Cost Audit: Definition
In a cost audit, the books of account and vouchers are examined to evaluate their accuracy. The exact calculation of the cost of a product is called a cost audit.
Cost Audit: Other Definitions
In the context of accounting, an audit is the systematic examination of the books, vouchers, and records of a business to enable the auditor to report whether the accounts are properly drawn up (i.e., so as to exhibit a true and fair view of the company’s state of affairs).
Initially, the scope of audits was limited to verifying official transactions. However, more recently, it has been extended to other fields, including cost audit. Cost audits seek to verify the correctness of cost records or cost accounts.
The Institute of Cost & Works Accountants of India defines a cost audit as follows: “An audit of efficiency of minute details of expenditure … Cost audit is mainly a preventive measure, a guide for management policy and decision … and a barometer of performance.”
The Institute of Cost & Management UK defined cost audits as “the verification of the correctness of cost accounts and a check on the adherence to the cost accounting plan.”
According to Smith and Day, a cost audit involves “detailed checking of the costing system, techniques, and accounts to verify their correctness and to ensure adherence to the objective of cost accounting.”
In the words of R. W. Dobson, “cost audit is the verification of the correctness of cost accounts and of the adherence to the cost accountancy plans.”
Based on these definitions, cost audit refers to the detailed verification of the correctness of costing techniques, costing systems, and cost accounts. In any manufacturing or service firm, it is crucial to calculate the correct cost of services to charge customers.
For this purpose, cost accounts or costing records are maintained. However, simply maintaining cost accounts is not sufficient. To determine the true and accurate cost of products and services, it is necessary to ensure that these records are accurate and correct.
As such, there is a need for proper auditing of the costing records. This means that they must be checked by a qualified and trained professional.
Cost Audit: Explanation
Cost audit is an examination of the efficiency of the minute details of expenditure while the work is in progress; it does not constitute a post-mortem examination.
The cost auditor can be appointed by the board of directors by taking prior permission of the central government. The cost auditor enjoys all the rights of a financial auditor.
Ultimately, cost audits are valuable for decision-making, price determination, internal control, and internal efficiency.
Objectives of Cost Audit
The following are the objectives of the cost audit:
(A) Prospective Aspects
(i) Proper ascertainment and control of costs
(ii) Detection of errors, omissions, and commissions, as well as detection of repetition
(iii) Verifying that cost accounts are correctly maintained in conformity with accepted cost accounting principles adopted in the industry
(iv) Ensuring that cost account routines are properly performed
(B) Constructive Aspect
Management’s attitude, the attitude of the appointing authority, and the scope of the cost audit influence the objectives. The auditor will work in an advisory capacity for the well-being of the company’s owners. Their functions may thus extend to judge:
(i) Whether or not the existing procedures are adequate and effective to the management for making decisions
(ii) Whether or not the projected expenditure can yield the optimal results
(iii) Whether the money invested in one type of investment could be more profitably invested in another
(iv) Whether the return from capital employed is adequate if not, and whether it can be improved
Summary of Objectives
The objectives of a cost audit can be summarized as follows:
(i) To verify the arithmetical accuracy of the cost books
(ii) To maintain accounts according to costing principles
(iii) To follow predetermined norms and concepts of cost accounting
(iv) To provide all data relating to cost records to the management for decision-making
(v) To detect errors and instances of fraud
(vi) To increase the effectiveness of internal control
Objectives From the Government Perspective
For governments, the objective of a cost audit is to address the following questions:
(i) Do specific industries require special attention?
(ii) Is protection given to any specific industry?
(iii) How is the industry managed?
(iv) Is the closure of the industry beneficial to the management?
(v) Is the industry suitable or not to the public?
(vi) What is a reasonable selling price to consumers?
Merits of Cost Audit
The chief merits of a cost audit are the following:
(i) Safeguards against the misuse of raw materials and labor
(ii) Useful for evaluating inefficiencies
(iii) Useful for highlighting irregularities and instances of fraud
(iv) Useful for checking uneconomical activities
(v) Provides all information to facilitate immediate action
(vi) Enables budgetary and standard costing
(vii) Assists in the valuation of inventory and work-in-progress
(viii) Promotes good relations between employees and top management
(ix) Leads to the recommendation of reasonable prices for consumers
(x) Highlights the strong and weak points in a firm, thereby showing options for corrective action
Qualifications for a Cost Auditor
Qualifications for the cost auditor are outlined as follows:
(i) Any person who is a practicing cost accountant, as per the Cost and Works Accountants Act
(ii) Any person who is a practicing charted accountant, according to the Charted Accountants Act
(iii) Member of the Institute of Chartered Accountants
(iv) Fellow with 10 years of standing
The main disqualifications for a cost auditor are the following:
(i) A person cannot be appointed who, according to the Companies Act 1956, is not a competent cost auditor
(ii) Any person who is appointed as the auditor of a company cannot be appointed as the cost auditor of the same company
(iii) Any person who becomes incompetent after their appointment as cost auditor should stop working in the role immediately
Scope of Cost Audit
The scope of cost audit has two important aspects:
- Propriety audit
- Efficiency audit
1. Propriety Audit
This aspect of a cost audit is concerned with the actions and plans of management that affect the finance and expenditure of the business concern.
Under this aspect, the cost auditor is required to ensure that an item of expenditure is sanctioned or approved by the proper authority. It is done with the help of documents and vouchers.
In addition, the cost auditor must ensure that the item of expenditure is proper and reasonable on the grounds of propriety.
Thus, the cost auditor has to report:
- Whether or not the planned expenditure can yield optimal results
- Whether or not the size or channels of investment were designed to produce the best results
- Whether the return on investment in certain channels could be improved by another plan of action
2. Efficiency Audit
This aspect of a cost audit focuses on performance evaluation. In particular, it covers the verification of the facts (i.e., that the expenditure has been incurred according to the plan and the results obtained have also been produced according to the plan).
The efficiency aspect of a cost audit involves examining the plan prepared in the form of budgets (financial and functional) and the comparison of the actual performance with the budgeted performance. The reasons for any variance are also analyzed.
Thus, the efficiency audit ensures that:
- Every dollar invested in capital or other areas yields the optimal return
- Investment in different spheres of the business is balanced to yield the optimal results
Therefore, the cost auditor plays the role both of a consultant and a financial adviser. They assist the chief executive of the business in judging the soundness of the financial plans and performance by coordinating the results of the actions of various department leaders.
Difference Between Cost Audit and Financial Audit
The main differences between cost audits and financial audits are summarized below.
|Cost Audit||Financial Audit|
|Where used: Wherever cost accounting techniques are used (e.g., manufacturing companies)||Wherever financial accounts are prepared|
|Objective: To find out how to reduce the cost of output||To ensure that books of account are accurate|
|Variation of what: Total cost and per-unit cost of output is shown or varied||Lays stress that the financial position shown is true and fair|
|Related to: Only the per-unit cost of output||Total income and expenditure|
|Laws: Only tests the organization’s working efficiency||Checks whether laws and formalities are conformed with or not|
|Performed by: External parties (e.g., government, customer trade associations, and tribunals)||Business owners|
|Valuation of closing stock: The stock is not more than the required quantum||It is the duty of the financial auditor to ensure the proper valuation of stock|
|Report: Submitted to the government/owner/company law board||Submitted to shareholders|
|Scope: Confined to factory/works||Confined to the office|
|Interest: Protects the interests of the government and producers||Protects the interests of shareholders|
|Period: Not confined to a specific period but related to objectives||Typically one year (or related to a special time, such as the accounting period)|
|Appointment: Cost auditor is appointed with the prior permission of the central government or board of directors||Financial auditor is appointed at the company’s general meeting|
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.