Cost Accounting Systems and Cost Recording

1 Introduction

This chapter looks at how the financial accounting system and the management accounting system interrelate. It also considers coding systems and computerised processing.

2 Cost and management accounting compared with external financial reporting

There are two sets of accounting information in many organisations:

Financial reporting information: for example, the amounts paid for purchases and wages. These are the amounts that appear in the financial statements published by businesses every year.

Cost and management accounting information: For example, how much materials and wages go into each item produced. This information is used internally by the company.

The main differences between these are:

However, when wages (and many other transactions) are paid this will affect both the external financial statements and the internal cost and management accounts. The same transactions often therefore have to be dealt with in two different ways: once for the accounting information and then again for the cost accounting information. There are two approaches to these requirements:

An integrated accounting system. Here, information is recorded once for the two separate purposes. This can save time and effort at the recording stage but might increase effort at the presentation stage.

An interlocking accounting system: here separate ledger systems are maintained for the financial information and the costing information. This increases the recording effort but can be more efficient later when presenting information.

Whether integrated or interlocking, both systems rely on a flow of documentation to generate the accounting data. The flow of documentation should be planned, consistent, and subject to controls and checks otherwise the information provided will be unreliable.

3 Cost units

A cost unit is the thing you are working out the cost of. It is the unit of output that costs are collected against, and everything else in cost accounting depends on choosing it sensibly. In a bakery the cost unit might be one loaf; in a car plant it is one car; in a brickworks it is more likely to be 1,000 bricks, because costing a single brick is not worth the trouble.

You choose the cost unit to suit the output. It should be something you can count, something the business actually sells or transfers, and something small enough to be useful for pricing and control but large enough to be worth measuring.

Some businesses cannot use a single measure. A haulier's costs depend on both weight and distance, so it uses a composite cost unit such as the tonne kilometre. Composite cost units come up again in service costing later in these notes.

4 The material control cycle

The material cycle can be depicted as:

At each stage there should be documents or other procedures that allow control to be exercised.

Purchase requisition: there will normally be a purchase requisition note showing:

• Sequential document number
  

• Date of requisition
  

• Stock code
  

• Quantity needed
  

• Supplier
  

• Supplier’s product code
  

• Signatures authorising the requisition
  

The purchase requisition notes are passed to the purchasing department where they will be examined and approved or queried. Sometimes, despite the supplier being entered on the purchase requisition, the purchasing department might ask several suppliers for quotations.

A purchase order is then raised (created). This will typically show:

• Our name, address and contact details
  

• Purchase order number
  

• Date
  

• Supplier’s name and address
  

• Details of goods required: product codes, description, unit price and total price.
  

• Authorisation
  

The order will have at least two copies: one for the supplier one for the stores to inform them that a delivery is expected.

When goods are received, they will usually be accompanied by a delivery note. This will show the information that is on the purchase order, except for the value of the goods. Goods should not be accepted before checking to a copy of the order that they have, in fact, been ordered. One copy of the delivery note is signed and kept by the supplier. Usually the receiving company will create a standard goods received note from the delivery note. The goods will be stored in the warehouse and stock records on bin cards (see below) will be updated from the goods received note.

A purchase invoice showing the payment due will be received from the supplier, and before this is approved for crediting to the suppliers account and subsequent payment, it should be matched to the order and goods received note to ensure that the correct goods have been received.

When materials are needed for production a materials requisition note should be created requesting the release of material from the stores: part/material code, quantity, job number and so on. This should be signed by the person requesting the goods. Stock records will be updated as goods are issued.

There might be production order setting out goods and labour needed for the production of the goods ordered by customers.

As goods are produced they will be transferred from the production line to the finished goods store. Stock records there should be updated with goods description, quantities and costs.

Customer orders will initiate sales. From those, despatch (or delivery notes) will be produced. These can be used as the basis for taking goods from stores, updating the bin card (see below) packing the goods and despatching them. There will usually be three copies of the delivery note: two go with the goods and of those one stays with the customer and one is signed by the customer and returned as proof of delivery receipt. One copy will stay in the despatch department in case of later queries.

Central to the material control cycle is the recording of the amount of inventory as this will determine when goods need to be ordered and will also record the receipt and issue of goods.

In manual accounting systems bin cards are used (a bin is where a specific item of inventory is stored). The equivalent records are now usually held in computer systems. A typical bin card would look as follows:

This allows a continuous recording of stock quantities.

5 The procedures and documentation to ensure the correct authorisation, analysis and recording of direct and indirect material costs

Direct materials are those which can be specifically traced to a unit of production.

Indirect materials cannot be specifically traced to a unit of production. For example, paint being used in the construction of a product will not be identified as going to a specific product.

Direct materials will be subject to formal requisition requests. Indirect material might simply be made available. For example, it is hardly likely to be cost-beneficial to account for individual screws or the use of drops of adhesive.

The costs of materials can be traced to production: the cost of direct material can be linked to specific items but the cost of indirect materials is likely to be allocated on an average basis.

6 The procedures and documentation needed to ensure the correct authorisation, coding, analysis and recording of direct and indirect labour and expenses.

Direct labour is labour that can be directly identified with a unit of production. A mechanic repairing a car would be an example of direct labour.

Indirect labour cannot be identified with specific units of production. For example a supervisor’s time is spread amongst all workers.

Labour time can be recorded using clock cards, time sheets, or by an assumption that everyone works a standard day. The clock card system is where the employee swipes a card through a reader when getting to work and again when leaving (“clocking-in and clocking-out”. The time working (or at least the time at work) can be calculated and wages calculated from that). The clocking-in and clocking-out processes should be supervised to ensure that employees do not clock in/out for friends.

Time sheets should be reviewed to ensure that time is recorded accurately against the jobs involved. For example, when an audit assistant spends time on a specific audit, an account code (or job code) will be placed against that time on the time sheet. This code will enable the total time spent on each job by each employee to be accumulated.

Any overtime worked should be authorised by supervisors.

Employee wage rates should have been approved by the human resources department.

Expenses

A direct expense is one that can be traced to a single unit, job or batch — a royalty payable on each unit produced, the hire of a machine brought in for one job, or a subcontractor's invoice for one contract. Every other expense is an indirect expense, or overhead: factory rent, power, insurance, telephone, audit fees.

Expenses reach the accounts as invoices rather than as requisitions or time sheets, so the system built around them is an invoice system. The expense should be committed on an authorised order in the first place. When the invoice arrives it is matched to that order and to evidence that the goods or service were actually received, and only then approved for payment by someone with the authority to approve that amount.

Coding is the step that makes the expense useful to the cost accounts. Before posting, the invoice is given a code with two parts: what the cost is (the expense type in the nominal ledger, such as power or insurance) and where it belongs (the cost centre, job or contract). A direct expense is coded to the job number; an indirect expense is coded to the cost centre that will later absorb it into production. Getting that code wrong is how a production overhead ends up as an administration cost.

Some expenses arrive without an invoice — depreciation, accruals for power used but not yet billed, an allocation of rent across departments. These are posted by journal, and journals should be supported by a calculation and authorised by someone other than the person who prepared them. Finally, expense codes should be analysed and reviewed against budget each period, because an expense posted to the wrong code usually shows up as one cost centre overspending while another underspends by the same amount.

7 The procedures and documentation to ensure the correct analysis and recording of sales.

Sales transactions will normally be initiated by receiving an order from a customer. It is important that orders are recorded as soon as possible, for example by entering them in a register (book).

The customer’s account will be checked to ensure that the customer is paying for previous orders satisfactorily and will remain within any credit limit if the new order is approved.

As outlined above, from the order a multi-set delivery note or despatch notes will be raised so that the goods can be packed and despatched to customers. It is, of course vital that all despatched goods are invoiced otherwise the company will effectively be giving goods away. One way of doing this is to enter invoice numbers against the original register of orders. This should mean that all orders received have been despatched and invoiced.

In a manual system, the invoices will be listed in the sales day book. Sometimes, the sales day book can have several columns for the sales of different categories of goods. The sum of these lists will be the total of sales made in each category.

8 The use of codes in categorising and processing transactions

It is universal practice in accounting systems to use coding systems to refer to customers, suppliers, accounts and employees. Codes are used because they are concise and precise, and can be subject to computer checking

Concise:   instead of referring to a product as a “50cm, high resolution LED monitor”, the product is given a code such as 50HRL. This is much quicker to write or type.

Precise:   there might be several makes of 50cm high resolution LED monitors and information might be confusing and ambiguous if the manufacturer (Sony, Panasonic, Samsung, LG etc) wasn’t specified. A code number can therefore be used to ensure that products and people are referred to uniquely eg 50HRLLG.

Checking:   if all inventory codes are 7 digits long then forms and input screens can be designed for this. Computers can check that all 7 digits are present; sometimes more sophisticated checks can be carried out on the structure of the code. This reduces the chance of errors.

Processing:   Codes can also help in processing transactions. For example if all income-related accounts have the structure 1xxxx, all expense-related accounts have the structure 2xxxx, all asset-related accounts 3xxxx and all liability accounts 4xxxx, then this will help the production of the income statement (all 1xxxx amounts less all 2xxxx amounts) and the statement of financial position (3xxxx as asset amounts and 4xxxx amounts as liabilities). This is particularly needed in computerised accounting systems because the computer cannot understand that, say, rent is an expense, but doesn’t need this understanding so long as rent is coded, say 21892. Because it starts with ‘2’ it will be treated as an expense.

9 Different methods of coding

There are several methods of coding. Codes should be:

• Simple to use
  

• Understandable
  

• Concise
  

• Precise
  

• Expandable
  

As we will see, these requirements can be in conflict.

Sequential codes

In this method products or customers are simply allocated numbers in sequence:

0001     Abrahams

0002     Adkins

0003     Ahmad

.

.

.

It is simple and concise, but as constructed might have some faults:

1. There is no relationship at all between the code and the item/person being encoded.

2. Expansion might be difficult once you have over 9999 customers if documents and computer files can hold only four digits. Additionally, if someone called Affleck becomes a customer, he will have to be tagged onto the end of the sequence ie not reflecting alphabetical order. To avoid this problem, often sequence codes proceed as 0010, 0020, 0030…etc so that gaps are built in for future use.

Hierarchical (or significant digit) codes

Here, as you progress through the code, information becomes increasingly specific. Many libraries use this system to code their books using the Dewey Decimal System

500 Natural sciences mathematics

.

.

510 Mathematics
520 Astronomy & allied sciences
530 Physics
540 Chemistry & allied sciences
550 Earth sciences
560 Paleontology, paleozoology
570 Life sciences
580 Botanical sciences
590 Zoological sciences

.

.

555 Earth sciences of Asia

In a business, hierarchical codes could be used to code the accounts in the general ledger. For example a code such as 3112 could be interpreted as the Machinery Cost Account, using the following system.

The great advantage of this type of code is that its structure provides information both to human users and to computers. For example, it would be easy to program the computer to work out the total cost of all fixed assets: simply add up all accounts starting 311.

Block codes

These lie somewhere between simple sequence codes and the full, detailed hierarchical code. They start off giving some information but then lose enthusiasm. So for general ledger codes you might have

1xxx = expenses

2xxx = income

3xxx = assets

4xxx = liabilities

Faceted codes

These are an improvement of block codes and provide more information but lack a logical hierarchical structure. The code is broken down into sections or groups of digits and each group codes for a particular attribute.

For example an employee code could be:

Facet 1 Sex of employee:       1 = male; 2 = female

Facet 2 Department:         01 = accounts; 02 = sales; 03 = IT etc

Facet 4 Full or part time       1 = full time; 2 = part time

Facet 5 Weekly or monthly paid:       01 = weekly; 02 = monthly

Mnemonic

All the codes illustrated so far have been purely numerical. Mnemonic codes contain letters to help humans to learn what the codes mean. The hierarchical code above:

could then become

It is not common to have full mnemonic codes and often just the first character will be mnemonic and the rest will follow another system.

10 Computer systems

Many, if not most, cost accounting systems are now computerised. As mentioned earlier this brings advantages relating to cost, speed, accuracy, more complex processing, and wider availability of information. Computer systems can be depicted by the following diagram: