CHAPTER 1
Nature and Scope of Cost Accounting
In the modern business world, the nature and functioning of business organisations have
become very complicated. They have to serve the needs of variety of parties who are interested
in the functioning of the business. These parties constitute the owners, creditors, employees,
government agencies, tax authorities, prospective investors, and last but not the least the
management of the business. The business has to serve the needs of these different category
of people by way of supplying various information from time to time. In order to satisfy the
needs of all these group of people a sound organisation of accounting system is very essential.
In the ancient days the information required by those who were interested with a business
organisation was met by practising a system of accounting known as financial accounting
system. Financial accounting is mainly concerned with preparation of two important
statements, viz., income statement (or profit and loss account) and positional statement (or
Balance Sheet). This information served the needs of all those who are not directly associated
with management of business. Thus financial accounting is concerned with external reporting
as it provides information to external authorities. But management of every business
organisation is interested to know much more than the usual information supplied to outsiders.
In order to carry out its functions of planning, decision-making and control, it requires
additional cost data. The financial accounting to some extent fails to provide required cost
data to management and hence a new system of accounting which could provide internal
report to management was conceived of.
NEED FOR COST ACCOUNTING
The need for cost accounting arises owing to the following:
To Overcome the Limitations of Financial Accounting
Financial accounting records in an overall manner the results of the operations of a business,
using conventional double entry book-keeping techniques. It suffers from the following
limitations:
(i) It provides only past data: Financial accounting provide out of date information
to management. But management is interested in current data but not past data
as it does not serve any purpose to it. Therefore it has been rightly pointed out
that financial accounting provide only a post-mortem analysis of past activities.
1
,2 COST AND MANAGEMENT ACCOUNTING
(ii) It reveals only over all result of the business: Financial accounting does not provide
data for each and every product, process, department or operation separately.
Instead it provides the financial information in a summary form for the entire
organization as a whole.
(iii) It is static in nature: Modern business is dynamic but not static. Financial accounting
does not incorporate the changes that take place within the business.
(iv) It fails to take into account the impact of price level change: In the modern
inflationary conditions the price level has significant impact over financial
statement. Under financial accounting, assets are shown at the actual or historical
cost. Consequently depreciation is also charged on actual or historical cost. This
under charging of depreciation will distort the profit figure.
(v) Possibility of manipulation of financial accounting: Very often financial accounting
is manipulated at the whims and fancies of management so as to project better
image in the minds of prospective investors. The chief forms of manipulating the
financial accounting assume the form of over or undervaluation of inventory,
excessive or inadequate provision for depreciation, creation of secret reserves, etc.
(vi) It fails to exercise control over resources: Financial accounting fail to exercise
control over materials, labour and other expenses incurred in a business enterprise.
As a results, avoidable wastages and losses go unchecked under this system of
accounting.
(vii) It fails to provide adequate data for price fixation: Financial accounting fail to
provide adequate cost data on the basis of which selling price is fixed. In the
absence of fixation of prices in advance, it is not possible to supply quotations to
the prospective customers. To that extent the income from such sales diminish.
(viii) It fails to provide adequate data for management in carrying out its functions:
Management of every organization relies heavily on adequate cost data for
formulating policies and in decision-making process. But financial accounting fails
to provide such useful cost data to management.
(ix) It does not provide a basis for cost comparison: Financial accounting does not help
in cost comparison over a period of time or between two jobs or two operations.
Thus a basis for judging the efficiency of an year with past year or worthfulness
of two different jobs or operations cannot be appraised.
(x) It does not make use of control techniques: Financial accounting fail to make use
of certain important cost control techniques such as budgetary control and standard
costing. Thus financial accounting does not facilitate measuring the efficiency of
the business with the help of control techniques.
(xi) It fails to ascertain break-even point: Financial accounting does not help in
ascertaining the break-even point, i.e., the sale or output where the revenue
equals the cost. Hence, the point of no-profit-no-loss cannot be made out under
financial accounting.
To Ensure Optimum Utilisation of Resources
In todays business world, the resources available are very scarce. Hence every business unit
must strive hard to obtain maximum output with the available input. In order to ensure the
optimum utilization of scarce resources, the value of input is measured against the value of
output. This implies matching cost per unit of production against the value of output or
, NATURE AND SCOPE OF COST ACCOUNTING 3
selling price. But financial accounting does not provide the information relating to cost per
unit of production. Hence the need for cost accounting was felt necessary.
To Achieve Overall Efficiency of Business
Every businessman will make constant effort to improve his business. In order to formulate
suitable policy and sound decision, he has to know answers to certain questions such as
(a) What is the maximum profit which a business can make ? (b) Is the profit earned by it
is more or less compared to the earlier years ? (c) Which product line is making more profit ?
(d) Has too much capital is blocked in raw materials ? (e) Whether the cost of production has
gone up compared to earlier years ? (f) Should the selling price requires revision ? Cost
accounting serves as an useful tool in the hands of management in this direction. By analysing
the cost of production of every unit, it helps management to know the answers to the above
questions.
GROWTH AND DEVELOPMENT OF COST ACCOUNTING
The history of cost accounting can be traced back to the fourteenth century. In the course
of its evolution it passed through following stages:
1. In the first stage of its development, cost accounting was concerned only with the
three prime cost elements, viz., direct material cost, direct labour cost and direct
expenses. For recording the transactions relating to materials the important
documents used were (a) stores ledger, (b) a material requisition note, and (c) materials
received note. To account for labour cost, employee time card and labour cost card
were devised by Mr. Metcalfe. Later on a distinction between manufacturing and
non-manufacturing cost was made by Mr. Norton. Thus material cost, labour cost
and manufacturing cost constituted prime cost.
2. Secondly, around the turn of the nineteenth century, the importance of non-
manufacturing cost (overheads) was recognized as one of the distinct element of cost.
The method of charging non-manufacturing cost to the production cost was devised
under this stage.
3. Thirdly, the techniques of estimation and standards are devised. Instead of using
actual cost, standard costs are used and by comparing with the actual cost the
differences are noted, analysed and disposed off accordingly. This helps in knowing
the efficiency of the business undertaking.
4. Fourthly, cost accounting methods were applied to all types of business undertakings.
The costing principles and techniques were also extended to important functions of
a business.
5. In modern times the development of electronic data processing has occupied significant
stage in the growth of cost accounting system.
Cost Accounting in Indian Context
The application of cost accounting methods in Indian industries was felt from the beginning
of the twentieth century. The following factors have accelerated the system of cost accounting
in our country:
(a) Increased awareness of cost consciousness by Indian industrialists with a view to
ascertain costs more accurately for each product or job.
Nature and Scope of Cost Accounting
In the modern business world, the nature and functioning of business organisations have
become very complicated. They have to serve the needs of variety of parties who are interested
in the functioning of the business. These parties constitute the owners, creditors, employees,
government agencies, tax authorities, prospective investors, and last but not the least the
management of the business. The business has to serve the needs of these different category
of people by way of supplying various information from time to time. In order to satisfy the
needs of all these group of people a sound organisation of accounting system is very essential.
In the ancient days the information required by those who were interested with a business
organisation was met by practising a system of accounting known as financial accounting
system. Financial accounting is mainly concerned with preparation of two important
statements, viz., income statement (or profit and loss account) and positional statement (or
Balance Sheet). This information served the needs of all those who are not directly associated
with management of business. Thus financial accounting is concerned with external reporting
as it provides information to external authorities. But management of every business
organisation is interested to know much more than the usual information supplied to outsiders.
In order to carry out its functions of planning, decision-making and control, it requires
additional cost data. The financial accounting to some extent fails to provide required cost
data to management and hence a new system of accounting which could provide internal
report to management was conceived of.
NEED FOR COST ACCOUNTING
The need for cost accounting arises owing to the following:
To Overcome the Limitations of Financial Accounting
Financial accounting records in an overall manner the results of the operations of a business,
using conventional double entry book-keeping techniques. It suffers from the following
limitations:
(i) It provides only past data: Financial accounting provide out of date information
to management. But management is interested in current data but not past data
as it does not serve any purpose to it. Therefore it has been rightly pointed out
that financial accounting provide only a post-mortem analysis of past activities.
1
,2 COST AND MANAGEMENT ACCOUNTING
(ii) It reveals only over all result of the business: Financial accounting does not provide
data for each and every product, process, department or operation separately.
Instead it provides the financial information in a summary form for the entire
organization as a whole.
(iii) It is static in nature: Modern business is dynamic but not static. Financial accounting
does not incorporate the changes that take place within the business.
(iv) It fails to take into account the impact of price level change: In the modern
inflationary conditions the price level has significant impact over financial
statement. Under financial accounting, assets are shown at the actual or historical
cost. Consequently depreciation is also charged on actual or historical cost. This
under charging of depreciation will distort the profit figure.
(v) Possibility of manipulation of financial accounting: Very often financial accounting
is manipulated at the whims and fancies of management so as to project better
image in the minds of prospective investors. The chief forms of manipulating the
financial accounting assume the form of over or undervaluation of inventory,
excessive or inadequate provision for depreciation, creation of secret reserves, etc.
(vi) It fails to exercise control over resources: Financial accounting fail to exercise
control over materials, labour and other expenses incurred in a business enterprise.
As a results, avoidable wastages and losses go unchecked under this system of
accounting.
(vii) It fails to provide adequate data for price fixation: Financial accounting fail to
provide adequate cost data on the basis of which selling price is fixed. In the
absence of fixation of prices in advance, it is not possible to supply quotations to
the prospective customers. To that extent the income from such sales diminish.
(viii) It fails to provide adequate data for management in carrying out its functions:
Management of every organization relies heavily on adequate cost data for
formulating policies and in decision-making process. But financial accounting fails
to provide such useful cost data to management.
(ix) It does not provide a basis for cost comparison: Financial accounting does not help
in cost comparison over a period of time or between two jobs or two operations.
Thus a basis for judging the efficiency of an year with past year or worthfulness
of two different jobs or operations cannot be appraised.
(x) It does not make use of control techniques: Financial accounting fail to make use
of certain important cost control techniques such as budgetary control and standard
costing. Thus financial accounting does not facilitate measuring the efficiency of
the business with the help of control techniques.
(xi) It fails to ascertain break-even point: Financial accounting does not help in
ascertaining the break-even point, i.e., the sale or output where the revenue
equals the cost. Hence, the point of no-profit-no-loss cannot be made out under
financial accounting.
To Ensure Optimum Utilisation of Resources
In todays business world, the resources available are very scarce. Hence every business unit
must strive hard to obtain maximum output with the available input. In order to ensure the
optimum utilization of scarce resources, the value of input is measured against the value of
output. This implies matching cost per unit of production against the value of output or
, NATURE AND SCOPE OF COST ACCOUNTING 3
selling price. But financial accounting does not provide the information relating to cost per
unit of production. Hence the need for cost accounting was felt necessary.
To Achieve Overall Efficiency of Business
Every businessman will make constant effort to improve his business. In order to formulate
suitable policy and sound decision, he has to know answers to certain questions such as
(a) What is the maximum profit which a business can make ? (b) Is the profit earned by it
is more or less compared to the earlier years ? (c) Which product line is making more profit ?
(d) Has too much capital is blocked in raw materials ? (e) Whether the cost of production has
gone up compared to earlier years ? (f) Should the selling price requires revision ? Cost
accounting serves as an useful tool in the hands of management in this direction. By analysing
the cost of production of every unit, it helps management to know the answers to the above
questions.
GROWTH AND DEVELOPMENT OF COST ACCOUNTING
The history of cost accounting can be traced back to the fourteenth century. In the course
of its evolution it passed through following stages:
1. In the first stage of its development, cost accounting was concerned only with the
three prime cost elements, viz., direct material cost, direct labour cost and direct
expenses. For recording the transactions relating to materials the important
documents used were (a) stores ledger, (b) a material requisition note, and (c) materials
received note. To account for labour cost, employee time card and labour cost card
were devised by Mr. Metcalfe. Later on a distinction between manufacturing and
non-manufacturing cost was made by Mr. Norton. Thus material cost, labour cost
and manufacturing cost constituted prime cost.
2. Secondly, around the turn of the nineteenth century, the importance of non-
manufacturing cost (overheads) was recognized as one of the distinct element of cost.
The method of charging non-manufacturing cost to the production cost was devised
under this stage.
3. Thirdly, the techniques of estimation and standards are devised. Instead of using
actual cost, standard costs are used and by comparing with the actual cost the
differences are noted, analysed and disposed off accordingly. This helps in knowing
the efficiency of the business undertaking.
4. Fourthly, cost accounting methods were applied to all types of business undertakings.
The costing principles and techniques were also extended to important functions of
a business.
5. In modern times the development of electronic data processing has occupied significant
stage in the growth of cost accounting system.
Cost Accounting in Indian Context
The application of cost accounting methods in Indian industries was felt from the beginning
of the twentieth century. The following factors have accelerated the system of cost accounting
in our country:
(a) Increased awareness of cost consciousness by Indian industrialists with a view to
ascertain costs more accurately for each product or job.
