Nature and purpose of cost accounting

Accounting is the method of identifying, measuring and communicating economic information to permit informed judgment and decision making by the users of the information.

It‟s that part of information system of business enterprise which provides financial information concerning the business activities of an enterprise to diverse groups of people such as: shareholders, managers, creditors, tax authorities etc

On the basis of purpose for which the information is required, accounting is divided in 2 parts:
i) Financial Accounting
ii) Management Accounting

Financial Accounting
Financial accounting is mainly concerned with recording business transactions in the books of accounts for the purpose of presenting final reports to the management, shareholders, and tax authorities.

The information supplied by financial accounts is summarized in the following statement at the end of given period generally one year:
 Profit and loss account (the income statement).
 Balance sheet.
 Cash flow statement.
 Statement of change in equity.

Management Accounting
It‟s that part of management that is concerned with identifying and presenting information for formulating strategies, planning and controlling activities, decision making on alternative decision, optimizing use of resources for interested parties and safeguarding assets of the business.

Cost Accounting
It‟s that part of management that deal with ascertaining cost of product operation, process etc

It‟s the combination of accounting and costing technique in the accumulating analysis and control of cots and revenue.

Refers to the resource sacrificed so as to achieve a given objective

Difference between Financial Accounting & Cost Accounting

1. Users of the information- Financial accounting information is used by external parties as well as internally by managers. Cost Accounting information is used internally by managers.
2. Compliance with GAAP- Financial Accounting statements are prepared in compliance with GAAP (Generally Accepted Accounting Principles) whereas cost accounting statements do not need to comply with any principles.
3. Format- Financial Accounting statements are prepared in the format presented by the (IAS) International Accounting Standards whereas Cost Accounting statements are prepared in the format internally decided by the management.
4. Periodicity of Reporting- Financial Accounting reports are issued periodically e.g. annually, semi-annually etc. Cost Accounting reports can be prepared when the management requires them.
5. Audit Requirements- Financial Accounts should be audited by an external or independent party. Cost Accounts needs not be audited unless they contain vital information for the audit.
6. Legal Requirement- Financial Accounting reports are compulsory by law (under CAP 486). Cost Accounting reports are prepared when management require them.
7. Sources of Information- Data used to prepare financial statement is historical by nature i.e. based on past transactions. Cost Accounting uses historical, current and sometimes future data to prepare its statement.
8. Precision- Financial Accounting requires accurate information otherwise external parties will not have confidence in the content of the report. Cost Accounting may allow for approximation of certain information required.
9. Unit of Measurement- All information under Financial Accounting is in terms of money value. Cost Accounting applies any unit of measurement that is useful in a given situation e.g. Labour hours, output, machine hours etc

Cost may be classified on the following bases:
 Functions
 Behaviour
 Traceability to end product
 Time
 Identify with stock
 Controllability
 Relevance for decision making

1. Classification by Function
On the basis of function, costs may be classified into production cost, administration cost, selling and distribution cost and research and development cost.

a) Production Cost
These are cost incurred in the factory in the production of goods e.g. Raw materials, labour, factory rent etc.

b) Administration Cost
These are costs incurred in the general management of the business e.g. office rent, salaries of office staff, depreciation of office machinery etc.

c) Selling and distributing cost
These are costs incurred in making the final products available in the market and convincing/ persuading customers to adopt them e.g. advertisement, delivery and sales commissions etc.

d) Research and development
These are costs incurred in developing new products and also improving on existing ones.

2. Classification by traceability to end products
a) Direct cost
Are costs that can be traced to the final products i.e. they can specifically be identified with the end products e.g. direct materials like timber in furniture, direct labour like wages paid to carpenters and direct expense like the hire of special equipment.

b) Indirect Cost (Overheads)
Are costs which are not traceable to the final products or may be traceable but constitute small proportions of the overall cost. They include:
 Indirect material like the cost of lubricating oils, paper, rivets, vanish etc.

 Indirect labour e.g. the salaries paid to indirect workers like watchmen, cleaners etc.
 Indirect expense like factory rents, factory power and other utilities, depreciation of factory plants and equipment etc.

Classification by Cost Behaviour
Cost behaviour refers to the changes in the cost arising from the changes in activity level. Activity level in an enterprise may be measured using the number of unit produced, sales volume, labour hour etc.

On the basis o behaviour cost can be classified into:-

i) Variable costs: Are cost which change with a change in the level activity. Variable costs can be described by a straight line equation of the form y = bx

y = total cost
b = variable cost per unit.
X = number of unit (activity level)

Graphically Variable costs are represented as:-

ii) Fixed cost – are costs which remain constant irrespective of the changes in the level of activity. They are represented by a straight line equation of the form y = a

y = Total cost
a = Total fixed cost

Graphically, fixed cost can be represented as follows

iii) Mixed cost: – Are cost with characteristic of both variables and fixed cost hey are further classified into semi-variable cost and semi-fixed cost.

a) Semi- variable cost: – Are cost where some components are fixed and some varies with activity level. It can be described by a straight line e.g… of the form.
Y= a+bx where y= total cost, b = variable cost per unit x = number of units (activity level)
a= fixed cost.
Graphically semi-variable costs are represented as follows.

b) Semi-fixed costs – Are cost which remain fixed within a given range of activity beyond which the cos changes to the new level where it remains constant within another new range of activity in a stepped /fanction.

Classified by time
On the basis of time cost can be classified into:-
– Sunk cost- is the cost that has already been incurred i.e. cost relating to 2 past transaction.
– These are historical costs which are considered to be irrelevant for classification making purpose because they cannot affect future decision.
– Future cost- are estimated for decision making purpose because the can affect future decision.

Classifications based on identification with stock.
1. Product cost:- refers to costs that are used in the valuation of the stock finishes gods. They‟re also referred to as inventoriable cost, since they form part of product cost. Such costs are into charged to the P&L a/c until the gods produced have been sold. If the goods are not sold, the cost is carried forward in the form of stock to be written off against future sales.
2. Period cost – there‟re cost that arise by virtue of passage of time and are W/off through the P&L a/c whether the good produced have been sold or e.g. insurance cost.

Classifications on the basis of controllability
1. controllable costs- are costs which can be influenced by management in the long run without negatively affecting the business operating e.g. research cost, marketing costs a/c cost etc
2. Uncontrollable cost- they cannot be influenced by managerial decision in the short run
e.g. insurance cost.

Classification based on the relevance for decision making
ii) Relevant cost – Are cost that result in a unique alternative in a decision making environment such cost usually differ between alternatives e.g. future cost, controllable costs etc.
iii) Irrelevant cost- They may not give a unique alternative in a decision making situation either because they‟re already been incurred or they do not differ between the alternative e.g. sunk cost, uncontrollable.

Other terminologies
a. Incremental cost- refers to the change in total cost (both variable and fixed when comparing 2 alternatives or when among a decision.
b. Marginal cost- refers to the change in variable cost when comparing 2 alternatives or when making a decision.
c. Discreet cost – are cost which incurred at the discretion of management i.e. the management has the freedom to decide whether the cost should be incurred or not.

d. Imputed cost- these are hypothetical cost which are not cost in the strict sense of the word because there are no financial obligations to pay any money e.g. the rent of premised which are owned by the organization can sometimes be included as a cost in their books.

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