit. Following are the various applicability of the cost accounting techniques:

 Cost Analysis: Cost accounting determines the deviation of the actual cost as compared to the
planned expense, along with the reason for such variation.
 Cost Audit: To verify the cost sheets and ensure the efficient application of cost accounting
principles in the industries, cost audits are done.
 Cost Report: Cost reports are prepared from the data acquired through cost accounting to be
analyzed by the management for strategic decision making.
 Cost Ascertainment: To determine the price of a product or service, it is essential to know the
total cost involved in generating that product or service.
 Cost Book Keeping: Similar to financial accounting; journal entries, ledger, balance sheet and
profit and loss account is prepared in cost accounting too. Here, the different cost incurred is
debited, and income from the product or service is credited.
 Cost System: It provides for time to time monitoring and evaluation of the cost incurred in the
production of goods and services to generate cost reports for the management.
 Cost Comparison: It examines the other alternative product line or activities and the cost involved
in it, to seek a better opportunity for generating high revenue.
 Cost Control: Sometimes, the actual cost of a product or service becomes higher than its standard
cost. To eliminate the difference and control the actual cost, cost accounting is required.
 Cost Computation: When the company is engaged in the production of bulk units of a particular
product or commodity, the actual per-unit cost is derived through cost accounting.
 Cost Reduction: It acts as a tool in the hands of management to find out if there is any scope of
reducing the standard cost involved in the production of goods and services. Its purpose is to obtain
additional gain.

Objectives of Cost Accounting

Cost accounting aims at eliminating the loopholes in the production process and ensures manufacturing of
goods at the lowest possible cost. Other than this, there are multiple objectives of the cost accounting
practices. Let us now discuss its importance in detail:

 Control and Reduce Cost: Cost accounting continuously focuses on managing the cost of
production per unit to improve profitability without compromising with the quality of the product.
 Determine Selling Price: It provides the total cost incurred in the product or service, which is the
base for fixing an appropriate selling price.
 Assist Management in Decision Making: The reports and cost sheets generated based on cost
accounting back the managerial decisions of the organization.
 Ascertain Closing Inventory: It determines the closing inventory value at the end of the financial
year.
 Ensure Profit from Each Activity: Cost accounting reviews the cost and takes corrective actions
at each level to ensure profitability from all business activities.
 Budgeting: It generates the estimated cost of products or services to assist in budget planning,
implementation and control.
 Setting Performance Standards: It provides a standard cost of goods or services to sets a level
for the future course of action.
 Business Expansion: It estimates the cost of production at different stages, based on this analysis,
the management can plan for expansion of the business.
 Minimizing Wastage: Cost control and reduction so attained helps in reducing the wastage during
the manufacturing process.
 Improves Efficiency: Cost accounting assures cost management, profit appreciation and less
wastage which ultimately enhances the overall production and manufacturing process of products.

Functions of Cost Accounting or Cost-Accountant:

According to Blocker and Weltemer - Cost Accounting is to serve management in the execution of
policies and in comparison, of actual and estimated results in order that the value of each policy may be
appraised and changed to meet the future conditions.

Following are main functions of cost accounting:

(i) To work out cost per unit of the different products manufactured by the organization;

(ii) To provide an accurate analysis of this cost;

(iii) To maintain costs to the lowest point consistent with the most efficient operating conditions. It
requires the examination of each cost in the light of the service or benefit obtained so that the maximum
utilization of each rupee will be obtained;

(iv) To work out the wastage in each process of manufacture and to prepare reports as may be necessary
to assist in the control of wastage;

(v) To provide necessary data for the fixation of selling price of commodities manufactured;
(vi) To compute profits earned on each of the products and to advise management as to how these profits
can be improved;

(vii) To help management in control of inventory so that there may be minimum locking up of capital in
stocks of raw materials, stores, work-in-process and finished goods

(viii) To install and implement cost control systems like Budgetary Control and Standard Costing for the
control of expenditure on materials, labour and overheads;

(ix) To advise management on future expansion;

(x) To advise management on the profitability or otherwise of new lines of products;

(xi) To carry out special cost studies and investigations which are invaluable to management in
determining policies and formulating plans directed towards profitable operations.