What is Costing? Operational Approach to Financial Decision

Costing is about figuring out how much different parts of a business cost, like customers, products, or processes. It includes planning, managing, and keeping track of cost information so businesses can budget, predict, and monitor their expenses accurately. Cost refers to the money spent on resources used to make products or provide services, but not all costs are counted as expenses; some are considered assets.

Scope of Costing

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Nature of Costing

• Branch of Knowledge: It is considered a branch of financial accounting but is distinct with its principles and concepts, varying across industries.

• Science: Cost accounting is regarded as a science due to its systematic knowledge encompassing various subjects like law, office practice, production, and material control.

• Art: It requires the skill and expertise of a cost accountant to apply its principles, procedures, and methods to specific management issues, such as cost control and profitability analysis.

• Profession: In recent years, cost accounting has emerged as a crucial and challenging profession, evidenced by the establishment of professional organizations and increased enrollment in relevant institutions for education and certification.

Objectives of Costing

1. Ascertainment of Cost: Costing aims to determine the cost of products, processes, or operations accurately. This involves recording costs such as materials, labor, and other expenses meticulously to ensure all costs are included in pricing. Costing provides managers with crucial information for establishing selling prices and evaluating profitability.
2. Cost Control: Beyond cost determination, costing focuses on controlling costs to enhance profitability. By comparing budgets, standards, and actual costs, managers identify discrepancies and take corrective actions to keep costs in check. Lower costs can lead to increased profits or lower selling prices, benefiting both the company and customers through improved product quality and customer loyalty.
3. Guidelines for Management: Costing serves as a valuable tool for managerial decision-making by providing cost data that supports organizational efficiency. Managers utilize cost information to make informed decisions, such as launching new product lines, optimizing capacity utilization, or identifying growth opportunities, ultimately contributing to the overall effectiveness of the organization.

Types of Costing

1. Variable Cost: These costs change directly in proportion to changes in the level of activity. Examples include raw materials and direct labor.
2. Fixed Cost: Fixed costs remain constant in total despite changes in activity levels. Examples include rent and salaries.
3. Direct Cost: Direct costs can be traced directly to specific segments of operations. Examples include materials used for a specific product.
4. Indirect Cost: Indirect costs cannot be directly identified with specific segments of operations. Examples include overhead costs shared by multiple departments.

• Relevant Costs: These are costs that influence the choice of alternatives in a particular decision and are affected by that decision.
• Irrelevant Costs: Irrelevant costs remain constant regardless of the decision made and are not affected by the alternatives chosen.

• Sunk Costs: Historical costs incurred in the past that cannot be changed by future decisions. They are always irrelevant in decision-making.
• Shutdown Costs: Unavoidable fixed costs incurred even when a plant is temporarily shut down. Managers consider these costs when deciding whether to shut down or continue operations.
• Imputed/Hypothetical/Notional Costs: Costs representing a sacrifice or resource use, measured in monetary terms, without actual cash outlay. For example, imputed rent for using owned premises.
• Pocket Cost / Explicit Costs: Costs requiring cash outlay due to a specific managerial decision, representing present and future cash outflows.

Advantages of Costing

1. Measurement and Improvement of Efficiency: Cost accounting enables organizations to measure and improve efficiency by analyzing cost differences over time. It helps identify areas of inefficiency and opportunities for improvement.
2. Identification of Profitable and Unprofitable Activities: Costing helps distinguish profitable and unprofitable activities by comparing costs with revenues. This information guides resource allocation and investment decisions.
3. Fixation of Prices: Cost accounting provides accurate cost information for pricing decisions. It ensures that prices are set at levels that cover costs and generate profits, preventing losses from underpricing.
4. Guidance in Price Reductions: During economic downturns, costing guides management in deciding when to reduce prices below total costs to remain competitive. It ensures informed decision-making during challenging market conditions.
5. Information for Proper Planning: Detailed cost information supports effective production planning by optimizing resource utilization and minimizing waste. It ensures that production processes are efficiently managed to meet demand without overworking or idling resources.

Basic Principles of Costing

1. Cause-and-effect Relationships: Costs should be closely tied to their root causes, and their impact on various departments should be determined. Only units that pass through the departments incurring costs should share those costs.
2. Exclusion of Past Unrecoverable Costs: Costs that could not be collected in the past should not be included in future costs. Including such costs can distort the results of future operations and financial statements.
3. Charge of Cost Only Upon Incurrence: Only costs that have been legitimately incurred should be included in unit costs. For example, selling costs should not be included in unit costs while a product is still in production.
4. Exclusion of Abnormal Costs: Costs incurred due to abnormal causes, such as theft or negligence, should be excluded from cost accounts. Including such costs can distort expense estimates and mislead management decisions.
5. Adherence to Double Entry Principles: Cost ledgers and control accounts should preferably be maintained using double-entry methods to minimize the risk of errors. This ensures the accuracy of cost sheets and statements used for cost estimation and control.

Classification of Costs

1. By Nature or Element;
2. By Functions; and
3. By Variability or Behaviour
4. By Capability
5. By Regularity
6. By Costs for Managerial Decision Making.