A costing system is set up alongside the accounting system, and is usually used by manufacturing organisations that need to monitor and control expenses and income. Devising the right coding system allows this to be organised effectively in line with business requirements.
The costing system will split out the expenses and categorise them by nature and function.
The nature of the cost can be direct or indirect. Direct costs are those directly attributable to the production of a specific unit, whereas indirect costs cannot be allocated to a specific unit. A direct cost will be either direct material, direct labour or direct expense. An indirect cost will be indirect material, indirect labour, or indirect expense.
Splitting costs by function means sorting them by the department that incurred the cost. For example, a cost could be allocated to distribution, admin, or cost of sale. This allows the business to see where costs arise.
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Devising a coding system
Once it has been decided how the costs will be split based on reporting needs, the company should agree on how the coding structure is set up so that everyone understands and can use it, and so that it can be further developed in line with future growth.
The codes used can be numerical, alphabetical or alphanumerical. Which method you use can be dictated by the number of codes required. A numerical coding system is often best if large numbers of codes are required.
The code will need to be split by nature, element and function for each type of cost. For example, a manufacturing organisation that makes tables might split the code as Nature.Element.Function primarily. So the wood for the table would be: Direct.Material.Cost of sale.
The code could then be: D (for direct), 001 (for material), 5 (for cost of sale)
If we then purchased nails, the code would be: D (for direct), 001 (for material), 5 (for cost of sale)
This means that the code for both wood and nails would be exactly the same. The organisation would then need to decide whether a further split should be made. For example, 001 could be materials, and then this is split into 0015 for wood, 00110 for nails, and 00115 for adhesive.
If organisations are geographically dispersed, with departments in different locations, then it might also be helpful to add a code for location.
An understanding of coding systems in cost accounting is essential for anyone looking to progress within accountancy. Costing is covered in detail at each level of the AAT qualification.