Cost Accounting: The Basics

Why Cost Accounting?

At this point you may be wondering if cost accounting is synonymous with regular (financial) accounting and why cost accounting is needed in the first place.

At a fundamental level, cost accounting is a managerial tool- it provides information to managers and helps take management decisions.

In fact, cost accounting emerged in response to the limitations of financial accounting:

  1. It does not provide a clear reason for profit or loss: Sometimes profit/loss may be more or less due to inflation or trade depression, not efficiency/inefficiency.
  2. It does not give the reason for the net result or show where the weakness lies- just the profit or loss.
  3. It does not help fixing prices: The total cost of production is shown but does not help determining the prices of products, services, etc.
  4. There is no classification of expenses and accounts: Data relating to costs incurred by departments/ services are not provided separately, nor are per unit cost of product lines. Similarly, expenses are also not classified (as direct/indirect, etc.) and the value added in each process is not reported.
  5. It does not provide data for comparison and decision-making and does not help control cost.
  6. It does not provide standards to assess performance and only provides historical information, not day-to-day cost information.
  7. No distinction is made between avoidable and unavoidable wastage and does not provide enough information for reports to outside agencies like banks, government, etc.
  8. Financial accounting is unable to answer questions like:
    • If an order or contract is accepted, is the price obtainable sufficient to show a profit?
    • Should an attempt be made to sell more products or is the company operating to capacity?
    • What would the effect on net profit be if the manufacture/sale of product A were discontinued and efforts were made to increase the sale of B? Etc.

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