Why organizations use costing systems
An organisation’s costing system is the foundation of the internal financial information system for managers. It provides the information that management needs to plan and control the organisation’s activities and to make decisions about the future. Examples of the type of information provided by a costing system and the uses to which it might be put include the following.
- Actual unit costs for the latest period; could be used for cost control by comparing with a predetermined unit standard cost, which would also be provided by the costing system. Could also be used as the basis for planning future unit costs and for decisions about pricing and production levels.
- Actual costs of operating a department for the latest period; could be used for cost control by comparing with a predetermined budget for the department. Could also be used as the basis for planning future budgeted costs and for decisions such as outsourcing.
- The forecast costs to be incurred at different levels of activity. Could be used for planning, for decision making and as a part of cost control by comparing the actual costs with the forecasts.
This is by no means an exhaustive list of the information that is provided by a costing system but it should serve to demonstrate that the main use of a costing system is to provide the basic information that management needs for planning, control and decision-making.The word ‘cost’ can be used in two contexts. It can be used as a noun, for example, when referring to the cost of an item. Alternatively, it can be used as a verb, for example, we can say that we are attempting to cost an activity. CIMA’s definition of cost used in these two contexts is as follows:
What is meant by ‘cost’?
- As a noun: ‘the amount of expenditure incurred on, or attributable to, a specified thing or activity’.
- As a verb: ‘to ascertain the cost of a specified thing or activity’.
The terminology goes on to explain that the word cost can rarely stand alone and should be qualified as to its nature and limitations. You will be seeing throughout this text that there are many different types of cost and that each has its usefulness and limitations in different circumstances.
The CIMA Management Accounting: Official Terminology defines a cost unit as ‘a unit of product or service in relation to which costs are ascertained’.
This means that a cost unit can be anything for which it is possible to ascertain the cost. The cost unit selected in each situation will depend on a number of factors, including the purpose of the cost ascertainment exercise and the amount of information available.
Cost units can be developed for all kinds of organizations, whether manufacturing, commercial or public service based. Some examples from the CIMA Terminology are as follows:
Industry sector Cost unit
Brick-making 1000 bricks
Electricity Kilowatt-hour (k W h)
Professional services Chargeable hour
Education Enrolled student
Activity Cost unit
Credit control Account maintained
Selling Customer call
The above is not exhaustive. A cost unit can be anything which is measurable and useful for cost control purposes. For example, with brick-making, 1,000 bricks is suggested as a cost unit. It would be possible to determine the cost per brick but perhaps in this case a larger measure is considered more suitable and useful for control purposes.
Notice that this list of cost units contains both tangible and intangible items. Tangible items are those which can be seen and touched, for example, the 1,000 bricks. Intangible items cannot be seen and touched but they can be measured, for example, a chargeable hour of accounting service.
Composite cost units
The cost units for services are usually intangible and they are often composite cost units, that is, they are often made up of two parts. For example, if we were attempting to monitor and control the costs of a delivery service we might measure the cost per tone delivered. However, ‘tone delivered’ would not be a particularly useful cost unit because it would not be valid to compare the cost per tone delivered from London to Edinburgh with the cost per tone delivered from London to Brighton. The former journey is much longer and it will almost certainly cost more to deliver a tone over the longer distance.
Composite cost units assist in overcoming this problem. We could perhaps use a ‘tonnemile’ instead. This means that we would record and monitor the cost of carrying one tone for one mile. The cost per tone-mile would be a comparable measure whatever the length of journey and this is therefore a valid and useful cost unit for control purposes.
Other examples of composite cost units might be as follows:
Business Cost unit
Hotel Bed night
Bus company passenger mile
Hospital In-patient day
The CIMA Terminology defines a cost centre as ‘a production or service location, function, activity or item of equipment for which costs are accumulated’.
A cost centre is used as a ‘collecting place’ for costs. The cost of operating the cost centre is determined for the period, and then this total cost is related to the cost units which have passed through the cost centre.
For instance, an example of a production cost centre could be the machine shop in a factory. The production overhead cost for the machine shop might be £ 100,000 for the period. If 1,000 cost units have passed through this cost centre we might say that the production overhead cost relating to the machine shop was £ 100 for each unit.
The CIMA definition of a cost centre also mentions a service location, a function, an activity or an item of equipment being used as a cost centre. Examples of these might be as follows but you should try to think of some others:
Type of cost centre Examples
Service location Stores, canteen
Function Sales representative
Activity Quality control
Item of equipment packing machine
If you are finding it difficult to see how a sales representative could be used as a cost centre, then work carefully through the following points.
What are the costs which might be incurred in ‘operating’ a sales representative for one period?
Examples might be the representative’s salary cost, the cost of running a company car, the cost of any samples given away by the representative and so on. Say these amounts to £ 40,000.
Once we have determined this cost, the next thing we need to know is the number of cost units that can be related to the sales representative.
The cost unit selected might be £ 100 of sales achieved. If the representative has achieved £ 400,000 of sales, then we could say that the representative’s costs amounted to £ 10 per £ 100 of sales. The representative has thus been used as a cost centre or collecting place for the costs, which have then been related to the cost units.