Cost Audit Procedures
Appointment of cost auditor
Duty of company
Eligibility, Rights and Duties
Budgetary control methods
Budgetary control and responsibility centres
Problems in budgeting
o Standard Costing Systems:
o Standard Costing Systems and Flexible Budgeting
o Reasons for using a Standard Costing System
Definition:An internal audit used for enterprise governance to assess operational
efficiencies and resource management. Special attention is given to verification
of cost records and adherence to acceptable cost accounting procedures.
Cost Audit represents the verification of cost accounts and check on the
adherence to cost accounting plan. Cost Audit as certain the accuracy of cost
accounting records to ensure that they are in conformity with Cost Accounting
principles, plans, procedures and objective.
Cost Audit comprises following;
1 Verification of the cost accounting records such as the accuracy of the
cost accounts, cost reports, cost statements, cost data and costing
2 Examination of these records to ensure that they adhere to the cost
accounting principles, plans, procedures and objective.
Objectives of Cost Audit
Prospective Objective: Under which cost audit aims to identify the undue
wastage or losses and ensure that costing system determines the correct and
realistic cost of production.
Constructive Objectives: Cost audit provides useful information to the
management regarding regulating production, economical method of operation,
reducing cost of operation and reformulating Cost accounting plans .
Types of Cost Audit
Cost Audit on behalf of the management.
Cost audit on behalf of a customer
Cost Audit on behalf of Government
Cost Audit by trade association
5 Statutory Cost Audit
Basic qualification for a cost auditor is the prescribed examinations and
practices by the professional & Regulatory body for Cost & Management
Accountancy of the country or in case a person is the member of other
professional bodies, exemption should be allowed to him/her under the mutual
recognition agreements (MRAs) to become a cost auditor.
Cost Audit Procedures
Cost audit comprises following three steps;
Cost Audit Importance
The important advantages of cost audit are briefly discussed as follows:
Advantages of Cost Audit to the Management
1. Cost audit provides reliable cost data for managerial decisions.
2. Cost audit helps management to regulate production.
3. Cost audit acts as an effective managerial tool for the detection of errors,
frauds and irregularities so that reliable and smooth functioning of the system is
4. Cost audit reduces the cost of production through plugging loopholes relating
to wastage of material, labor and overheads.
5. Cost audit can fix the responsibility of an individual wherever irregularities
or wastage are found.
6. Cost audit improves efficiency of the organization as a whole and costing
system in particular by constant review, revision and checking or routine
procedures and methods.
7. Cost audit helps in comparing actual results with budgeted results and points
out the areas where management action is more needed.
8. Cost audit also enables comparison among different units of the factory in
order to find out the profitability of the different units.
9. Cost audit exercises moral influence on employees which keeps them
efficient and alert.
10. Cost audit ensures that the cost accounts have been maintained in
accordance with the principles of costing employed in the industry concerned.
Advantages of Cost Audit to the Shareholders
1. Cost audit ensures that proper records are maintained as to purchases,
utilization of materials and expenses incurred on various items i.e wages and
overheads etc. It also makes sure that the industrial unit has been working
efficiently and economically.
2. The cost audit enables shareholders to determine whether or not they are
getting a fair return on their investments. It reflects managerial efficiency or
3. Cost audit ensures a true picture of company's state of affairs. It reveals
whether the resources like plant and machinery are being properly utilized or
Advantages of Cost Audit to the Society
1. Cost audit tells the true cost of production. From this the consumer may know
whether the market price of the article is fair or not. The consumer is saved
from the exploitation.
2. Cost audit improves the efficiency of industrial units and thereby assists in
economic progress of the nation.
3. Since price increase by the industry is not allowed without justification as to
increase in cost of production, consumers can maintain their standard of living.
Advantages of Cost Audit to the Government
1. Cost audit assists the 'Tariff Board' in deciding whether tariff protection
should be extended to a particular industry or not.
2. Cost audit helps to ascertain whether any particular industry should be given
any subsidy in order to develop that industry.
3. Cost audit provides reliable data to the government for fixing up the setting
prices of the various commodities.
4. Cost audit helps the government to take necessary measures to improve the
efficiency of sick industrial units.
5. Cost audit can reveal the fraudulent intentions of the management.
6 Cost statements may be helpful to authorities in imposing tax or duty at the
cost of finished products.
7 Cost audit facilitates settlement of trade disputes of the companies.
Cost audit is the independent audit of cost records maintained by companies.
The concept of cost audit was introduced in 1965 when Companies Act, 1956
was amended to incorporate the provisions relating to the maintenance of cost
accounting records and cost audit. Cost audit got an impetus in 2011 when its
scope was expanded and the rules and reporting formats were simplified to
address industry concern of confidentiality.
The Companies Act, 2013 has retained the provisions relating to maintenance of
cost records and cost audit. The government has notified the Companies (cost
records and audit) Rules 2014 on June 30, 2014. The 2014 Rules have severely
curtailed the scope of cost audit. This U-turn in policy has dismayed the cost
accounting profession and experts.
The new Rules mandate the maintenance of cost records in companies engaged
in the production of specified goods in strategic sectors, companies engaged in
an industry regulated by a sectoral regulator or a ministry or department of
central government, companies operating in specified areas of public interest
and companies engaged in the production, import and supply or trading of
specified medical devices.
The Rules also provide for a threshold in terms of net worth or turnover of
companies, thus, restricting its applicability to large companies.
It appears that the government has mandated maintenance of cost records and
cost audit only in those sectors, which might require policy intervention. For the
first time, it has brought construction companies, companies engaged in health
services and companies engaged in education services within the ambit of cost
audit. The government has categorised those as companies operating in the area
of public interest.
The government has excluded the industries in which the competition among
companies is significant. Presumably, the government has taken the view that
cost audit is not relevant in companies that operate in a competitive
It is argued that those companies maintain cost records voluntarily, as they are
required to continuously analyse cost and revenue data for managing costs, in
order to retain and enhance competitiveness on the face of competition from
competing firms or competing substitutes.
In those companies, the management information system draws data from cost
records. Therefore, there is no need to mandate maintenance of cost records and
cost audit. But there is a flaw in this argument. Cost audit is no less relevant for
companies operating in a competitive environment.
Any audit provides reasonable assurance about the integrity of audited
information. For example, financial audit provides assurance to shareholders
and other stakeholders about the integrity of information provided through
financial statements. Financial audit is mandated to protect the interest of
minority shareholders from the opportunistic behavior of managers. The
underlying assumption in mandating financial audit is that managers are human
beings and, therefore, are inherently opportunistic.
Managers show opportunistic behavior even in presenting information before
the board of directors. This is the reason why SEBI had to mandate the
minimum information to be presented before the board of directors. It is not
unknown that managers man oeuvre board process to get favorable board
Companies Act, 2013 aims to strengthen corporate governance by empowering
the board of directors. It requires independent directors to get involved in
critical decisions. They have been made responsible for strategy review, risk
management, performance evaluation and key appointments.
All these require analyses of cost and revenue data. If, we agree that managers
are inherently opportunistic, the board of directors need an assurance from an
independent agency about the integrity of cost and revenue information that is
placed before it. Only cost audit by an independent cost auditor can provide that
Cost audit has not lost relevance, even for companies operating in a competitive
environment. Benefits from cost audit outweigh its cost. If a company is already
maintaining cost records, the incremental cost is the audit fee.
The cost of regular staff, which support the audit, is fixed in nature. Therefore,
while the cost is immaterial, benefits in terms of improved corporate
governance are immense, may not be from the management's perspective. By
introducing the concept of 'public interest', which is difficult to define, the
government has made the 2014 Rules unnecessarily complicated and difficult to
implement. Rules should be transparent and simple.
The current Rules provides the scope for jockeying for inclusion and exclusion
of companies from the ambit of cost audit. The government should bring all
companies, except small companies, within the ambit of cost audit. It is also
important that the cost accounting profession quickly upgrades skills in
developing costing systems for emerging businesses, including those in the
Statutory Audit is an checking of accounts required by law. A municipality may
be required by its own law to have an annual audit of financial records or a
company which is governed by any Law, the Law may require the audit to be
conducted and the manner in which audit should be conducted and to whom the
report of auditors should be presented. like in case of companies the Companies
Act requires audit of accounts, its reporting and manner of audit report.
One conducted to meet the particular requirements of a governmental agency.
Where such audits take place, the scope and audit programs are set by the
governmental body. Banks, insurance companies, and brokerage firms have
Since the auditor's report must conform to standards required by the governing
agency, the statements and other financial data generated from these audits may
not conform to Gaap.
Statutory auditors are elected by shareholders and hold a position in the
hierarchy alongside the board of directors A company must have at least one
Cost Audit as per Companies Act, 2013
The companies act, 2013 has come into existence on 29.08.2013 that replaces a
nearly six decade-old legislation and overhauls the way corporate function and
are regulated in the country. This article contains the description of some
provisions related to cost audit as per companies Act, 2013.
When cost audit is required:Central government may direct to conduct cost audit in respect of companies
engaged in the production of such goods or providing such services and have a
net worth or turnover as may be prescribed. Note: If company is regulated by
any special act then central government can direct to conduct cost audit only
after consulting with regulatory body constituted under special act.
Appointment of cost auditor:Cost auditor shall be appointed by board whereas remuneration of cost auditor
shall be determined by members.
Who can be appointed as cost auditor:Cost audit shall be done by cost accountant in practice. Qualifications,
disqualifications, rights and duties of cost auditor:-Cost auditor shall have same
qualifications, disqualifications, rights and duties as that of a company auditor.
Further, it is the duty of cost auditor to comply with cost auditing standards and
to submit his report to BOD.
Duty of company:After receiving the cost audit report, company shall furnish full information and
explanations on every reservations or qualifications to CG within 30 days of
receipt of cost audit report. If CG requires any further information then it is the
duty of company to furnish such information within given time.
Punishment for contravention in case of company:If company contravenes any of the above mentioned provisions then company
shall be punishable with fine of Rs. 25,000 to Rs. 5, 00,000 and officers of
company shall be liable for fine of Rs. 10,000 to Rs. 1, 00,000 or imprisonment
for a term which may extend to 1 year.
Punishment for contravention in case of cost auditorIf Cost auditor contravenes any of the above mentioned provisions unknowingly
then he shall be punishable with fine of Rs. 25,000 to Rs. 5, 00,000. Whereas,
he contravenes any of the above mentioned provisions knowingly then he shall
be punishable with fine of Rs. 1,00,000 to Rs. 25,00,000 along with
imprisonment for a term which may extend to 1 year. Further, he shall be liable
to refund the remuneration and pay damages to company.
COST AUDITOR: ELIGIBILITY, RIGHTS AND DUTIES
The Cost Auditor has to be appointed by the Board of Directors under Section
233-B of the Companies Act subject to prior approval of the Company Law
Board. This will be done on receipt of specific order from the Company Law
Board for getting audited the Cost Accounting Records of a particular year for
For appointment of auditor, the Board of Directors is required to pass a
resolution either in its meeting or by circulation with a condition that the same
is subject to approval of the Central Government. From the above, it can be
concluded that the Cost Auditor is not appointed on regular annual basis as it is
in the case of financial auditor.
Cost audit is not an annual feature. It is conducted only when ordered by the
Central Government. As mentioned earlier, a Cost Auditor is appointed by the
Board of Directors of a company subject to the prior approval of the Central
Government under Section 233-B of the Companies Act, 1956 whereas a
financial auditor is appointed by shareholders under Section 224 of the
Companies Act, 1956.
Appointment of cost auditor is made on the receipt of an order from Central
Government within a specified period. The person to be appointed as auditor
must hold a certificate of practice from the Institute of Cost and Works
Accountants of India.
Consent of the cost auditor should be obtained before making an appointment.
Application in prescribed form (23-C) is submitted to the Central Government
with the prescribed fee alongwith a copy of the Board’s resolution.
Approval for appointment is communicated by the Central Government to the
company after considering the application and the name of the auditor proposed
subject to the condition that the cost auditor is not disqualified under Section
233-B(5) of the Companies Act, 1956 as amended.
A copy of this communication will also be sent by the Central Government to
the Cost Auditor giving the time limits, submission of Report in triplicate, the
date of commencement and completion of audit.
The company should issue a formal letter of appointment to the concerned
auditor after receiving the approval of the Central Government so that he can
start the work of his assignment.
After receiving the letter of his appointment, the cost auditor should
communicate with the previous auditor, if any, for his reaction. He must send
his formal acceptance of the assignment to the company.
The MCA, vide its order dated April 2011 has amended the procedure of
appointments of Cost Auditors.
Under the revised procedure, appointment of Cost Auditor will be through Audit
Committee and also revised the procedure of prior approval requirement of the
Eligibility for Appointment
Following persons are eligible to be appointed as cost auditor under Section
(1) Cost Accountant within the meaning of the Cost and Works Accountants
Act, 1959, or
(2) Any such Chartered Accountant within the meaning of the Chartered
Accountants Act, 1949 and a Fellow of the Institute of Chartered Accountants of
India for a period of 10 years and has passed Part I of the Management
Accountancy Examination of the Institute of Chartered Accountants of India, or
(3) Other person, as may possess the prescribed qualifications.
DISADVANTAGES OF COST AUDITS
Cost audits verify expense records and accounts. Audits also
ensure that accountants and bookkeepers are in compliance
with ethical practices. Effective cost audits provide a complete
breakdown of expenses that give a company financial clarity
about accounts. Although they provide such transparency,
there are many disadvantages to conducting cost audits.
One primary disadvantage associated with cost audits is the
excessive fees. Auditors are typically independent contractors
who can charge relatively high prices for services rendered. In
addition to initial charges, auditors may increase fees in the
middle of the project if companies fail to prohibit such action in
the contract. A person or corporation can essentially go from
paying $4,000 to $6,000 for an audit.
Cost audits are also lengthy processes that require employee devotion. Although
the auditor may be an outside contractor, employees must provide requested
information and be accessible in case further explanation of documents is
necessary. People must also provide contractors with a proposed schedule. If a
company wants an audit to be completed in three months, employees must give
the auditor a road map on how to accomplish the goal within the given time
frame. This process requires additional time and effort on an employee's part.
Although thorough, an auditor's report is usually given three to five weeks after
the balance sheet is released. This means people who have been stealing from
an establishment have nearly a month to form an excuse or leave the company.
Regardless of the chosen option, time lost between the balance sheet release and
auditor's report may cost the company money as evidence against the employee
Because a major part of the process involves estimating, there's the possibility
of numerical figures being wrong. In addition, if receipts and other forms of
recordkeeping are skewed, an auditor relying on such documents may produce
an inaccurate report. Unorganized companies won't find cost audits helpful,
because the process merely lays out information without putting it in order.
A system of management control in which actual income and spending are
compared with planned income and spending, so that you can see if plans are
being followed and if those plans need to be changed in order to make a profit.
Budgetary control methods
A formal statement of the financial resources set aside for carrying out specific
activities in a given period of time.
It helps to co-ordinate the activities of the organisation.
An example would be an advertising budget or sales force budget.
b) Budgetary control
A control technique whereby actual results are compared with budgets.
Any differences (variances) are made the responsibility of key individuals who
can either exercise control action or revise the original budgets.
Budgetary control and responsibility centres.
These enable managers to monitor organisational functions.
A responsibility centre can be defined as any functional unit headed by a
manager who is responsible for the activities of that unit.
TYPES OF RESPONSIBILITY CENTRES
a) Revenue centres
Organisational units in which outputs are measured in monetary terms but are
not directly compared to input costs.
b) Expense centres
Units where inputs are measured in monetary terms but outputs are not.
c) Profit centres
Where performance is measured by the difference between revenues (outputs)
and expenditure (inputs). Inter-departmental sales are often made using "transfer
d) Investment centres
Where outputs are compared with the assets employed in producing them, i.e.
ADVANTAGES OF BUDGETING AND BUDGETARY CONTROL
There are a number of advantages to budgeting and budgetary control:
Compels management to think about the future, which is probably the
most important feature of a budgetary planning and control system.
Forces management to look ahead, to set out detailed plans for achieving
the targets for each department, operation and (ideally) each manager, to
anticipate and give the organisation purpose and direction.
Promotes coordination and communication.
Clearly defines areas of responsibility. Requires managers of budget
centres to be made responsible for the achievement of budget targets for
the operations under their personal control.
Provides a basis for performance appraisal (variance analysis). A budget
is basically a yardstick against which actual performance is measured and
assessed. Control is provided by comparisons of actual results against
Departures from budget can then be investigated and the reasons for the
differences can be divided into controllable and non-controllable factors.
Enables remedial action to be taken as variances emerge.
Motivates employees by participating in the setting of budgets.
Improves the allocation of scarce resources.
Economises management time by using the management by exception
Problems in budgeting.
Budgets can be seen as pressure devices imposed by management, thus resulting
a) bad labour relations.
b) inaccurate record-keeping.
· Departmental conflict arises due to:
a) disputes over resource allocation.
b) departments blaming each other if targets are not attained.
· It is difficult to reconcile personal/individual and corporate goals.
· Waste may arise as managers adopt the view, "we had better spend it or we
will lose it". This is often coupled with "empire building" in order to enhance
the prestige of a department.
Responsibility versus controlling, i.e. some costs are under the influence of
more than one person, e.g. power costs.
· Managers may overestimate costs so that they will not be blamed in the future
should they overspend.
CHARACTERISTICS OF A BUDGET
A good budget is characterised by the following:
· Participation: involve as many people as possible in drawing up a budget.
· Comprehensiveness: embrace the whole organisation.
· Standards: base it on established standards of performance.
· Flexibility: allow for changing circumstances.
· Feedback: constantly monitor performance.
· Analysis of costs and revenues: this can be done on the basis of product lines,
departments or cost centres.
Budget organisation and administration:
In organising and administering a budget system the following characteristics
a) Budget centres: Units responsible for the preparation of budgets. A budget
centre may encompass several cost centres.
b) Budget committee: This may consist of senior members of the organisation,
e.g. departmental heads and executives (with the managing director as
chairman). Every part of the organisation should be represented on the
committee, so there should be a representative from sales, production,
marketing and so on. Functions of the budget committee include:
· Coordination of the preparation of budgets, including the issue of a manual.
· Issuing of timetables for preparation of budgets.
· Provision of information to assist budget preparations.
· Comparison of actual results with budget and investigation of variances.
c) Budget Officer: Controls the budget administration the job involves:
· liaising between the budget committee and managers responsible for budget
· dealing with budgetary control problems.
· ensuring that deadlines are met.
· educating people about budgetary control.
d) Budget manual:
· charts the organization.
· details the budget procedures.
· contains account codes for items of expenditure and revenue.
· timetables the process.
· clearly defines the responsibility of persons involved in the budgeting system.
Firstly, determine the principal budget factor. This is also known as the key
budget factor or limiting budget factor and is the factor which will limit the
activities of an undertaking. This limits output, e.g. sales, material or labour.
a) Sales budget: this involves a realistic sales forecast. This is prepared in units
of each product and also in sales value. Methods of sales forecasting include:
· sales force opinions.
· market research.
· statistical methods (correlation analysis and examination of trends).
· mathematical models.
In using these techniques consider:
· company's pricing policy.
· general economic and political conditions.
· changes in the population.
· consumers' income and tastes.
· advertising and other sales promotion techniques.
· after sales service.
· credit terms offered.
b) Production budget: expressed in quantitative terms only and is geared to the
The production manager's duties include:
· analysis of plant utilization.
· work-in-progress budgets.
If requirements exceed capacity he may:
· plan for overtime.
· introduce shift work.
· hire or buy additional machinery.
· The materials purchases budget's both quantitative and financial.
c) Raw materials and purchasing budget:
· The materials usage budget is in quantities.
· The materials purchases budget is both quantitative and financial.
· production requirements.
· planning stock levels.
· storage space.
· trends of material prices.
d) Labour budget: is both quantitative and financial.
This is influenced by:
· production requirements.
· man-hours available.
· grades of labour required.
· wage rates (union agreements).
· the need for incentives.
e) Cash budget: a cash plan for a defined period of time. It summarises
monthly receipts and payments. Hence, it highlights monthly surpluses and
deficits of actual cash. Its main uses are:
· to maintain control over a firm's cash requirements, e.g. stock and debtors.
· to enable a firm to take precautionary measures and arrange in advance for
investment and loan facilities whenever cash surpluses or deficits arises.
· to show the feasibility of management's plans in cash terms.
· to illustrate the financial impact of changes in management policy, e.g. change
of credit terms offered to customers.
Receipts of cash may come from one of the following:
· cash sales.
· payments by debtors.
· the sale of fixed assets.
· the issue of new shares.
· the receipt of interest and dividends from investments.
Payments of cash may be for one or more of the following:
· purchase of stocks.
· payments of wages or other expenses.
· purchase of capital items.
· payment of interest, dividends or taxation.
MANAGEMENT ACTION AND COST CONTROL
Producing information in management accounting form is expensive in terms of
the time and effort involved. It will be very wasteful if the information once
produced is not put into effective use.
There are five parts to an effective cost control system. These are:
a) preparation of budgets.
b) communicating and agreeing budgets with all concerned.
c) having an accounting system that will record all actual costs.
d) preparing statements that will compare actual costs with budgets, showing
any variances and disclosing the reasons for them, and
e) taking any appropriate action based on the analysis of the variances in d)
Action(s) that can be taken when a significant variance has been revealed will
depend on the nature of the variance itself. Some variances can be identified to
a specific department and it is within that department's control to take corrective
action. Other variances might prove to be much more difficult, and sometimes
impossible, to control.
Variances revealed are historic. They show what happened last month or last
quarter and no amount of analysis and discussion can alter that. However, they
can be used to influence managerial action in future periods.
Zero base budgeting (ZBB)
After a budgeting system has been in operation for some time, there is a
tendency for next year's budget to be justified by reference to the actual levels
being achieved at present.
In fact this is part of the financial analysis discussed so far, but the proper
analysis process takes into account all the changes which should affect the
future activities of the company.
Even using such an analytical base, some businesses find that historical
comparisons, and particularly the current level of constraints on resources, can
inhibit really innovative changes in budgets.
This can cause a severe handicap for the business because the budget should be
the first year of the long range plan. Thus, if changes are not started in the
budget period, it will be difficult for the business to make the progress
necessary to achieve longer term objectives.
One way of breaking out of this cyclical budgeting problem is to go back to
basics and develop the budget from an assumption of no existing resources (that
is, a zero base). This means all resources will have to be justified and the chosen
way of achieving any specified objectives will have to be compared with the
For example, in the sales area, the current existing field sales force will be
ignored, and the optimum way of achieving the sales objectives in that
particular market for the particular goods or services should be developed. T
his might not include any field sales force, or a different-sized team, and the
company then has to plan how to implement this new strategy.
The obvious problem of this zero-base budgeting process is the massive amount
of managerial time needed to carry out the exercise. Hence, some companies
carry out the full process every five years, but in that year the business can
almost grind to a halt.
Thus, an alternative way is to look in depth at one area of the business each year
on a rolling basis, so that each sector does a zero base budget every five years or
Standard costing is the practice of substituting an expected cost for an actual
cost in the accounting records, and then periodically recording variances
showing the difference between the expected and actual costs.
A standard, as the term is usually used in management accounting, is a budgeted
amount for a single unit of output. A standard cost for one unit of output is the
budgeted production cost for that unit.
Standard costs are calculated using engineering estimates of standard quantities
of inputs, and budgeted prices of those inputs.
For example, for an apparel manufacturer, standard quantities of inputs are
required yards of fabric per jean and required hours of sewing operator labor per
Budgeted prices for those inputs are the budgeted cost per yard of fabric and the
budgeted labor wage rate.
Standard quantities of inputs can be established based on ideal performance, or
on expected performance, but are usually based on efficient and attainable
Research in psychology has determined that most people will exert the greatest
effort when goals are somewhat difficult to attain, but not extremely difficult.
If goals are easily attained, managers and employees might not work as hard as
they would if goals are challenging.
But also, if goals appear out of reach, managers and employees might resign
themselves to falling short of the goal, and might not work as hard as they
otherwise would. For this reason, standards are often established based on
efficient and attainable performance.
Hence, a standard is a type of budgeted number; one characterized by a certain
amount of rigor in its determination, and by its ability to motivate managers and
employees to work towards the company’s objectives for production efficiency
and cost control.
There is an important distinction between standard costs and a standard costing
Standard costs are a component in a standard costing system. However, even
companies that do not use standard costing systems can utilize standards for
budgeting, planning, and variance analysis.
Standard Costing Systems:
A standard costing system initially records the cost of production at standard.
Units of inventory flow through the inventory accounts (from work-in-process
to finished goods to cost of goods sold) at their per-unit standard cost.
When actual costs become known, adjusting entries are made that restate each
account balance from standard to actual (or to approximate such a restatement).
The components of this adjusting entry provide information about the
company’s performance for the period, particularly with regard to production
efficiency and cost control.
STANDARD COSTING SYSTEMS AND FLEXIBLE BUDGETING
There is an important connection between flexible budgeting, which was
discussed in Chapter 5, and standard costing. In fact, a standard costing system
tracks inventory during the period at the flexible budget amount. Recall that the
flexible budget is the budgeted per-unit cost multiplied by the actual number of
Hence, a standard costing system answers the question: what would the income
statement and balance sheet look like, if costs and per-unit input requirements
were exactly as planned, given the actual output achieved (units made and units
Given the point made in the previous paragraph, it follows that the adjustment
made at period-end to restate the inventory accounts for the difference between
the standard cost account balance and the actual cost account balance
constitutes the difference between the flexible budget amount and actual costs.
For direct costs, such as materials and labor, this adjusting entry represents the
sum of the price (or labor wage rate) variance and the efficiency (or quantity)
variance. For overhead costs, this adjusting entry represents misapplied
For variable overhead, misapplied overhead consists of the sum of the spending
variance and the efficiency variance. For fixed overhead, misapplied overhead
consists of the sum of the spending variance and the volume variance.
Hence, standard costing systems track inventory at flexible budget amounts
during the period, and post adjusting entries at the end of the period that provide
variance information that managers use for performance evaluation and control.
Reasons for using a Standard Costing System:
There are several reasons for using a standard costing system:
Cost Control: The most frequent reason cited by companies for using
standard costing systems is cost control. One might initially think that
standard costing provides less information than actual costing, because a
standard costing system tracks inventory using budgeted amounts that
were known before the first day of the period, and fails to incorporate
valuable information about how actual costs have differed from budget
during the period. However, this reasoning is not correct, because actual
costs are tracked by the accounting system in journal entries to accrue
liabilities for the purchase of materials and the payment of labor, entries
to record accumulated depreciation, and entries to record other costs
related to production.
Hence, a standard costing system records both budgeted amounts (via
debits to work-in-process, finished goods, and cost-of-goods-sold) and
actual costs incurred. The difference between these budgeted amounts
and actual amounts provides important information about cost control.
This information could be available to a company that uses an actual
costing system or a normal costing system, but the analysis would not be
an integral part of the general ledger system. Rather, it might be done, for
example, on a spreadsheet program on a personal computer.
The advantage of a standard costing system is that the general ledger
system itself tracks the information necessary to provide detailed
performance reports showing cost variances.
Smooth out short-term fluctuations in direct costs: Similar to the
reasons given in the previous chapter for using normal costing to average
the overhead rate over time, there are reasons to average direct costs. For
example, if an apparel manufacturer purchases denim fabric from
different textile mills at slightly different prices, should these differences
be tracked through finished goods inventory and into cost-of-goods-sold?
In other words, should the accounting system track the fact that jeans
production on Tuesday cost a few cents more per unit than production on
Wednesday, because the fabric used on Tuesday came from a different
mill, and the negotiated fabric price with that mill was slightly higher?
Many companies prefer to average out these small differences in direct
When actual overhead rates are used, production volume of each
product affects the reported costs of all other products: This reason,
which was discussed in the previous chapter on normal costing,
represents an advantage of standard costing over actual costing, but does
not represent an advantage of standard costing over normal costing.
Costing systems that use budgeted data are economical: Accounting
systems should satisfy a cost-benefit test: more sophisticated accounting
systems are more costly to design, implement and operate.
If the alternative to a standard costing system is an actual costing system
that tracks actual costs in a more timely (and more expensive) manner,
then management should assess whether the improvement in the quality
of the decisions that will be made using that information is worth the
In many cases, standard costing systems provide highly reliable
information, and the additional cost of operating an actual costing system
is not warranted.