Cost Audit: Definition, Advantages, Disadvantages, Types

Meaning and Definition of Cost Audit

Cost Audit is the detailed checking of the costing system, technique, and accounts to verify their correctness and ensure adherence to the objective of cost accountancy.

Cost audit is the verification of cost records and accounts, a check on adherence to the prescribed cost accounting procedures, and the continuing relevance of such procedures.

Cost auditing checks and verifies cost accounts’ accuracy, actuality, authenticity, and overall adherence to the company’s cost accounting plan. This involves not only the examination of cost accounts but also the fact that the plan prepared in this connection has been duly executed.

A cost audit is an audit of the efficiency of minute details of expenditure in which the work is in progress and not a post-mortem examination.

• The first function of a cost audit is verifying cost accounting records according to the cost accounting system, and
• the second is checking on adherence to the cost accounting plan.

A cost audit, therefore, includes verifying the correctness of the cost accounts, cost statements, cost reports, cost data, and costing techniques applied and checking these data to see that they adhere to cost accounting principles, plans, procedures, and objectives.

Objectives of Cost Audit

The following are some of the objectives for which cost audit is undertaken:

1. To establish the accuracy of costing data. This is done by verifying the arithmetical accuracy of cost accounting entries in the books of accounts.
2. To ensure that cost accounting principles are governed by the management objectives and these are strictly adhered to in preparing cost accounts.
3. Ensure that cost accounts are correct and detect errors, fraud, and wrong practices in the existing system.
4. To check up on the general working of the cost department of the organization and to make suggestions for improvement.
5. To help the management make correct decisions on certain important matters
6. to determine the actual cost of production when the goods are ready.
7. To reduce the amount of detailed checking by the external auditor, its effective internal cost audit system is in operation.
8. To determine whether each item of expenditure involved in the relevant components of the goods manufactured or produced has been properly incurred.

Advantages of Cost Audit

The important advantages of cost audit are briefly discussed as follows:

Advantages of Cost Audit to the Management

1. It provides necessary information for prompt decision decisions.
2. It helps management to regulate production.
3. Errors, omissions, fraud, and mistakes can be detected and prevented due to the effective auditing of cost accounts.
4. It reduces the cost of production by plugging loopholes relating to wastage of material, labor, and overheads.
5. It can fix the responsibility of an individual wherever irregularities or wastage are found.
6. It improves the organization’s efficiency and the costing system by constantly reviewing, revising, and checking routine procedures and methods.
7. It helps compare actual results with budgeted results and points out the areas where management action is more needed.
8. It also enables comparison among different factory units to determine the profitability of the different units.
9. It exercises a moral influence on employees, which keeps them efficient and alert.
10. It ensures that the cost accounts have been maintained under the costing principles employed in the industry concerned.
11. It ensures effective internal control.
12. It helps to increase the overall efficiency of productivity.
13. Suitable corrective actions can eliminate inefficiency.
14. It facilitates cost control and cost reduction.
15. It assists in the valuation of stock of materials, works in progress, and finished goods.
16. It ensures maximum utilization of available resources,
17. It enables the management to choose economic methods of operations and thus earn profits to satisfy the shareholders and the investing public.
18. It enables the management to chalk out the future policy based on the report by the cost auditor, especially regarding labor, raw material, plant, etc., to maximize production and reduce the cost of production.
19. It tests the effectiveness of cost control techniques and evaluates their advantages to the enterprise.

How do Company’s Shareholders Benefit from Cost Audit? – Advantages of Cost Audit to the Shareholders

1. It 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 ensures that the industrial unit has been working efficiently and economically.
2. It enables shareholders to determine whether or not they are getting a fair return on their investments. It reflects managerial efficiency or inefficiency.
3. It ensures a true picture of the company’s state of affairs. It reveals whether resources like plants and machinery are properly utilized or not.
4. It creates an image of the creditworthiness of the concern.

How is Cost Auditing Benefits Society important? (Advantages of Cost Audit to the Society)

1. It 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 exploitation.
2. It improves the efficiency of industrial units and thereby assists the nation’s economic progress.
3. Since the price increase by the industry is not allowed without justification as to an increase in the cost of production, consumers can maintain their standard of living.

(Why Cost Auditing is Important For Government) – Advantages of Cost Audit to the Government

1. It assists the tariff board in deciding whether tariff protection should be extended to a particular industry or not.
2. It helps to ascertain whether any particular industry should be given any subsidy to develop that industry.
3. It provides reliable data to the government to fix the selling prices of various commodities.
4. It helps in fixing contract prices in a cost-plus contract.
5. It determines whether differential pricing within the industry is desirable.
6. It helps the government to take necessary measures to improve the efficiency of sick industrial units.
7. It can reveal the fraudulent intentions of the management.
8. Cost statements may be helpful to authorities in imposing taxes or duties at the cost of finished products.
9. It facilitates the settlement of trade disputes among the companies.
10. It imposes an automatic check on inflation.
11. It assists the Tariff Board in considering the extension or removal of protection.

Disadvantages of Cost Audit

Cost audits verify expense records and accounts. The audit also ensures that accounts and bookkeepers comply with ethical practices.

Effective cost audits provide a complete breakdown of expenses, giving a company financial clarity about accounts. Although they provide such transparency, there are many disadvantages to conducting cost audits.

Expensive

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 go from paying $4,000 to $6,000 for an audit.

Lengthy

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 if further explanation of documents is necessary.

Lost Time

Although thorough, an auditor’s report is usually given three to five weeks after the balance sheet is released. This means people stealing from an establishment have nearly a month to form an excuse or leave the company.

Uncertainty

Because a major part of the process involves estimating, numerical figures can be wrong.

Besides, if receipts and other record-keeping forms are skewed, an auditor relying on such documents may produce an inaccurate report.

Circumstances Under Which Cost Audit is Desirable

The following are the circumstances under which a cost audit is ordered:

1. Price Fixation.
2. Cost variation within the industry.
3. Inefficient Management.
4. Tax Assessment.
5. Trade Disputes.

Types of Cost Audit

three important types of cost audits are;

Efficiency Audit.

An efficiency audit measures whether corporate plans have been effectively executed. It is concerned with utilizing resources in an economical and most remunerative manner to achieve the objectives of the concern.

For example, the effective utilization of capital in an organization can be gauged by determining the return on capital employed.

Propriety Audit.

The propriety Audit is concerned with executive actions and plans bearing on the finance and expenditure of the company. The auditor has to judge whether the planned expenditure is designed to give optimum results.

Statutory Audit.

The compulsory audit required maintaining the related books and accounts of specified establishments. The chief aims of this type of audit are that the government wants to ascertain the relationship between costs and prices.

Difference between Financial Audit and Cost Audit

The basic nature of audit is checking, which is good for both the cost and financial audits. However, the following are the points of difference between these two audits:

Cost Audit Program

A suitable program for cost audit should be drawn out in detail, specifying each item of audit work to be carried out.

An audit program is a written plan prepared by the cost auditor showing the following salient features:

• How much work is to be done?
• Who is going to do a particular portion of work?
• And what is the time by which the work is to be finished?

Prof. Meig defines, “An audit program is the detailed plan of auditing work to be performed specifying the procedures to be followed in the verification of each item in the financial statements and giving the estimated time required.”

Areas Where Cost Audit Program is Carried Out

The areas in which a cost audit program should include are as below:

1. Inventory of stores and work in progress;
2. Labor;
3. Overheads;
4. Selling, distribution, office, and administrative expenses;
5. Capital expenditure;
6. Utilization of capacity, plant, and equipment.

Advantages of Cost Audit Program

The following advantages will accrue if a cost audit is carried out with the help of a cost audit program:

1. It helps the auditor to know about the progress of the audit.
2. It increases the efficiency of the cost audit associates.
3. It facilitates uniformity in work.
4. It helps to safeguard against omission.
5. It guides for proper distribution of work and fixing responsibility.
6. It serves as a defense against a charge of negligence.
7. It serves as a reference for future audits of the same concern.

Disadvantages of Cost Audit Program

There are certain disadvantages if the cost audit work is carried out with the help of a cost audit program. They are as follows:

1. For small concerns, it would be unnecessary to prepare a program.
2. Audit associates have no interest and initiative since they perform their work mechanically.
3. As each business has its problems and procedures, a rigid audit program cannot be laid for all types of businesses.

Cost Audit Report

On completion of an audit, an auditor has to submit his audit report incorporating a certificate regarding the correctness or otherwise of accounts along with his suggestion, if any, for improvements in the operation.

The report should be concise and submitted to the appropriate authorities at the right time to effectively use the parties concerned. It should comply with statutory provisions, if any.

Annexure to Cost Audit Report

Generally, a cost audit report contains the following matters.

General Information in Cost Audit Report

• Name and address of the concern/firm.
• Date of the company’s registration.
• Types of company, i.e., public or private.
• Brief description of the company’s function.
• Location of the factory.
• Opening date of commercial production.
• Types of accounts.
• Production capacity.

Cost Accounting System in Cost Audit Report

Here, the cost auditor mentioned whether the accounts are maintained according to the GAAP or cost accounting system. Generally, cost accounting methods include;

• Cost accounting system regarding materials.
• Cost accounting system regarding labor.
• Depreciation, overhead, and its allocation on production cost.
• The condition of by-product, joint product, etc.

Financial Position in Cost Audit Report

• Capital employed.
• Net worth.
• Profit before tax.
• Expenses to be specified.