Cost Audit: Definition, Advantages, Disadvantages, Types of Cost Audit

What is Cost AuditCost audit may be defined as “the verification of cost records and accounts and a check on the adherence to the prescribed cost accounting procedures and the continuing relevance of such procedures.”

Smith and Day in their book ‘Advanced Cost Accountancy’ define it, “the term ‘Cost Audit’ is meant the detailed checking of the costing system, technique and accounts to verify their correctness and to ensure adherence to the objective of cost accountancy.”

R.W. Dobson Smith and Day, in their book Introduction to Cost Accountancy,’ defines it, “Cost audit is the verification of the correctness of cost accounts and the adherence to the cost accountancy plan.”

Cost audit is the verification of the correctness of cost accounts and a check on the adherence to the cost accounting plan.

This is, it involves not only the examination of cost accounts but also the fact that the plan prepared in this connection has been duly executed. Cost audit as 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 cost audit is the verification of cost accounting records according to the cost accounting system, and the second function is the checking on the adherence to the cost accounting plan.

A cost audit, therefore, includes verification of correctness of the cost accounts, cost statements, cost reports, cost data, and costing techniques applied and finally 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. To ensure that cost accounts are correct and also to detect errors, frauds, and wrong practice in the existing system.
  4. To check up the general working of the cost department of the organization and to make suggestions for improvement.
  5. To help the management in taking 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 find out whether each item of expenditure involved in the relevant components of the goods manufactured or produced has been properly incurred or not.

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, omission, fraud, and mistakes can be detected and prevented due to the effective auditing of cost accounts.
  4. It reduces the cost of production through 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 efficiency of the organization as a whole and costing system in particular by constant review, revision, and checking or routine procedures and methods.
  7. It helps in comparing actual results with budgeted results and points out the areas where management action is more needed.
  8. It also enables comparison among different units of the factory to find out 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 principles of costing employed in the industry concerned.
  11. It ensures effective internal control.
  12. It helps to increase the overall efficiency of productivity.
  13. Inefficiency can be eliminated by suitable corrective actions.
  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 to evaluate their advantages to the enterprise.

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 makes sure 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 plant and machinery are properly utilized or not.
  4. It creates an image of the creditworthiness of the concern.

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 in the economic progress of the nation.
  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.

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 for fixing up the selling prices of the 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 tax or duty at the cost of finished products.
  9. It facilitates settlement of trade disputes of the companies.
  10. It imposes an automatic check on inflation.
  11. It assists the Tariff Board to consider 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 expense that gives a company financial clarity about accounts. Although they provide such transparency, “there are many disadvantages to conducting cost audits.

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

  1. 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 in case further explanation of documents is necessary.

  1. Lost Time

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.

  1. Uncertainty

Because a major part of the process involves estimating, there’s the possibility of numerical figures being wrong.

Besides, if receipts and other forms of record-keeping 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 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

The following are the important types of Cost Audit:

  1. Efficiency Audit.
  2. Propriety Audit.
  3. Statutory Audit.

These are explained below;

  1. Efficiency Audit.

Efficiency Audit is directed towards the measurement of whether corporate plans have been effectively executed. It is concerned with the utilization of 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.

  1. 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.

  1. Statutory Audit.

It is the compulsory audit that 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, and it holds good for both the cost audit as well as the financial audit.

However, the following are the points of difference between these two audits:

Financial AuditCost Audit
It is statutorily compulsory under Companies.It is not compulsory except in certain cases.
It covers all the financial transactions recorded in financial books and financial records.It covers only cost records and cost accounts.
It aims to examine that business transactions have been recorded correctly.It aims to verification of cost accounts and ensures the plan prepared in this connection has been duly executed.
It is concerned with the past and history.It concerned with a forward-looking approach.
Reporting the true and fair view of the company’s earnings and state of affairs.Cost Auditor is required to report to the management except for statutory audits.
The financial aspect of the accounts is a matter of concern.The cost aspect of the account is of main concern.
It is concerned with the scrutiny of reliability or otherwise of transactions.It is concerned with the propriety and efficiency of the transactions.
The financial audit is primarily concerned with serving the interests of the shareholders.8. The cost audit is concerned with serving the interests of the management.
The role of the financial auditor is in the office.The role of the cost auditor is in the factory.
A financial audit is conducted every year.Cost audit may be done in the year in which it is required by the government or any other agency.
In a financial audit, an auditor has to check the exact value of the closing stock for the balance sheet.In a cost audit, an auditor has to check the adequacy of the stock, keeping in view the needs of the concern.
In the financial audit, the report is submitted to the management to be laid in the general meeting of the shareholders.The report of the cost auditor is submitted to the company and also to the company law board.

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 duration of 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 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 the uniformity in work.
  4. It helps to safeguard against omission.
  5. It guides for proper distribution of works 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 concern, 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 business.

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 be of effective use to 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.

  1. General Information: This includes;
  • 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.
  1. Cost Accounting System: 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.
  1. Financial Position: It includes;
  • Capital employed.
  • Net worth.
  • Profit before tax.
  • Expenses to be specified.

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