Why Is Cost Accounting So Important to the Success of the Firm - Coursework Example

Why is cost accounting so important to the success of the firm? What are the various methods of cost accounting and how are they used?

Introduction

Accounting is an essential element of any business activity, which allows the firms to measure their profits and costs. This process of measuring can be quite complicated as the plethora of numbers often may be difficult to understand and interpret especially if some information is not as clear-cut and obvious as it may seem (Tracy, 2013). Taking into consideration the fact, that firms have to be especially careful with correct calculation and estimation of its costs, accountants may use different methodologies and approaches. One of such methodologies is cost accounting. This paper aims to provide a more detailed analysis of the cost accounting system and its importance to the success of the firm. Some of the methods of cost accounting and its application also will be briefly discussed.

Cost Accounting – defined and explained

Cost accounting is defined as “a quantitative method that accumulates, classifies, summarizes and interprets information for the three major purposes”, including: (1) operational planning and control; (2) special decisions; and (3) product decisions (Alex, 2012). Another definition is given by the Chartered Institute of Management Accountants, who explain it as “the process of accounting for costs from the point at which expenditure is incurred with cost units” (cited in Alex, 2012: n.p.).

Cost accounting is an alternative form of financial accounting, which was developed to address such limitations as lack of clarity of the operating efficiency of the organization. More specifically, financial accounting in contrast to cost accounting does not disclose the operational and managerial aspects of accounting (Alex, 2012). In cost accounting, the data are estimated, while in financial accounting they are actual (Alex, 2012). Financial accounting provides a limited view, whereas the focus is made on the historical data and events displayed in numerical terms. As a result, there was gradually developed cost accounting method, embracing a wider range of functions varying from the function of statistical data preparation and application of cost control methods to ascertaining costs incurred or planned (Alex, 2012).

Objectives of Cost Accounting

The primary objective of Cost Accounting is to ascertain true cost of all operations, including cost of processes, cost of products, cost of service, cost of transactions, etc. (Alex, 2012). Thus, cost accounting allows organizations to control and better manage the costs by contrasting the actual costs to the estimated. Some other objectives of cost accounting include the following: determining the selling price, determining sales, matching costs with revenues, determining and controlling manufacturing efficiency (Alex, 2012). Furthermore, cost accounting is a helpful mechanism, which can be used for preparing comprehensive financial statements and other reports (Alex, 2012). Cost accounting provides thus management with all necessary information in time and provides data that are necessary for periodical preparation of the balance sheets and profit and loss account (Rajasekaran & Lalitha, 2010).

Advantages of Cost Accounting

In order to emphasize the role and importance of cost accounting in business context, it may be essential to discuss some of the key advantages of this accounting method. There are many different groups of stakeholders who benefit from using cost accounting in different ways, including: management, employees, government, and public.

For management, cost accounting offers key benefits associated with fixing the prices, fixing the sales, fixing the profits, adjusting and selecting a sales mix, alternative choices of production patterns, fixing remuneration for employees, etc. (Alex, 2012). Cost accounting is very helpful in adverse periods of economic fluctuations, recession, competition and trade depression (Rajasekaran & Lalitha, 2010). During such periods, management can more easily to focus on loss reduction initiatives optimizing costs (Rajasekaran & Lalitha, 2010). What is more importantly cost accounting helps management to eliminate wastages and to maximize profit through elimination or avoidance of costly or non-profitable lines. Another important aspect is associated with enhanced efficiency and productivity. Costing helps the firm to increase productivity of labor and materials and to eliminate wastages making the organization more efficient and cost effective, and, therefore, successful.

Costing records are clear and transparent, and can be easily accessed by employees as their financial incentives are tied to the firm’s performance (Rajasekaran & Lalitha, 2010). Thus, employees also benefit from cost accounting due to attractive wage policy, suitable bonus plan, increased motivation due to efficiency performance evaluation and relevant incentive schemes (Alex, 2012). Government and local authorities also benefit from cost accounting due to facilitated assessment of income tax and excise duty, as well as formation of relevant policies to specific industry or sector (Alex, 2012). Overall, the government benefits if the firm generates higher revenues and thus contributes to the national economy through taxes and other type of payments (Rajasekaran & Lalitha, 2010). General public also benefits from cost accounting through fair pricing policy, underpinned by strict control over costs and wastage (Alex, 2012). Furthermore, cost accounting is useful for creditors who rely on costing records as on authentic and reliable document. Thus, the firm is able to communicate more effectively with potential investors, banks and other creditors/lending institutions (Rajasekaran & Lalitha, 2010).

Methods of Cost Accounting

There exist several different methods of cost calculation. The choice of the costing method usually depends on various factors including the firm’s operational activities and manufacturing process (Rajasekaran & Lalitha, 2010). There are defined two generic group of cost accounting methods: specific order costing and process costing. Specific order costing is also called terminal costing or job costing (Rajasekaran & Lalitha, 2010). This method is appropriate for cost accounting of work of separate unit, which related to a specific order. This category may include the following: job costing, contract costing, and batch costing (Rajasekaran & Lalitha, 2010).

Specific order costing

Specific order costing is a cost accounting method, which implies accumulation of costs for each job performed. This method is especially relevant for industries where each job is clearly and distinctly identified (Rajasekaran & Lalitha, 2010).

There is also another variation of job costing method known as contract costing. This method of cost accounting is especially relevant to civil engineering and building construction industries as it allows to extend the job for more than one accounting period (Rajasekaran & Lalitha, 2010).

Finally, batch costing also is one of the variations of job costing, which can be used in situations if firms produce identical or similar goods/items in large quantities as a batch (Rajasekaran & Lalitha, 2010). More specifically, such firms as bakeries, accessories, and spare parts can use this method of cost accounting. Under this method, costs are accumulated for each batch and the cost per unit is calculated by dividing the total cost incurred for producing one batch by the number of total units in this batch (Rajasekaran & Lalitha, 2010).

Process costing is known as period costing or operation costing, and is more applicable for firms operating in manufacturing industries and using a series of repetitive operations or processes (Rajasekaran & Lalitha, 2010). Process costing method implies that the firm manufactures many various units of the product during a specific period of time. In this case, each process of manufacturing separate good is evaluated in terms of costs incurred, while the product cost is calculated on average formula (Rajasekaran & Lalitha, 2010). In case, if the organization is involved in continuous manufacturing of identical units, there is applied one operation costing method. Under operating costing method, the costs are calculated for the whole manufacturing cycle and the total accumulated costs is broken down by the number of produced units (Rajasekaran & Lalitha, 2010).

Another method is multiple operation costing, which implies that manufacturing process is comprised of multiple distinct operations (Rajasekaran & Lalitha, 2010). Usually, this approach relates to the process of calculating costs incurred from converting raw materials and supplies into ready-to-use/sell products (Rajasekaran & Lalitha, 2010). Under this method, accountants take into account the rejections in each stage and then determined input units and costs (Rajasekaran & Lalitha, 2010). Thus, the cost per unit is calculated with consideration of the final output.

One more cost accounting method is composite costing. This method of costing is especially relevant for the firms that use component parts produced separately but further are used in assembling process of the final product (Rajasekaran & Lalitha, 2010). Good example of such industry is automotive or technology industry, whereas firms incur different types of costs and apply combined approaches to costing.

Service costing is a method which is more applicable to operational activities rather that manufacturing (Rajasekaran & Lalitha, 2010). Firms use this method to cost accounting in order to ascertain the costs of rendered services such as logistics, insurance, transportation, electricity, etc.

Importance of Cost Accounting to Business Concerns

Cost accounting plays an important role in firm’s performance and contributes to its success. As it has been already mentioned, cost accounting allows firms to keep effective control over different types of costs, utilizing thus firm’s financial resources more productively. Thus, for example, cost accounting allows firms to keep control of material costs, which quite often make up an essential share off the total cost of the product or manufacturing process. By keeping control over materials cost, the company is able to lower the prime cost and thus to offer more competitive prices or to generate higher profit margins (Alex, 2012). Another important feature of cost accounting is its focus on controlling the labor costs. Headcount costs also often make up a significant portion of the company’s total costs. Cost accounting allows firms to control labor costs, to maximise employee productivity, and to reduce employee turnover (Alex, 2012). Also, cost accounting allows firms to control overheads more effectively. These include various indirect costs that are incurred at manufacturing facility, in administration office, or sales division (Alex, 2012). Furthermore, cost accounting is an effective instrument that can be used for measuring firm’s efficiency throughout the whole organization. Cost accounting department should set up key performance indicators or standards and measure performance efficiency by comparing actual versus planned results (Alex, 2012). Another important aspect of cost accounting is its crucial role in budget preparation process. Relevant, timely and comprehensive information/data retrieved through cost accounting method allows management to make proper and timely decisions (Alex, 2012). More specifically, cost accounting provides especially helpful basis for making such strategic decisions as: to buy or to make, to operate or to shut down, to determine relationship between the cost, profitability, and volume, etc. (Rajasekaran & Lalitha, 2010).

Limitations of Cost Accounting

However, despite the fact that cost accounting has many advantages and benefits for different types of stakeholders, especially management of the firm, there are some essential limitations of this approach. One of the limitations is associated with the fact that cost accounting is not applicable to small firms and enterprises of small sizes (Alex, 2012). Cost accounting is an expensive method, which requires installation of a costing system, which often does not allow covering the benefits implied (Alex, 2012). Another limitation is associated with lack of reliability of cost accounting as it is based on human estimates. Thus, for example, some types of indirect costs are based on individuals’ assumptions and estimations rather than actual evidence. Therefore, there always is a risk of biased estimates. Furthermore, lack of uniform methods and procedures also poses challenges to those who apply and use cost accounting (Alex, 2012).