Actual and Planned Costs

We have stated that cost information is required for the under-mentioned four major purposes:

(1) to assist in planning decisions;

(2) to assist in the control of operations;

(3) to assist in the measurement of reported profits;

(4) to report to employees.

The measurement of reported profit requires information of the actual or current costs of production during the accounting period. For the purposes of planning and control decisions, however, information is required not only about historical and current costs, but also about future costs. Since decisions are concerned with future events, the costs which are relevant for decision making are future costs. Past events are useful in this respect only if they influence judgements about future events. As we noted in Part 4, the risk - attendant upon decisions stems from the uncertainty affecting future events. Management makes plans on the basis of current knowledge and management judgement about the future. One significant factor which has increased the risk attached to business decisions is inflation. Prior to the occurrence of rapid inflation in the early 2000s, for example, sales forecasting tended to be the major element of uncertainty in profit planning. Cost forecasts were relatively reliable, and appropriate pricing decisions could be made. With high levels of inflation, profit planning is much more uncertain in view of the greater difficulty of forecasting costs and making suitable pricing decisions.

Planning and control decisions are often made on the basis of special types of unit costs which are called standard costs. A standard cost is a predetermined cost which is established in relation to specific operating conditions, and takes into consideration all the factors and circumstances which are likely to influence production costs. They are applied to both prime and overhead costs, and their objective is to establish standards both for the rate of usage of resources and their input price.

Standard costs are used both for planning and for control purposes. Thus, they are used for the purposes of drawing up plans and budgets, and they are used also for maintaining control over operations.

Actual costs serve two very useful roles for planning and control purposes. As regards planning decisions, they act as feedback information which either validates those decisions, or assists in improving the planning process by examining the reasons for previous errors. For control purposes, actual costs are compared with planned costs as a means of checking that actual performance is conforming with planned performance. Variance analysis is a central aspect of the control process.

Standard costs are also used in the measurement of reported profit, as they form the basis on which costs are calculated. If the standards used reflect current conditions, they are current costs, and may be used in a current cost accounting system. A company that uses a standard cost system will be able to calculate the cost of sales adjustment from the variances associated with purchases.

For More Information On Narrowing Accounting Differences

Read on: Limitations of Total Cost Calculations

Limitations of total cost calculations

It is clear from the foregoing examination of the problems associated with overhead costs that full-product costs cannot be measured with complete accuracy. To some extent, all methods used for apportioning overhead costs are arbitrary, and are based upon assumptions which are subjective to a degree. We stated that the 'benefit received' should be the main criterion for apportioning factory overhead costs to cost centres. It is difficult, however, to find bases which are suitable for this purpose. For example, the cost of the factory personnel department may... see: Limitations of Total Cost Calculations