Lesson 1, Topic 1

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Cost Accounting Terms

Cost

A cost is simply a quantification or measurement of the economic sacrifice made to achieve a given objective. It is, therefore, a measurement of the amount of resources sacrificed in attaining a specified goal. For a product, cost represents the monetary measurement of resources used such as materials, labor and overheads. For a service, cost is the monetary sacrifice made to provide the service. Accountants generally use cost with other descriptive terms, for example, historical, product, prime, labour or material. Each of these terms defines some characteristic of the cost measurement process or an aspect of the object being measured.

Cost object or cost unit

This is an activity for which a separate measure of costs is desired. Examples include cost of providing a service to a client or cost of manufacturing a specific product or undertaking a specific assignment, and cost of running an organizational segment. In other words, a cost object/cost unit is the quantitative unit of the product or service in relation to which costs are ascertained. It is determined by the nature of the business enterprise.

Cost accountant

He/she is a member of the accounting department responsible for collecting product costs and preparing accurate and timely reports to evaluate and control company operations. He/she assembles, classifies and summarizes financial and economic data on the production and pricing of goods and services. Some of the roles that he plays in the various aspects of the organization include:

Material cost control: this includes tracing materials issued to departments, reporting of the cost of material wasted (variance analysis) and provision of information about ordering and holding costs of stocks.
Labour cost control: this includes time keeping and payroll operation, establishing of standard labour cost for various products, monitoring productivity of labour and analysis of hours worked
Overhead cost planning and control: understanding the cost behavior of cost items, identifying the expenditure on overheads by various departments and establishing the absorption rate guides.
Operational efficiency: this includes ensuring that maximum output is achieved at minimum cost.

Cost analysis

This is an activity that uses engineering, time and motion studies, timekeeper’s records and planning schedules from production supervisors. Cost analysis techniques include break-even analysis, comparative cost analysis, capital expenditure analysis and budgeting techniques. After determining what is actually happening, accountants should identify available alternatives. Professional judgment is then needed to apply and interpret the results of each costing technique.

Cost benefit approach

This is the primary criterion for choosing among alternative accounting approaches. In a company, there is a direct relationship between the amount of time and the funds that management is willing to spend on cost analysis and the degree of reliability desired. If a company wants detailed records with a high degree of accuracy, managers should provide additional time and money for compiling and maintaining cost information. Managers should only use cost analysis and control techniques when anticipated benefits in helping achieve management goals exceed the cost.

Responsibility center

This is a part of the organization in which a manager who has a budget is made responsible for the plans and the resulting information on the performance of the plans.

Responsibility accounting is the use of budgeting with standard costing. Responsibility center makes it necessary for the organization to be organized with clear statements of the responsibilities of each manager who has a budget. The process of responsibility center enables management by exception principle to be practised. This is where a subordinate is given a clearly defined role with the requisite authority and resources to carry out that part of the overall plan assigned, and if activities do not proceed according to plan, the variations are reported to a higher authority. There are various types of responsibility centers, namely, cost center, revenue center, profit center and investment center, among others.

This refers to a production or service department in an organization where costs are incurred for the production of goods and services. Cost centers accumulate costs directly incurred and apportioned in order to ascertain the total cost of a department or center for a particular period. Cost centers ascertain costs and relate to cost units for control purposes. They help in ascertaining the total cost incurred in each center, determining whether the cost centers are working efficiently, controlling costs effectively, allocating costs to appropriate departments or cost units and, planning the activities of a particular department and improving their performance.

ROLE OF COST ACCOUNTING IN MANAGEMENT

Cost accounting is utilized for a number of purposes, some of which are briefly described in the following points:

Accounting for costs

This may be seen as a record keeping or score-keeping role. Information must be gathered and analyzed in a manner which will help in planning, controlling and decision making

Planning and budgeting

This involves the quantification of plans for future operations of the enterprise; such plans may be for the long or short term, for the enterprise as a whole or for the individual aspects of the enterprise.

Control of operations of the enterprise

Control may be assisted by the comparison of actual cost information with that included in the plan. Any differences between planned and actual events can be investigated and corrective action implemented as appropriate

Decision making

Cost accounting information assists in the making of decisions about future operations of the enterprise; such decisions making may be assisted by the information from cost techniques and cost-volume-profit analysis.

Resource allocation decisions

For example product pricing in determining whether to accept or reject jobs. This is based on cost and revenue implications of the relevant decisions

Performance evaluation

Cost accounting information is used to measure and evaluate actual performance so as to make a decision of the degree of optimality or efficiency of resource utilization.

SCOPE OF COT ACCOUNTING

As part of their jobs, cost accountants interpret results, report them to management and provide analyses that assist decision-making in the following departments:

Manufacturing

Cost accountants work closely with production personnel to measure and report manufacturing costs. The efficiency of the production departments in scheduling and transforming materials into finished units is evaluated for improvements.

Engineering

Cost accountants and engineers translate specifications for new products into estimated costs; by comparing estimated costs with projected sales prices, they help management decide whether manufacturing a product will be profitable.

Systems design

Cost accountants are becoming more involved in designing computer integrated manufacturing (CIM) systems and databases corresponding to cost accounting needs. The idea is for cost accountants, engineers and system designers to develop a flexible production process responding swiftly to market needs

Treasury

The treasurer uses budgets and related accounting reports developed by cost accountants to forecast cash and working capital requirements. Detailed cash reports indicate where there are excess funds to invest or where cash deficits exist and need to be financed.

Financial accounting

Cost accountants work closely with financial accountants who use cost information in valuing inventory for external reporting and income determination purposes.

Marketing

Marketing involves the cost accountant during the product innovation stage, the manufacturing planning stage and the sales process. The marketing department develops sales forecast to facilitate preparing a products manufacturing schedule.

Cost estimates, competition, supply, demand, environmental influences and the state of technology determines the sales price that the product will be offered and will command in the market.

Personnel

Personnel department administers the wage rate and pay methods used in calculating each employees pay. This department maintains adequate labour records for legal and cost analysis purposes.

At this point, it cannot be over-emphasized that cost accounting is simply an information system designed to produce information to assist the management of an organization in planning and controlling the organization’s activities. It also assists the management to make informed decisions so as to enable the organization to operate at maximum effectiveness and efficiency.

ROLE OF COST ACCOUNTING DEPARTMENT

The cost accounting department is responsible for keeping cost accounting records. This includes gathering, compiling and communicating a variety of information regarding an organization’s cost activities. For the records kept to be of proper use for the managerial functions, they should

Analyze production, administration, selling and distribution costs in such a way as to help management reach decisions required.
Be used to produce periodic performance statements or control reports which are necessary to the management for control purposes.
the cost accounting system should be capable of analyzing o past costs for profit measurement and stock valuation purposes o future costs of planning and decision making

Information obtained may be non-mutually exclusive in nature. This means that information gathered as part of the management information system may be used in two or more subsystems for differing purposes. An example of this information is with regard to the amount and location of work in progress: (work in progress refers to partly completed units of products where a product passes through a number of operations and processes before being passed into finished goods store or to the customer). Work in progress information may be used by:

Production planning department; in order to monitor the progress of parts of an order through the production process and to instigate action to speed up the completion of slow moving parts of an order.
Quality control department; in comparing one batch of product with another in highlighting the incidences of process losses and their location.
Cost management department; in the quantification and valuation of actual losses as compared to the level originally allowed for in the business plan.
Financial accounting department; in the valuation of work in progress for balance sheet purposes and for purposes of determining the cost of sales in the income statement.

COST ACCOUNTING AND OTHER ACCOUNTING SUBJECTS

Accounting can be described as a specialized information system that is used for purposes of decision making by the management of the organization and other users such as tax authorities, investors, creditors and the public. Accounting is broadly divided into Financial Accounting and Management Accounting.

Cost accounting and Management accounting distinguished

CIMA defines management accounting as “provision of information required by the management for such purposes as formulation of policies, planning and controlling the activities of the enterprise, decision making on the alternative courses of action, disclosure to those external to the entity (shareholders and others), disclosure to employees and safeguarding assets. Cost accounting and management accounting have basically the same functions.

Management accounting is part of accounting that relates to the provision of financial information to people and managers within the organization to aid in the execution of management functions: planning, organizing, controlling, evaluation of performance and decision making such as make/ buy decisions. It involves professional skills and knowledge. In particular, it involves preparation and presentation of information to all levels of management in the organization. The information generated by management accounting is, therefore, for internal uses and is not guided by any standards or legal requirements.

Management Accounting, unlike financial accounting, is proactive i.e. it is future-oriented. In a nutshell, cost accounting enables a business to, not only find out what various jobs or processes have cost, but also what they should have cost. It indicates where losses are occurring before the work is finished and therefore corrective action can be undertaken. However, there is a very slim distinction between Cost accounting and Management accounting. In fact, cost accounting is part of management accounting.

Cost accounting and financial accounting distinguished

Financial Accounting is concerned with provision of information to parties outside the organization. This is the analysis, classification and recording of financial transactions and the ascertainment of how such information will be reported to the various users. It involves the development of general-purpose financial statements largely for external reporting. It requires that costs should be matched with revenues in order to calculate the profits for the period under consideration.

These statements are developed in accordance with standards imposed by the public (through the professional accounting bodies such as the Institute of Certified Public Accountants of Kenya (ICPAK) and the International Accounting Standards Board (IASB) as well as the requirements of the Companies Act Chapter 486.

Cost accounting and financial accounting are distinguishable in various aspects. The major differences between the two branches of accounting are:

Generally accepted accounting principles

There are a number of accounting standards that are followed in producing accounting information. Financial statements must be prepared in accordance with the Generally Accepted Accounting Principles applicable in the industry in which the firm operates. The statements produced are intended for use by external users. Such users require assurance that the information they are receiving has been prepared with some common set of ground rules. Otherwise, there could exist an opportunity of fraud or misinterpretation which would destroy their confidence in the financial statements.

However, in cost accounting, managers are not governed by any standards or principles. They use a number of techniques, which include budgeting, standard costing, marginal costing and cost-volume-profit analysis. They set their own ground rules.

Statutory requirement

Financial accounting is mandatory. It is governed by the Companies Act Cap 486, which requires that a number of accounting records be kept and made available, for instance,

a summary of cash flows. For limited companies, audited financial statements must be produced, which in the opinion of the auditor, portray a true and fair view.

Cost and management accounting is not mandatory. It is entirely optional. Information prepared by the managers may or may not be produced depending on the managers’ intention. In addition, managers may or may fail to create a cost accounting department.

Focus on segments of the organization

Financial accounting focuses on the organization as a whole. It is primarily concerned with the reporting of business activities for the company as a whole.

On the contrary, cost accounting focuses less on the whole and more on the parts or segments of the company. It lays emphasis on segments of the business while conducting analysis; examination of job, process, product or service. Examples of segments include departments, product lines and company divisions.

Emphasis on non-monetary measures

Non-monetary measures are used in the interpretation of accounting statements, for example, expressing gross profit as a percentage of sales revenue to obtain the markup. Thus, monetary base is predominant in financial accounting. However, in cost accounting, there will be greater use of non-monetary measures. Managers lay more emphasis on non-monetary measures. These include areas like materials requirement and labour input, material losses, machine efficiency, e.t.c.

Futuristic cost accounting versus historical financial accounting

Cost accounting is futuristic in that it focuses on the future thus necessitating managers to have a strong future orientation. Managers concentrate more on planning, as it is the key to success. Without proper plans, most of the activities of the company may be bound to fail. Nevertheless, historical information is crucial in the planning process. Managers analyze historical information and use it in the planning process. Use of historical information in forecasting poses a great challenge since managers cannot simply assume that the future will be simply a reflection of the past. Changes taking place, however, demand managers planning framework be built in large part of estimated data that may or may not be a reflection of past experience.

In financial accounting, there is the statutory requirement for provision of historical data from which accounting statements may be prepared. Such statements may be used in the forecasting of future trends for use by potential investors or investment analysts.

Precision and accuracy of information provided

Financial accounting lays more emphasis on precision and accuracy of data to the nearest cent except in subjective areas such as determination of depreciation and other allowances.

On the contrary, in cost accounting, accuracy of information will tend to vary with the circumstances. For instance, Management Reports may summarize figures to the nearest thousand shilling whereas the material cost per unit of a product may be expressed to four decimal places. At times, cost accounting recognizes the need for good estimates and approximations rather than for numbers, which are accurate to the last, penny. When information is needed, speed becomes more important than precision. The faster the information is obtained, the faster the problems are attended to and resolved. Thus, the manager is often willing to trade off some accuracy for information that is immediately available.

Is accounting a means to an end or an end in itself?

Financial accounting is an end in itself in so far as it fulfils the statutory requirements in relation to accounting records and the publication of financial accounting statements. It is also a means to an end in that it provides an overview of the business, which may be interpreted by the various users of accounting information, which the Companies Act seeks to protect. Cost and management accounting is a means to an end. It may be used to assist management in future planning, control and decision-making required for the efficient implementation of the objectives of the enterprise and the strategies, which will best lead to achievement of these objects.

To what extent does the discipline draw from other disciplines?

Cost and Management accounting draw heavily from other disciplines for instance finance, statistics, operation research and organizational behavior. This forms a strong interdisciplinary network. Cost accounting extends beyond the boundaries of traditional accounting. The external sources give managerial accounting a strong interdisciplinary flavor.

For what use is information generated intended?

Cost accounting system provides information to be used internally in an organization. That means much of the information that a manager needs would be confusing or valueless to external stakeholders. The manager uses information derived from the cost and management accounting system to direct day-to-day operations, plan the future, solve problems and make decisions.

On the other hand, financial accounting provides information for external use. Users of financial accounting information include stockbrokers, the government, potential and existing investors and customers.

What are the pertinent qualities of the information generated from the system?

Financial accounting data are expected to be objectively determined and verifiable since they are intended for external use.

The manager is more concerned about receiving relevant and flexible information than completely objective and verifiable information. In cost accounting, relevance and objectivity may be viewed as a matter of secondary importance.

In summary, the comparison and contrast can be summarized in the table below:

	Cost and management accounting	Financial accounting
1	Cost accounting is not governed by any principles or concepts.	Financial Accounting is highly regulated and is governed by the Generally Accepted Accounting Principles.
2	Cost accounting is not mandatory, the management may practice it or not	Financial management is a statutory requirement. It is mandatory.
3	Cost accounting looks at segments of the organization and the organization as a whole.	Financial accounting looks at the organization as a whole. It is less concerned with segmental performance.
4	Cost accounting is futuristic; it places more emphasis on the future.	Financial accounting is historical in that it reports what has already taken place.
5	Cost accounting places less emphasis on precision and more emphasis on nonmonetary data.	Financial accounting places more emphasis on monetary data and precision.
6	Cost accounting draws heavily from other disciplines such as economics, finance, statistics and operation research.	Financial accounting draws little if any from other disciplines. It is governed by the statutes and the Generally Accepted Accounting Principles
7	Cost and management accounting provides data for internal use by management.	Financial accounting provides data for external uses.
8	Cost accounting emphasizes the relevance and flexibility of data.	Financial accounting emphasizes more on objectivity and verifiability of data

SELECTION OF AN IDEAL ACCOUNTING SYSTEM

A system is a set of interdependent parts, which together form a unitary whole that performs certain functions. A number of sub systems make up the whole. In this context of an organization, a management information system may be seen as the overall system with a number of subsystems including the cost and management accounting system that provide the information to management for purposes of planning, organizing, directing and controlling the organization’s activities so as to achieve corporate goals, including profit maximization.

A number of features and factors must be taken into account when designing a cost and management accounting system. These are:

Preliminary investigations must be made before a system is installed. This helps to disclose weaknesses and inefficiencies.
For accuracy of cost records, a system of material cost, labour cost and production overheads cost is essential
Nature of the business enterprise must be put into consideration when designing the cost accounting system. The system developed should be practical and must suit the business
The system should be cost effective in that the benefits derived from the system must be greater than the cost of running it.

The following factors must be taken into account before finalizing the cost accounting system design

The system must be designed in such a way as to meet the managerial information needs. There should be no duplication in reporting. Only relevant management information should be provided. Information is relevant if it has an impact on the decision made by the management.
The factory layout and production sequence. This is important for the identification of the sequence of production i.e. the starting and the ending points.
Control exercised over production; the cost data must focus on specific areas of control so that the responsibility of any variances between the actual and the standard costs can be identified with an individual manager or department.
Nature of raw materials used affect the system adopted. This is because it affects the recording and issuance of raw materials and the method of pricing
The deployment of workers, who may work as a team or as individuals. This affects the method of remuneration and the analysis of time worked. For instance, where employees work as a team, there may be group bonus awards, which do not exist in situations where employees work individually.
Key personnel and office staff; their cooperation is vital for the success of the system. In addition, the system needs to be simple and easy to understand to enhance acceptability
Relative size of cost element; it is only reasonable to analyze cost elements with a significant value. Cost elements of insignificant value may be left out of the analysis depending on the composition of the cost items
Need for uniformity; a business needs to observe the industrial norms and thus follow the industrial practices as regards the accounting. If the business, for instance, belongs to a trade association, it will need to follow the association’s recommendation on cost accounting principles and in order to facilitate comparison of its data with that of other businesses in the industry.
The cost benefit analysis should be carried out and it is only reasonable to run a system whose benefits are more than the costs incurred in terms of money, time spent in designing, installing, testing, running and maintaining the cost accounting system.
The system should be capable of adapting to changing conditions. It should be logical and simple. Flexibility is vital to any accounting system bearing in mind that the organization exists in an open system. It is only a subsystem of a larger system.
Periodical upgrade of the system is crucial to avoid the danger of going obsolete as the world is rapidly changing.

The business enterprise may be such that:

Individual orders are received from customers for work which is undertaken according to the specific requests of the customer (specific order costing).
Output is the result of a series of continuous operations or processes (process costing)
A service is provided to the customer (operation/service costing).

The costing and management accounting system is designed and operated such that costs can be identified and accumulated for each unit of output. The costs are then accumulated for the various cost centers and further analysis done to produce useful information for planning, controlling, decision-making and performance evaluation.

A Cost Center Framework/Approach in Cost Accounting

Cost accounting is based on the concept or framework of cost centers, i.e. all the costs incurred during the production process have to be identified and accumulated around certain points of the production process, referred to as cost centers.

A cost center may be defined as ‘any point at which costs are gathered in order to control cost, fix responsibility and enable costs to be recharged on an equitable basis. Each cost will be the responsibility of one management member and will have costs charged to it and also costs recharged from it if such costs are incurred for purposes of offering a service to other cost centers.

Summary of features of an effective cost center framework

In establishing cost centers, an organization should consider the following points:

Clear definition of the cost center boundaries: This should ensure that there is no overlapping of the boundaries defined in two or more centers and that no gaps exist where some aspect of the business, which incurs cost, is not contained in a cost center.
A clear link with the manager responsible so as to hold someone responsible for the costs incurred in a cost centre.
Costs should be analyzed into clearly defined categories in order to ensure that planned and actual expenditure may be analyzed in the same way.

CHAPTER QUIZ

State two definitions of cost accounting.
Highlight the various distinctions between cost accounting and financial accounting
Distinguish between qualitative and quantitative information.
Highlight the areas in which cost accounting may be useful in an organization
Define a cost center
Some of the definitions include.

“That part of management accounting which establishes budgets and standard costs and actual costs of operations, processes, departments or products and the analysis of variances, profitability or social use of funds” (Chartered Institute of Management Accountants – CIMA)”

“That which identities, defines, measures, reports and analyses the various elements of direct and indirect costs associated with producing and marketing goods and services. Cost accounting also measures performance, product quality and productivity” (Letricia Gayle Rayburn)”

EXAM QUESTIONS

“A systematic process of collecting, summarizing and recording data regarding the various resources and activities in a firm so as to calculate the basis of production costs used in financial accounting or making other relevant decisions in a firm (Horngren C.T)

Differences between cost accounting and financial accounting can be summarized under the following:
- Restriction by GAAP
- Statutory requirement
- Focus on segments of the organization
- Emphasis on non-monetary measure
- Futuristic versus historical accounting
- Precision and accuracy of information provided
- Intended use
- Pertinent qualities of information generated from the system
Quantitative is that which may be measured in monetary terms or other physical units e.g. Material may be expressed as Shs.1000 or 250 kilos. It is easily objectively expressed. Qualitative information is that information that cannot be objectively expressed
Areas where cost accounting may be useful in an organization include product pricing, sensitivity analysis, analysis of performance, and production planning and decision making.
A cost center is any point at which costs are gathered in order to control cost, fix responsibility and enable costs to be recharged on an equitable basis.

PAST PAPER

Question one

Explain the areas in which cost accounting may be useful in an organization (10 marks )

Question two

Identify the types of responsibility centers used in responsibility accounting and discuss how the performance of each responsibility centre type might be measured. (20 marks )

Question three

Discuss controllable and non-controllable factors (10 marks )

CASE STUDY

Coordination between operational and strategic planning is very essential in any organization, but lack of it may result in unrealistic plans, inconsistent goals, poor communication and inadequate performance measurement.

In the context of strategic planning goal of sustaining competitive advantage at minimum cost through speedy delivery of quality products to clients, key features or characteristics, which a company Y should incorporate in each of strategic planning and operational planning include:

Unrealistic operational plan will force staff to try hard with few resources. Mistakes and failure are almost inevitable. This means poor quality products; costs include lost sales, arranging for returns, and time wasted dealing with complaints and rectification work. Over-ambitious plan may also mean that more stocks are produced than an organization could realistically expect to sell (meaning the costs of written-offs, opportunity costs of wasted production resources and unnecessary stock holding cost are incurred).
Inconsistent strategic planning and operational planning goals may mean that additional cost is incurred. For example, an operational plan may require additional inspection point in a production process so as to ensure that quality products are delivered to customers. The resulting extra costs will be at odds with the strategic planning goal of minimum costs.
Poor communication between the senior management who set strategic goals and lower level operational management could mean that operational managers are unaware of the strategic planning goal of sustaining competitive advantage at minimum cost through speedy delivery of quality products to customers. Some operational managers may, therefore, choose to focus on quality of products while others attempt to produce as many product as possible as quickly as they can; still others will simply keep their heads down and do as little as possible. This will lead to lack of co-ordination; there will be bottlenecks in some operational areas, needing expensive extra resources in the short term, and wasteful idle time in other areas.
Inadequate performance measurement will mean that the organization has little idea of which area is performing well and that which needs attention. If quality of products and speed of delivery are the main source of competitive advantage, a business needs to know how good it is in the two. For example, if an organization measures only conventional accounting results it will know how much stock it has and how much it has spent on ‘carried out’. It will not know the opportunity cost of cancelled sales though not having stock available when needed or not being able to deliver it on time.

Otherwise, repairs and maintenance costs of machinery would vary with the level of activity. But machines would still need a certain level of maintenance even if they were not being used,(the company might, on the other hand, be considering selling the machinery, accounts of which may not have been taken).

Finally, the costs of buying in may also be highly subjective. Accounts may not have been taken of costs such as increases or decreases in time spent delivering the components (from abroad perhaps) or complaints or costs resulting from badly made component. It is, therefore, obvious that the behavior of costs associated with a decision must be fully understood and their relevance to that decision ascertained before the decision is finally made.