I can imagine the very first business activity which occurred on earth would be a barter trade, maybe it was an exchange of a bucket of rice with a bucket of wheat or a piece of meat? To analyse the fairness of the deal, both parties must have asked themselves” is the bucket of rice is worth the same as the bucket of wheat?” At the times when there was no currency, it must be difficult to gauge the comparative values unlike now-a-day when we can find out the market value of any product easily and assess if one is striking a good deal or not.
So how would you assess a transaction like that in the old times?
One way to assess that barter trade, which I think is the most appropriate one, would be to think about how much effort was put in growing those two crops, harvesting and then further processing to make those seeds edible. If you know few things about growing wheat and rice, you will know that rice is more resource intense to grow, e.g., it needs a lot more water than wheat etc. If I put myself into the shoes of rice grower, I would say that it is not a fair deal to exchange a bucket of rice with a bucket of wheat as it took a lot more effort to grow rice. The efforts to grow rice (and wheat) is the cost of growing it and it can be concluded that cost of growing rice is higher than growing wheat.
In this scenario, I am not considering the taste of rice and wheat and availability of the products from other parties, as this is a demand and supply issue rather than a costing one.
The above scenario created a branch of knowledge which we now call Accounting (cost accounting, to be more precise) and it may also suggest that that the original/ initial function of the accounting was to determine the cost of producing (or buying) and cost accounting is the original accounting. We can also derive a basic definition of cost from the above scenario which is “cost is the value of resources and efforts used or consumed in creating or producing a product or providing a service.”
In modern world, we simply put a monetary value to those resources and efforts which has made the modern complex trade possible. If you search online the meaning of cost, one of the definitions is “an amount that has to be paid or spent to buy or obtain something” which is simpler than the one above as we have replaced efforts and resources with “money.” The money we have earned and are carrying in our pockets or bank accounts is the cost of our time and efforts to the person or organisation for whom we work.
Traditionally, the purpose of accounting (Cost) was to deal with the costing i.e., determining the total cost of the different products, services and functions (e.g. departments) of the business. This was the time when reporting financial performance was not an objective of the accounting department. Financial Accounting which is the other main area of accounting discipline evolved later when calculation and reporting of business activities became a necessity (or legal requirement) for tax purposes and later for corporate governance related issues.
In the past, when businesses were small and were producing only one or similar products (which would take similar efforts, time and material) and where organisational structure was simple, calculating the cost of a product was simple and it could be claimed that the total cost of the products/services could be calculated to 100% accuracy.
However, now a days, even small business’s costing can be very complicated, rest aside the large manufacturing organisations which are producing 100s of different products. The organisational structures are also more complex with offices and manufacturing facilities in different countries and complex supply chains. No doubt Cost Accounting has evolved to meet the needs of these complex costing issues and dozens of new costing techniques have been invented including Activity-Based Costing, Process Costing, Target Costing etc. However, you will find this interesting that none of the methods would give us 100% accurate cost of a unit of product/service. Some are more accurate than others though, therefore, management should always strive to calculate the cost as accurately as possible. Although costing is not considered the main purpose of the management, it can be a primary concern of the management to control costs. We usually use the word “control” with regards to the cost even though the ideal things would be to reduce them. However, this is not possible all the time to reduce the cost, so the world control is more appropriate.
Why accurate costing is crucial?
Accurate costing can be very critical to the business success and survival. Most of the time, prices of the products and services are based on the cost of producing/ buying the products and providing the services. Many businesses have a standard mark-up percentage which they will add to the cost of the products to set the price of the product or service. A mark-up is an amount which is based on the cost of the products. For example, if a product is bought for £10 and the organisation policy is to charge a mark-up of 50%, the price will be fixed at 10+ 10×50%= £15.
If the cost of the product is calculated low which is a possibility if the business ignores (or simply forgets) certain costs to be added to the product’s cost believing those costs are not relevant, the price of the product will be set lower than it should be which will result in the lower profits or even loss.
If the price is set too high due to miscalculation of the cost, then the customers would go to competitors to buy that product. As management would always want to make some profit on each product they sell, they may not be willing to reduce the price to match competitors’ price. Hence business could be losing customers and profit due to incorrect costing. This scenario can be more likely in the organisations where multiple products are beings produced/ bought and sold and/or services being offered. This happens due to common costs which are not always easy to allocate to different products precisely.
So How do we ensure our costing is correct?
This can be achieved by determining all costs which are being incurred in the business. As mentioned above, Cost accounting deals with the determination of the cost of different products and functions of a business. For example. If you buy a product for £5, one might say that the cost of selling this product is also £5 and if you set a price of £10 for it, you will be making a profit of £5. However, for most of the businesses in modern economy, cost of selling a product also include
•Carriage inwards
•Cost of storage space i.e., warehouse costs
•Cost of handling i.e., warehouse staff
•Insurance costs
•Cost of obsolescence
•Interest cost
We will look at all possible costs, its categorisations and definitions, in the next article.
Point to remember;
-Cost is the amount spent on creating or producing a product or providing a service.
-Cost Accounting deals with the determination the total cost of different products, services and functions of the business as accurately as possible.
-Accurate costing is crucial for businesses’ success and survival.
-There are many different cost accounting techniques which would calculate different costs for the same products in a business. Some techniques are more accurate than others.
This article is written by Raja Mizan who is a senior lecturer in accounting & finance in a UK university. He is an ACCA member and also runs his own accountancy practice RMR Accountants & Business Advisors.