Purpose of costing

Costing enables the managers of a business to know the cost of the firm's output. Once costing information is available, managers can use it to assist with decision making, planning the future and the control of expenditure.

Cost accounting is widely used by:

A manufacturing business
A business that provides a service

By being able to work out the cost of a product or service, the managers of an organisation can then use this cost to:

Determine a selling price
Value inventory
Provide information for financial statements
Make management decisions

What is a costing system

A costing system is used by an organisation to collect information about costs and use that information for decision making, planing and control.

Financial accounting and management accounting

What is financial accounting: Financial accounting is concerned with recording financial transactions that have happened already, and with providing information form the accounting records.

The main features of financial accounting are:

Records transactions hat have happened already
Accurate to the nearest penny
A legal requirement
Maintains confidentiality of information

What is management accounting: Management accounting is concerned with looking at actual transactions in different ways from financial accounting. In particular, the costs of each product or service are considered both in the past and as the likely costs in the future. In this way, management accounting is able to provide information to help the business or organisation plan for the future.

The main features of management accounting are:

Makes estimates for the future
Looks in detail at the costs and sales income
Looks forward to show what is likely to happen in the future
Provides management with reports
Used internally within the business
Maintains confidentiality of information

Sources of data for costing

Costs can be seen as:

Historic costs
Current costs
Future costs

Introduction to classifying costs and income

The elements of cost:

Materials
Labour
Expenses

Materials costs include:

Raw materials
Products bought for resale
Service items/consumables

Labour costs include:

Wages
Salaries
Public sector wages

Expenses is a term that refers to all other running costs of the business or organisation that cannot be included under the headings of materials and labour. eg. rent, rates, heating lighting.
Expenses may also be classed as 'overheads'.

Classification of costs by function and nature

As well as dividing costs into materials, labour and expenses, it is also useful to show why the costs have been incurred. This breakdown of costs is sometimes called 'functional' as it links to the different sections of an organisation.
The two main functions are generally carried out in:

The factory
The warehouse

Costs in the factory - production costs

The costs incurred in the factory are production costs. 'Production' is the function into which these costs are classified.
We can divide these production costs further into:

Direct costs
Indirect costs

This analysis is sometimes called classification by nature.

Direct costs - Costs that can be directly identified with each unit of output.
Indirect costs - Costs that cannot be directly identified with each unit of output.

Direct costs:

Direct materials - The cost of the materials used to make the items produced.
Direct labour - The cost of paying the employees that make the product.
Direct expenses

The total of direct costs is also called the prime cost.

Indirect production costs:

Indirect materials - The cost of materials that cannot be directly linked to specific items produced.
Indirect labour - The cost of employing people in the factory who do not actually make the products.
Indirect expenses - The other costs of running the factory.

The total of direct costs and indirect production costs is simply known as total production costs.

Non production costs (indirect):

Administration
Selling and distribution
Finance

Key terms:

Costing system - The system that an organisation has developed to collect information about costs and income so that it can be used to help with decision making, planning and control.

Management accounting - The area of accounting that includes costing; it concentrates on providing internal information about the future in a form that is useful; it has no externally set rules that must be followed.

Financial accounting - The area of accounting that includes bookkeeping; it concentrates on providing historic information that can be used internally and also provided to external parties.

Budget - A future plan for an organisation, showing all the detail in financial terms; it is usually made up of various individual budgets.

Cost classification by element - Grouping costs together according to the type of cost based on three categories; materials, labour and expenses.

Cost classification by nature - Grouping costs together according to whether they are direct costs or indirect costs.

Direct costs - Costs that are directly identified with the units of output.

Prime cost - A term relating to the total of direct costs; it is often used to describe the total direct cost for a unit of output.

Indirect costs - Costs that are not directly identified with the units of output; these costs are divided into production and non-production costs in a manufacturing organisation.

Cost of production - A term relating to the total of direct costs and indirect production costs.

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