Monday, March 15, 2010

Suspense accounts and error correction

Suspense accounts and error correction

by Neil Stein

16 May 2007

Suspense accounts and error correction are popular topics for examiners because they test understanding of bookkeeping principles so well.

A suspense account is a temporary resting place for an entry that will end up somewhere else once its final destination is determined. There are two reasons why a suspense account could be opened:

1. a bookkeeper is unsure where to post an item and enters it to a suspense account pending instructions

2. there is a difference in a trial balance and a suspense account is opened with the amount of the difference so that the trial balance agrees (pending the discovery and correction of the errors causing the difference). This is the only time an entry is made in the records without a corresponding entry elsewhere (apart from the correction of a trial balance error - see error type 8 in Table 1).

Types of error

Before we look at the operation of suspense accounts in error correction, we need to think about types of error - not all types affect the balancing of the records and hence the suspense account. Refer to Table 1.

Table 1: Types of error

Error type Suspense account involved?

1 Omission - a transaction is not recorded at all No

2 Error of commission - an item is entered to the correct side of the wrong account (there is a debit and a credit here, so the records balance) No

3 Error of principle - an item is posted to the correct side of the wrong type of account, as when cash paid for plant repairs (expense) is debited to plant account (asset)

(errors of principle are really a special case of errors of commission, and once again there is a debit and a credit) No

4 Error of original entry - an incorrect figure is entered in the records and then posted to the correct account

Example: Cash $1,000 for plant repairs is entered as $100; plant repairs account is debited with $100 No

5 Reversal of entries - the amount is correct, the accounts used are correct, but the account that should have been debited is credited and vice versa

Example: Factory employees are used for plant maintenance:

Correct entry:

Debit: Plant maintenance

Credit: Factory wages

Easily done the wrong way round No

6 Addition errors - figures are incorrectly added in a ledger account Yes

7 Posting error

a an entry made in one record is not posted at all

b an entry in one record is incorrectly posted to another

Examples: cash $10,000 entered in the cash book for the purchase of a car is:

a not posted at all

b posted to Motor cars account as $1,000 Yes

8 Trial balance errors - a balance is omitted, or incorrectly extracted, in preparing the trial balance Yes

9 Compensating errors - two equal and opposite errors leave the trial balance balancing (this type of error is rare, and can be because a deliberate second error has been made to force the balancing of the records or to conceal a fraud) Yes, to correct each of the errors as discovered

For examination purposes we are more often concerned with the second of these - differences and error correction.

Correcting errors

Errors 1 to 5, when discovered, will be corrected by means of a journal entry between the accounts affected. Errors 6 to 9 also require journal entries to correct them, but one side of the journal entry will be to the suspense account opened for the difference in the records. Type 8, trial balance errors, are different. As the suspense account records the difference, an entry to it is needed, because the error affects the difference. However, there is no ledger entry for the other side of the correction - the trial balance is simply amended.

An illustrative question

The bookkeeping system of Turner is not computerised, and at 30 September 20X8 the bookkeeper was unable to balance the accounts. The trial balance totals were:

Debit $1,796,100

Credit $1,852,817

Nevertheless, he proceeded to prepare draft financial statements, inserting the difference as a balancing figure in the balance sheet. The draft profit and loss account showed a profit of $141,280 for the year ended 30 September 20X8.

He then opened a suspense account for the difference and began to check through the accounting records to find the difference. He found the following errors and omissions:

1. $8,980 - the total of the sales returns book for September 20X8, had been credited to the purchases returns account.

2. $49,600 paid for an item of plant purchased on 1 April 20X8 had been debited to plant repairs account. The company depreciates its plant at 20% per annum on a straight line basis, with proportional depreciation in the year of purchase.

3. The cash discount totals for the month of September 20X8 had not been posted to the general ledger accounts. The figures were:

Discount allowed $836

Discount received $919

4. $580 insurance prepaid at 30 September 20X7 had not been brought down as an opening balance

5. The balance of $38,260 on the telephone expense account had been omitted from the trial balance

6. A car held as a non-current asset had been sold during the year for $4,800. The proceeds of sale were entered in the cash book but had been credited to the sales account in the general ledger. The original cost of the car $12,000, and the accumulated depreciation to date $8,000, were included in the motor vehicles account and the accumulated depreciation account. The company depreciates motor vehicles at 25% per annum on a straight line basis with proportionate depreciation in the year of purchase but none in the year of sale.


a Open a suspense account for the difference between the trial balance totals. Prepare the journal entries necessary to correct the errors and eliminate the balance on the suspense account. Narratives are not required. (10 marks)

b Draw up a statement showing the revised profit after correcting the above errors. (6 marks)

Total (16 marks)


The approach to the question should be:

1 Read the requirement paragraph at the end of the question.

2 Attack the question - note that narratives are not required. Begin by opening the suspense account. Which side? More debit is needed to balance the trial balance, so debit the suspense account with $56,717.

Then deal with the errors in order:

1. Sales returns should have been debited to the sales returns account and they have been credited to the purchases returns account. There are two errors here - the wrong account has been used and an entry which should have been a debit has been entered as a credit. The suspense account entry must therefore be for 2 x $8,980 or $17,960.

2. An error of principle - no suspense account entry. Depreciation must be adjusted.

3. Items have not been posted, therefore the suspense account is involved.

4. Effectively a posting error - the suspense account is again involved.

5. A trial balance error must affect the suspense account - but no ledger entry.

6. This one needs thought. Take it one sentence at a time. Is the suspense account involved? No, because we have an error of commission followed by some unrecorded transactions.

Attempt Part (a) of the question before studying the answer as detailed in Table 2. Let's now turn to Part (b). The most convenient format for the answer is two columns for - and +. Set them up and enter the adjustments appropriately. Which of the errors affect the profit? In fact they all do. Attempt Part (b) now before looking at the answer detailed in Table 3.

Table 2: Answer - Part (A)

Suspense Account

$ $

Difference 56,717 Sales returns 8,980

Discount received 919 Purchases returns 8,980

Discount allowed 836

Insurance 580

Telephone (trial balance) 38,260

57,636 57,636

Journal entries

$ $

1 Sales returns account 8,980

Suspense account 8,980

Purchases returns account 8,980

Suspense account 8,980

2 Plant account 9,600

Plant repairs account 9,600

Depreciation (income statement) 960

Plant depreciation account 960

3 Discount allowed account 836

Suspense account 836

Suspense account 919

Discount received account 919

4 Insurance account 580

Suspense account 580

5 Trial balance (no ledger entry) 38,260

Suspense account 38,260

6 Sales account 4,800

Motor vehicles disposal account 4,800

Motor vehicles disposal account 12,000

Motor vehicles asset account 12,000

Motor vehicles depreciation account 8,000

Motor vehicles disposal account 8,000

Motor vehicles disposal account 800

Income statement 800

Table 3: Answer - Part (b)

Adjustment to profit

- +

$ $

Profit as in draft income statement 141,280

1 Sales returns adjustment (2 x $8,980) 17,960

2 Plant: reduction in repairs 9,600

depreciation - 6/12 x 20% x $9,600 960

3 Discount allowed 836

Discount received 919

4 Insurance - opening balance omitted 580

5 Telephone expense omitted 38,260

6 Profit on sale of car 800

Proceeds taken out of sales 4,800

63,396 152,599


Revised net profit 89,203

Some hints on preparing suspense accounts

• Does a correction involve the suspense account? The type of error determines this. Practice, and study of Table 1 should ensure that you see immediately which errors affect the balancing of the records and hence the suspense account.

• Which side of the suspense account must an entry go? This is one of the most awkward problems in preparing suspense accounts. The best way of solving it is to ask yourself which side the entry needs to be on in the other account concerned. The suspense account entry is then obviously to the opposite side.

• Look out for errors with two aspects. In the illustrative question earlier, error 1 is a case in point. An entry has been made to the wrong account, but also to the wrong side of the wrong account. Both errors must be corrected. It is very easy to fall into the trap of correcting only one of the errors, especially when working quickly under examination conditions.

Neil Stein is former examiner for Paper 1.1

Stock control

Stock control

by Tony Mock

12 Feb 2004

Stock control features in the syllabuses of several ACCA examination papers, including CAT Papers 4 and 10, and Professional Scheme Papers 1.2 and 2.4. The areas usually tested in these papers are:

• determining an economic order quantity (EOQ) – calculations to assess how many units of a particular stock item to order at a time

• finding an optimal re-order level (optimal ROL) – providing some idea of the level to which stocks can be allowed to fall before placing an order for more

• discussions of various practical aspects of stock management – often referred to by students with no practical experience as ‘theory’.

Advantages and disadvantages of holding stock

The basis of the theoretical calculations of an EOQ and an optimal ROL is that there are advantages and disadvantages of holding stock (of buying stock in large or small quantities). The advantages include:

• the need to meet customer demand

• taking advantage of bulk discounts

• reducing total annual re-ordering cost.

The disadvantages include:

• storage costs

• cost of capital tied up in stock

• deterioration, obsolescence, and theft.

The aim behind the calculations of EOQ and ROL is to weigh up these, and other advantages and disadvantages and to find a suitable compromise level.


When determining how much to order at a time, an organisation will recognise that:

• as order quantity rises, average stock rises and the total annual cost of holding stock rises

• as order quantity rises, the number of orders decreases and the total annual re-order costs decrease.

The total of annual holding and re-order costs first decreases, then increases. The point at which cost is minimised is the EOQ. This cost behaviour is illustrated by the graph in Figure 1.

Figure 1

The way in which this EOQ is calculated is based on certain assumptions, including:

• constant purchase price

• constant demand and constant lead-time

• holding-cost dependent on average stock

• order costs independent of order quantity.

The assumptions result in a pattern of stock that can be illustrated graphically as shown in Figure 2.

Figure 2

The Formula

Using the standard ACCA notation in which:

CH = cost of holding a unit of stock for a year

CO = cost of placing an order

D = annual demand


TOC = total annual re-ordering cost

THC = total annual holding cost

x = order quantity


average stock = x/2

THC = x/2 × CH


number of orders in a year = D/x

TOC = D/x × CO

The total annual cost (affected by order quantity) is:

C = THC + TOC = x/2 × CH + D/x × CO

This formula is not supplied in exams – it needs to be understood (and remembered).

The value of x, order quantity, that minimises this total cost is the EOQ, given by an easily remembered formula:

Use of EOQ Formula

You need to take care over which figures you put into the formula, particularly in multiple-choice questions. The areas to beware of fall into two categories:

1. Relevant costs – only include those costs affected by order quantity. Only include those holding costs which (in total in a year) will double if you order twice as much at a time. Only include those order costs which (in total in a year) will double if you order twice as often. (Thus, fixed salaries to storekeepers or buying department staff will be excluded.)

2. Consistent units – ensure that figures inserted have consistent units. Annual demand and cost of holding a unit for a year. Both holding costs and re-ordering costs should be in £, or both in pence.

Bulk Discounts

A common twist to exam questions is to ask students to evaluate whether bulk discounts are worth taking. While prices reduce, total annual holding costs will increase if more stock is ordered at a time, so the matter needs a little thought. The common approach is one of trial and error. This involves finding the total annual cost (holding cost, re-ordering cost and purchasing cost) at the level indicated by the EOQ and at the level(s) where discount first becomes available.

Figure 3 shows total costs (now including cost of purchasing the stock) plotted against order quantity with discount incorporated.

Figure 3

Point A represents the cost at the order quantity indicated by the EOQ. If stock is ordered in larger quantities, total costs will increase to point B1, at which stage bulk discounts are available, bringing the costs down to point B. Any calculations will involve finding which cost out of A, B or C is the lowest, as Example 1 will show.

Example 1

Moore Limited uses 5,000 units of its main raw material per month. The material costs £4 per unit to buy, supplier’s delivery costs are £25 per order and internal ordering costs are £2 per order. Total annual holding costs are £1 per unit. The supplier has offered a discount of 1% if 4,000 units of the material are bought at a time.


a. Establish the economic order quantity (EOQ) ignoring the discount opportunities.

b. Determine if the discount offer should be accepted.

Example 1 solutions

Re-order levels

As important as how much to order at a time is the question of when to order more stock. If an order is placed too late, when stocks have been allowed to run too low, a ‘stock-out’ will occur, resulting in either a loss of production or loss of sales, or possibly both.

If orders are placed too soon, when there are still substantial supplies in stock, then stock levels and holding costs will be unnecessarily high. The re-order level as explained below should not be confused with the stock control levels referred to in textbooks – this article ignores these. When it comes to calculating re-order levels, three sets of circumstances can be envisaged.

Lead-time is zero

‘Lead-time’ is the interval between placing an order with a supplier and that order arriving. It is unlikely that this could be reduced to zero – it would require astonishingly co-operative and efficient suppliers. If it were possible, a re-order level of zero could be adopted. An organisation could simply wait until it ran out of stock, click its corporate fingers, and stock would arrive instantaneously.

Constant demand, fixed finite lead-time

The assumption of constant demand is consistent with the assumptions underlying the EOQ formula. If suppliers take some time to provide goods, orders need to be placed in advance of running out. Figure 4 illustrates the problem and its solution.

Figure 4

If the lead-time is, say, 5 days, an order has to be placed before stocks have been exhausted. Specifically, the order should be placed when there is still sufficient stock to last 5 days, i.e:

Re-order level (ROL) = Demand in lead-time

So, if lead-time for a particular stock item is 5 days and daily demand is 30 units, the re-order level would be 5 days at 30 units per day, 150 units.

Variable demand in the lead-time

If demand in lead-time varied, it could be described by means of some form of probability distribution. Taking the previous example of the demand in lead-time being 150 units, we’re considering the possibility of demand being more than 150 or less than that. See Figure 5.

Note: This aspect of stock control produces a few problems. The EOQ formula requires that demand (and lead-time) for a stock item be constant. Here the possibility of demand varying or lead-time varying or both varying is introduced. Setting that problem aside, most ACCA syllabuses at the lower levels avoid any discussion of uncertainty or probability distributions. However, uncertainty in lead-time demand in stock control has featured in exams.

In these circumstances, a firm could place an order with a supplier when the stock fell to 150 units (the average demand in the lead-time). However, there’s a 33% chance (0.23 + 0.08 + 0.02 = 0.33) that demand would exceed this re-order level, and the organisation would be left with a problem. It is therefore advisable to increase the re-order level by an amount of ‘buffer stock’ (safety stock).

Buffer stock

Buffer stock is simply the amount by which ROL exceeds average demand in lead-time. It is needed when there is uncertainty in lead-time demand to reduce the chance of running out of stock and reduce the cost of such shortages.

If a ROL of 160 units was adopted, this would correspond to a buffer stock of 10 units (and reduce the chance of running out of stock to 0.08 + 0.02 = 0.1, or 10%). A ROL of 170 is equivalent to a buffer stock of 20 and reduces the chance of running out to 2%, and a ROL of 180 implies 30 units of buffer stock (and no chance of running short).

Optimal Re-order Levels

This leaves the problem of how to calculate the optimal ROL. There are two common ways in which one could determine a suitable re-order level (if the information was available):

1. A tabular approach – Calculate, for each possible ROL (each level of buffer stock) the cost of holding different levels of buffer stock and the cost incurred if the buffer is inadequate (‘stock-out’ costs). The optimal re-order level is that level at which the total of holding and stock-out costs are a minimum.

2. A ‘service level’ approach – An organisation has to determine a suitable level of service (an acceptably small probability that it would run out of stock), and would need to know the nature of the probability distribution for lead-time demand. These two would be used to find a suitable ROL.

Paper 4 candidates should note that this article goes beyond the requirements of the Paper 4, Accounting for Costs syllabus.

Tony Mock is a freelance lecturer and writer and an ACCA syllabus co-ordinator

Incomplete records

by Neil Stein

26 Aug 2004

Examiners like questions on incomplete records because they provide the opportunity to test a variety of bookkeeping and accounting techniques.

The two main instances in which incomplete records can be found are where:

• there are no records at all

• some records exist and information is available to calculate missing figures.

No records at all

It is still possible to calculate a profit or loss figure by using the fact that the profit of a business must be represented by more assets. We list and value the opening and closing net assets, then calculate the profit as the difference between the two:

Profit = Closing net assets - Opening net assets

Allowance must be made for proprietor's drawings and extra capital introduced, so the formula becomes:

Profit = Closing net assets - Opening net assets + Drawings - Capital introduced

There is little scope here for a major question, but it could form the basis of a two-mark multiple-choice question.

Incomplete records

This a more common scenario, both in exam questions and in practice. There are standard techniques for calculating missing figures:

• Opening capital

• Missing figures for sales and purchases

• Missing figures for cash.

Opening capital

We need to have the opening capital of the business at the beginning of a period to provide a starting point - the capital in the balance sheet account. Questions will usually give us a list of opening assets and liabilities, and we use this to arrive at the opening capital.

Missing figures for sales and purchases

If we know the opening and closing debtors of a business, and the cash received from customers, we can calculate sales. All we need to do is set up a sales ledger total account (see Figure 1).

Figure 1: Sales ledger total account (figures invented)

£ £

Opening debtors 38,600 Cash received 218,650

Sales (balancing figure) 221,250 Closing debtors 41,200

259,850 259,850

If any three of these figures is known, the fourth can be calculated.

All we are doing here is using the sales ledger control account format, but instead of proving the accuracy of the sales ledger, we are calculating what the sales must have been in order for the other figures to be what they are. The same technique may be used to calculate credit purchases. If the sales figure is given we can calculate the cash received.

There is another way to calculate sales, purchases or stock figures, and that is to use the trading account format. We normally set up the trading account as (figures invented):

£ £

Sales 100,000

Less: cost of sales

opening stock 10,000

purchases 78,000


less: closing stock 13,000 75,000

gross profit 25,000

Suppose the closing stock has been destroyed by fire, along with all the stock records. Then we wouldn't have the closing stock total to include in our trading account. However, we can calculate it if we know the gross profit percentage on sales - or, of course, the mark-up on cost of sales.

In the example above, gross profit is 25 per cent of sales. If we are told this, we can insert the gross profit of £25,000 and so calculate the missing stock figure as a balancing item. We can also find a missing purchases figure, or even a missing sales figure.

Suppose we are given:

£ £

Cost of sales

opening stock 10,000

purchases 78,000


less: closing stock 13,000 75,000

We are also told that gross profit percentage on sales is 25 per cent. If gross profit is 25 per cent on sales, cost of sales must be 75 per cent of sales. The sales total is therefore:

£75,000 x 100/75 = £100,000.

Whenever the gross profit percentage is given in an incomplete records question, you know that this technique is needed.

Missing figures for cash

We may be given details of cash receipts and payments plus details of opening and closing balances, but with one figure missing, often the proprietor's drawings. We can calculate the missing figure by setting up a cash account to find the balancing item required.

Here are the incomplete records techniques:

Construct To calculate

1 Opening assets and liabilities Opening capital

2 Sales or purchases ledger total accounts Any missing figure

3 Trading account (gross profit percentage must be given) Any missing figure

4 Cash account Any missing figure

There is only one way to develop fluency in incomplete records questions, and that is to practise as many questions as you can. Here are three short exercises:

1. The net assets of Altese, a trader, at 1 January 2003 amounted to £128,000. During the year to 31 December 2003, Altese introduced a further £50,000 of capital and made drawings of £48,000. At 31 December 2003, Altese's net assets totalled £184,000. Using this information compute Altese's total profit for the year ended 31 December 2003.

2. Senji does not keep proper accounting records, and it is necessary to calculate her total purchases for the year ended 31 January 2004 from the following information:


Trade creditors

31 January 2003 130,400

31 January 2004 171,250

Payments to suppliers 888,400

Cost of goods taken by Senji for her personal use 1,000

Refunds received from suppliers 2,400

Discounts received 11,200


Compute the figure for purchases for inclusion in Senji's financial statements.

4. Aluki fixes prices to make a standard gross profit percentage on sales of 331/3%. The following information is available for the year ended 31 January 2004 to compute her sales total for the year:



1 February 2003 243,000

31 January 2004 261,700

Purchases 595,400

Purchases returns 41,200


Calculate the sales figure for the year ended 31 January 2004.




Opening capital 128,000

Capital introduced 50,000


less: Drawings 48,000


Closing capital 184,000

Profit is therefore 54,000


3. See Figure 2.

Figure 2: Purchases total account

£ £

Payments to suppliers 888,400 Balance brought forward 130,400

Discounts received 11,200 Goods taken by Senji 1,000

Balance carried forward 171,250 Refunds from suppliers 2,400

Purchases (balancing figure) 937,050

1,070,850 1,070,850



£ £

Cost of sales

Opening stock 243,000

Purchases 595,400

less: Returns 41,200 554,200


less: Closing stock 261,700


Sales figure is therefore:

£535,500 x 3/2 = 803,250

These three examples are quite elementary, but they illustrate techniques that you will find in nearly all incomplete records questions.

Neil Stein is examiner for Paper 1.1

Cost accounting - system requirements

Cost accounting - system requirements
by Nigel Coulthurst
01 Apr 1999
Students preparing for the paper 3, Management Information, examination need to be able to demonstrate that they understand, and can apply, the principles relating to the processing of cost accounting transaction data. This is not just a question of posting transactions but of understanding the factors that influence the cost recording process.
In outline, the process involves accounting for input costs, which relate to resources acquired and consumed in the form of materials, labour and various other resources, and then attaching those costs to work done in the form of outputs of final product or service.
Ultimately, measures of profit in relation to final products/services (by group of product/service or in relation to different customers/geographical areas) will be required. However, many activities in an organisation provide product/service at an intermediate stage where performance measurement will also be necessary if resources are to be well managed.
Whilst there are a number of generic principles regarding cost processing, their application will vary depending both upon the nature of the business and also upon each business’ specific information requirements.
This article reviews the principles affecting the establishment of cost accounting information requirements. A subsequent article will illustrate the processing of cost accounting data to meet those information requirements.
System objectives
The broad objectives of a cost accounting system should be:
• score-keeping;
• attention-directing.
As an extension of financial accounting, especially in manufacturing industries where cost allocations to enable stock valuation are likely to be required, cost accounting provides the basis on which business performance, in terms of profit or loss, can be assessed in line with specified practice (score-keeping).
More significantly, cost accounting provides the basis for management accounting via the provision of regular and detailed information to management so that resources may be acquired and used as economically, efficiently and effectively as possible. The objective should be to provide the right stimulus for management decision-making and control action (attention-directing) by ascertaining product costs and profitability, and by reporting the costs of operations in a useful manner.
With this in mind, cost accounting system design should focus attention on exactly what information is useful, to whom and when, which also raises questions about how frequently and how quickly the information should be provided, and to what degree of detail and accuracy.
Otherwise there is a danger that cost accounting systems produce masses of data without satisfying key information requirements. It is necessary to balance the requirements of scorekeeping, which may necessitate detail, with the requirements of attention-directing, where the focus should be on highlighting exceptions.
An organisation structure chart is a useful start point, along with a clear idea of individuals’ responsibilities and their span of control. Costing environment
Businesses may be placed along the following continuum:
What distinguishes a manufacturing organisation from a service organisation is the existence of a manufactured, physical product. Service organisations towards the manufacturing half of the above continuum will have many of the characteristics of a manufacturer. For example, a shoe repairer will have premises and machinery, and will incur significant materials, as well as labour, costs.
Cost accounting systems are appropriate for all businesses, whether large or small, manufacturing or service, and regardless of their ownership structure. However, greater scope for more extensive cost analysis, and thus also for subsequent use of information, is provided by a manufacturing environment. As a result such an environment usually occupies centre stage in cost accounting textbooks and examinations, especially in the area of cost ascertainment.
It is important to recognise changes in the environment within which businesses operate, especially changes in the manufacturing environment, and the impact that such changes may have on information requirements and thus on the cost accounting system.
In order to compete effectively, businesses engaged in manufacturing have been required to produce increasingly sophisticated products of the highest quality and with first class service, but at low cost. They have also had to develop the flexibility to cope with shorter product and equipment life cycles and with demands for greater product variety, the combined effects of increased competition and more discriminating customers.
This has necessitated reduced set-up times, increased machine and workforce flexibility and reduced randomness previously caused by uncertain supply, quality and manufacturing performance. Advances in computer technology applied to manufacturing have helped to both drive, and also facilitate, change.
Cost accounting systems have thus had to adapt to new information requirements. Accounting information provision has also been profoundly influenced by the ongoing revolution in information technology. Such advances have enabled:
• flexibility of information provision, with opportunities to tailor reports to users and use, and thus the provision of more focused information;
• more frequent availability of information;
• greater detail if required;
• faster feedback;
• more exception reporting, with reduced emphasis on routine;
• more user friendly access and presentation.
What has to be avoided is mountains of paper output from computer systems with a resulting information/data overload. It remains the case that the technology is only useful and valuable if information is provided to the right person, in the right form and at the right time.
low tech
service =====> Multi-product,
high tech
Cost objects, cost units and cost centres
The term ‘cost object’ is used to describe any aspect of business for which a separate measure of cost is required. This could be, for example, a product, an activity, a department, a region, a customer, or a project.
Where the measurement of the profit generated by each of the different final outputs of a business is required, the cost (and revenue) per unit of output will need to be determined. In this case the cost object becomes a ‘cost unit’, which may be defined as a quantitative unit of product or service in relation to which costs are ascertained.
Areas of a business that provide an internal service (i.e., support other areas within the business) are usually measured on cost performance alone as they do not directly generate sales and thus profit. The cost object becomes a ‘cost centre’, which may be defined as a location, person or item of equipment (or grouping of these) in relation to which costs are ascertained. Costs are identified, and analysed, in absolute terms at the level of the cost centre as a whole.
It may, however, be possible and useful to also establish a cost unit for the centre. For example, a distribution cost centre may use a composite cost unit, e.g., cost per kilogramme/kilometre. This can provide the basis for charging for the service and a means of improving cost control. Each separate activity may become a cost centre and the key driver of the costs of each activity may be identified and used to determine unit costs.
It may also be possible, and may be judged useful, to establish a value for the output of intermediate areas of the business that is other than cost, attempting to reflect the true
value of the output. Cost centres may become ‘profit centres’, or even ‘investment centres’. In an investment centre, performance is measured not simply as revenue minus costs (the measurement criteria in a profit centre); in addition, profit is related to the capital required to generate it.
Thus a product or service may pass from one area of a business to another at a transfer price that seeks to reflect market value at that point. Service departments, for example computer operations, may establish a value for their service, and thus a charge for users which is based upon market values rather than simply upon average costs.
Both absolute and relative measures may be useful. Whereas absolute measures provide, for example, a measure of the total cost of each cost centre, relative measures provide comparisons of one variable with another (e.g., cost per hour, profit per unit, profit per £ of sales).
Cost classification
Cost classification is the process of arranging cost items into groups according to their degree of similarity. Cost items can be similar to one another in several different respects, the particular classification depending upon the purpose of grouping costs together.
A particularly important distinction in stock valuation is between product costs and period costs. Product costs are those costs that have been incurred in getting stock to its present location and condition and are thus used to value any stock carried forward to a future period. In a manufacturing organisation all manufacturing costs should be regarded as product costs for external reporting purposes. Period costs are those costs that are not included in the stock valuation and as a result are treated as expenses of the period in which they are incurred.
Other classifications used to sort and separate costs are according to type (e.g., material, labour) and/or function (e.g., manufacturing, administration, selling). Beyond that, costs may be classified according to directness or according to behaviour.
Direct costs are those that can be allocated to a particular cost object. Indirect costs are those that cannot be so allocated but instead need to be apportioned i.e., shared between two or more cost objects. The smaller the cost object the fewer the costs that can be allocated and the greater will be the costs that have to be apportioned. For example, all costs are direct at the total business level; they become increasingly indirect as the organisation is split further and further into separate units. Whether a cost is direct or indirect depends entirely on the particular cost object.
Where the cost unit is a unit of finished product, direct costs will generally be limited to the raw materials used in the product and the labour employed in production departments on product manufacture. All other manufacturing costs will be indirect as they will have to be apportioned amongst the different products manufactured. Indirect costs in relation to final cost units are referred to as overheads. Earlier Newsletter articles (1 and 2) reviewed the processes relating to the accounting for overheads and the issues involved.
An important classification for decision-making and for cost control is according to behavioural characteristics. Some costs tend to vary with the output level of a particular activity; other costs are incurred because of having an activity, but are largely unaffected by its output level. Raw materials used in a manufactured product are an example of the first; rent and rates paid on a factory an example of the second.
Important concepts here are those of time and relevant range of activity. In the long run all costs become to some extent variable. The classification of costs as fixed or variable is on the assumption of its use for short-term analysis for which it provides relevant information. The classification is also only likely to remain valid as a predictor of costs within a specified range of activity.
A behavioural classification may also form the basis for stock valuation for internal (as opposed to external) reporting (i.e., using only variable, rather than total, manufacturing costs). This would be the case where marginal costing principles are employed in a non-integrated system (see later).
Cost coding
A code can be defined as a system of symbols designed to be applied to a classified set of items. Cost coding is symbols applied to sets of cost items (which may be cost elements, products, cost centres), giving a brief, accurate and logical reference, which facilitates entry, collation and analysis of items in the accounts to meet information requirements. Cost accumulation
The bought-in materials (be they raw materials or components for use in product manufacture, finished products, or consumable materials) and the various services (e.g., insurance, heating, telephone) are introduced into the cost accounts through the purchase ledger. The payroll provides the other prime source of cost data.
Once source data has been recorded, via purchase ledger or payroll systems, cost accounting is concerned with placing values on internal transactions, which represent transfers of value throughout an organisation. Internal transactions reflect the conversion of input resources to outputs of goods or services. Outputs include goods and services provided from one area of an organisation to another as well as those provided to the organisation’s external customers.
At each stage the objective should be to highlight not only the costs to be passed on to the next stage but the economy, efficiency and effectiveness of the stage completed. Both relative and absolute measures may be useful and including both financial and non-financial quantitative data.
Economy is the level of input resources applied to a particular task. Efficiency is the relationship between the resources applied to a task and the output of work generated. Effectiveness is the relationship between the output generated and the output desired.
Absorption versus marginal costing
The identification of the profitability and/or cost of different areas of a business is, as previously stated, a prime purpose of any internal accounting system. Without this information management will have little knowledge of the areas from which the business derives its profit and, therefore, will not be in a position to optimise the allocation of production capacity and selling effort. But this begs the question as to what is the correct measure of cost, and thus profit, to use in measuring performance.
Traditionally the measure of cost that has been used has been total cost because profit will only be made once all costs have been recovered. An absorption costing system seeks to determine product/service profitability net of all costs.
In contrast, a marginal costing system focuses on short-term variable costs in order to identify the contribution that a product/service makes towards the total fixed costs of a business. A behavioural classification of costs, as well as classification by element, function and directness, is required in marginal costing.
The contrast between absorption and marginal costing systems, as far as output information is concerned, is highlighted in the illustrations (see Figure 1) of the format and content of product profitability statements (for a manufacturing organisation) using the two different approaches. The behavioural classification and the emphasis on contribution in the marginal costing statement can be contrasted with the functional classification and total cost apportionment of the absorption format. In a service organisation the cost of sales would include those costs closely related to each service provided.
Figure 1: Product performance measurement: contrasting absorption and marginal costing
Trading and Profit and Loss Account
Product 1 Product 2 Total
Sales x x x
Less: Manufacturing cost of sales x x x
Gross Profit x x x
Less: Selling and administrative overhead x x x
Net Profit x x x
Income Statement
Product 1 Product 2 Total
Sales x x x
Less: Variable Cost of Sales x x x
Contribution x x x
Less: Fixed Overhead x
Net Profit x

The contrasting absorption and marginal approaches will determine different transaction processing requirements. With absorption costing, all costs are attached to final cost units, including a share (for a manufacturing organisation) of all manufacturing costs being included in the valuation of finished goods stock. In a marginal costing system, only variable costs are attached to cost units, fixed costs being treated as period (non-product) costs.
The contrasting processing requirements are illustrated in Figures 2 and 3. In a service organisation there would not be a finished stock account; the costs of services are charged to Trading and Profit and Loss Account when complete.

Relationship with financial accounts
When setting up a cost accounting system a final issue to resolve is the relationship that the system will have with the financial accounts. Cost accounting systems vary from, at one extreme having a cost accounting system as an internal accounting system that is completely independent of the financial accounts, through having linked systems (interlocking accounts), to at the other extreme having the cost accounting system fully integrated with the financial accounts as a single comprehensive system. Separation enables independence but results in duplication of source transaction recording.
Refer again to Figures 2 and 3. The diagrams show only one aspect of source transactions (e.g., materials bought rather than creditors; sales rather than debtors). The other aspect of each transaction in the cost accounts (the end of the dashes in the top corners of the diagrams) will depend upon the relationship with the financial accounts.
Interlocking accounts is a system in which the cost accounts are distinct from the financial accounts, the two sets of accounts being kept continuously in agreement by the use of control accounts or reconciled by other means.
The interlocking of the two systems is generally carried out by the use of control accounts in each of the separate cost and financial accounts. However, both practice and textbook treatment vary. One common approach is where the financial accounting system has the normal debit and credit entries within itself and in addition has a memorandum Cost Ledger Account. This account will have posted to it all items that are transferred to the cost accounting system.
In the cost ledger there will be the necessary accounts for costing purposes e.g., Raw Material Stock Control Account, Work-in-Progress Control Account, and in addition an account which is equal and opposite to the memorandum Cost Ledger Account in the financial (general) ledger. This control account in the cost ledger may be termed the Financial (general) Ledger Control Account. Other titles for the account that are sometimes used are Cost Ledger Control Account, Cost Ledger Contra Account, and Financial (General) Ledger Adjustment Account.
This reconciling control account in the cost ledger is an essential element of the ledger because it forms part of the double entry system, as well as enabling the financial and cost ledgers to be interlocked and avoiding duplication of those accounts that are not
required for cost accounting purposes. For example, in the cost accounts the purchase of raw materials on credit would be debited to the raw material stock account: a credit to the financial ledger control account avoids duplication of the creditors’ accounts.
At one time, integration was commonly viewed as a desirable aim. A single system would be expected to reduce costs and obviate the need for any reconciliation. However, the conventions of financial accounting will tend to take precedence in such a system. This may restrict the usefulness of information, in any case restricted by its historic transaction basis, for management purposes. Only a completely separate cost accounting system would be completely free from such restrictions, but the requirement in a manufacturing organisation, for stock valuation in line with accepted reporting principles, would remain.
This article has sought to review the requirements, and issues, relating to the establishment of a cost accounting system. A subsequent article will provide illustrations of the processing of transaction data within such a system.
1 Coulthurst N., ‘Overheads: the traditional whys and wherefores’, ACCA Students’ Newsletter, September 1998.
2 Coulthurst N., ‘The ABC of overheads’, ACCA Students’Newsletter, February 1999.

Figure 1: Product performance measurement: contrasting absorption and marginal costing


Trading and Profit and Loss Account

Product 1 Product 2 Total

Sales x x x

Less: Manufacturing cost of sales x x x

Gross Profit x x x

Less: Selling and administrative overhead x x x

Net Profit x x x


Income Statement

Product 1 Product 2 Total

Sales x x x

Less: Variable Cost of Sales x x x

Contribution x x x

Less: Fixed Overhead x

Net Profit x