BASIC INTRODUCTION

Manufacturing organizations: purchase raw materials from suppliers and convert these materials
into tangible products through the use of labour and capital inputs (e.g. plant and machinery).
Merchandising companies: such as supermarkets, retail departmental stores and wholesalers sell
tangible products that they have previously purchased in the same basic form from suppliers.
Service organizations: such as accounting firms, insurance companies, advertising agencies and
hospitals provide tasks or activities for customers. A major feature of service organizations is that
they provide perishable services that cannot be stored for future use.
Cost accounting is defined by the Institute of Management Accountants as:
"A systematic set of procedures for recording and reporting measurements of the cost of
manufacturing goods and performing services in the aggregate and in detail. It includes methods for
recognizing, classifying, allocating, aggregating and reporting such costs.
Cost accounting provides the detailed cost information that management needs to control current
operations and plan for the future.
Cost accounting information is also commonly used in financial accounting, but its primary function
is for use by managers to facilitate their decision-making.
Cost Accounting: involves assigning costs to cost objects that can include a company's products,
services, and any business activities.
Managerial accounting: is the practice of identifying, measuring, analyzing, interpreting, and
communicating financial information to managers for the pursuit of an organization's goals.
Managerial accounting involves the presentation of financial information for internal purposes to
be used by management in making key business decisions.
Financial accounting: is the systematic procedure of recording, classifying, summarizing,
analyzing, and reporting business transactions. The primary objective is to reveal the profits and
losses of a business. Financial accounting provides a true and fair evaluation of a business. It,
therefore, safeguards the interests of stakeholders

2. Comparison of cost accounting and financial accounting

Financial Accounting Cost Accounting

Purpose Prepared to meet a legal or Prepared to meet the needs of
regulatory requirement. management.
Users Used to prepare financial statements Used to prepare information for
for shareholders and other external management (internal use only).
users. (Might also provide some
information for management but this
is not their primary purpose).
Contents Content usually specified by a Content specified by the
regulatory framework. management of a company.
Timeframe Prepared within a time frame Prepared within a time frame
specified by a legal or regulatory specified by management.
framework.
Recording Records revenues, expenditure, Records costs of activities and
assets and liabilities. used to provide detailed
information about costs, revenues
and profits for specific products,
operations and activities.
Scope Used mainly to provide a historical Provides historical information,
record of performance and financial but also used extensively for
position. forecasting (forward-looking).

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Costing systems

Scenario Example Costing system

(i) Identical (similar) products in large Bottles of soft drink Actual, historic or
numbers Mobile phones standard
Garments Absorption
Process
(ii) Identical products in large numbers Aircraft (which may vary Actual, historic or
customised in some way for in internal fit and external standard
different customers painting) Own-brand Absorption
foods for supermarkets Job costing
(iii) One-off products to a customer’s Ships Actual
specification Airport facilities Absorption
Roads Job costing
Bridges

Note: Marginal costing is normally used for decision making only.

(b) Service organisations

Similar to the manufacturing industry there are a great many different kinds of Service organisations.
For example:

 Training and education

 Healthcare
 Travel and tourism
 Financial services
 Entertainment and leisure

The need to know about costs

 Make sure that the product or service is sold at a profit;

 measure the actual profit that has been made; and
 in the case of some companies, such as manufacturing companies, value Inventory at the end
of each accounting period.
4. Some Important Terminologies
A cost is composed of three elements – Material, Labour and Expenses (Overheads). Each of
these three elements can be direct and indirect, i.e., direct materials and indirect materials, direct
labour and indirect labour, direct expenses and indirect expenses.

Cost object: Any activity for which a separate measurement of costs is needed. In other words, if the
users of accounting information want to know the cost of something, this something is called a cost
object. Examples of cost objects include the cost of a product, the cost of rendering a service to a bank
customer or hospital patient, the cost of operating a particular department

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Examples of cost objects include:

 The cost of a product

 The cost of a service
 The cost of a department
 The cost of a project

Cost Unit: A unit of product or service for which costs are determines. (e.g a box, a bag, per foot, per
kilometer etc)

Unit Cost: Unit cost is the cost incurred by a company to produce, store and sell one unit of a
particular product. Unit cost includes all fixed costs and all variable costs involved in production

Business Cost object Cost unit

(i) Car manufacture Cars produced A small car, a featured car
(ii) Bakery Bread produced Small bread, a batch of bread
(iii) Steel works Steel produced Tonne of steel, foot of steel
(iv) Carpet manufacture Carpets produced Square metre of carpet
(v) Passenger transport Fuel cost Cost per kilometer
(vi) University Cost of teaching, cost of Cost per student, cost per class
lab section

An organization with one cost object might have different cost unit.

5. Cost Classification:
Cost classification involves the separation of a group of expenses into different categories. A
classification system is used to bring to management's attention certain costs that are considered
more crucial than others, or to engage in financial modeling. cost collection system typically
accounts for costs in two broad stages:
1 It accumulates costs by classifying them into certain categories such as by type of expense (e.g.
direct labour, direct materials and indirect costs) or by cost behaviour (such as fixed and variable
costs).
2 It then assigns these costs to cost objects
Why Cost Classification?
The purpose of cost classification is to enable businesses to analyze and monitor their
expenditures, make informed decisions about resource allocation, and ultimately improve
their financial performance.
5.1 Cost classification by type/nature
 Material costs
 Labour costs
 Other expenses
5.2 Cost classification by function
(i) production costs (manufacturing costs); and
(ii) non-production costs (non-manufacturing costs).

a) Selling costs;
b) Distribution costs;
c) Administrative costs;
d) Finance costs.

5.3 Cost classification by behaviour

A knowledge of how costs and revenues will vary with different levels of activity (or volume) is
essential for decision-making. Managers might require information in order to answer questions such
as these:
1 How will costs and revenues change if activity is increased (or decreased) by 15 per cent?

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2 What will be the impact on profits if we reduce selling price by 10 per cent based on the estimate
that this will increase sales volume by 15 per cent?
3 How do the cost and revenues change for a university if the number of students is increased by 5
per cent?
Cost behaviour refers to the way in which costs change as the volume of activity changes.

The volume of activity may be:

 the volume of sales;

 the volume of production;
 total labour hours worked, machine hours worked;
 the number of production units inspected;
 the number of journeys (for buses or trains) or deliveries, and so on.

Fixed costs
Fixed costs are items of cost that remain the same in total during a time period, no matter how many
units are produced, and regardless of the volume or scale of activity. For example depreciation of
equipment, property taxes, insurance costs, supervisory salaries and leasing charges for cars used by
the sales force.
Variable costs
Variable costs are costs that increase, usually by the same amount, for each additional unit of product
that is made or each additional unit of service that is provided. For example direct materials, direct
labor, energy to operate the machines and sales commissions.

Cost behaviour graphs: fixed and variable costs

Semi-variable costs

A semi-variable cost, is a cost that is partly fixed and partly variable. A cost Behaviour graph showing
the total costs for an item of mixed cost is shown Below.

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Stepped cost: A stepped fixed cost is a cost which:
has a fixed cost behaviour pattern within a limited range of activity, and goes up or down in steps
when the volume of activity rises above or falls below certain levels.

On a cost behaviour graph, step fixed costs look like steps rising from left to right.

5.4 DIRECT AND INDIRECT COSTS

Costs may also be classified as:

 direct costs; or
 indirect costs (also known as overheads).
DIRECT COSTS: Costs that can be traced in full to a cost unit. A direct cost can be attributed in its
entirety to the cost of an item that is being Produced.
Direct Materials:
Direct materials are all materials that become part of the cost unit. Direct materials are all materials
that can be attributed directly in full to a cost unit. They are used directly in the manufacture of a
product or in providing a service.

Direct materials may consist of either or both:

 raw materials, such as glass, metals and chemicals
 components purchased from an external supplier: for example the direct

Materials of a car manufacturer include components purchased from other Suppliers, such as
windows, wheels and tyres.
Direct Labour
Direct labour is labour time that can be attributed directly in full to a cost unit.
Direct expenses
Direct expenses are expenses that can be attributed directly in full to a cost unit. Direct expenses are
expenses that have been incurred in full as a direct Consequence of making a unit of product, or
providing a service, or running a Department.
Prime Cost

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The prime cost of a cost unit is the sum of all of the direct costs of making that Unit.

Indirect Cost
An indirect cost (overhead cost) is any cost that is not a direct cost. Indirect costs (overheads) cannot
be attributed directly and in full to a cost unit.
Indirect Material Costs
Indirect materials are any materials that are used or consumed that cannot be attributed in full to the
item being costed. Indirect materials are treated as an overhead cost, and may be classified as
production overheads, administration overheads or sales and distribution overheads.

Indirect materials in production include cleaning materials and any materials used by production
departments or staff who are not engaged directly in making a product.

Indirect production materials may also include some items of materials that are inexpensive and
whose cost or value is immaterial. These may include nails, nuts and bolts, buttons and thread, and so
on. The effort of measuring a cost for these materials is not worth the value of the cost information
that would be produced; therefore these ‘direct’ materials are often treated as indirect materials.
Indirect Labour Costs
Indirect labour costs consist mainly of the cost of indirect labour employees. Indirect labour
employees are individuals who do not work directly on the items That are produced or the services
that are provided.
Indirect Expenses
Many costs incurred cannot be directly linked to cost units.
For example, the rental costs for a factory and the costs of gas and electricity Consumption for a
factory cannot be attributed in full to any particular units of Production. They are indirect production
costs (production overheads).
Full Cost
The full cost of a unit of product (or the full cost of a unit of service) is a cost that Includes both direct
costs and some overheads. The full cost of a unit of product Might be analysed as follows:

5.5 PRODUCT COSTS AND PERIOD COSTS

Product Cost

Product costs are costs associated with goods that are produced or purchased for Resale.

Product costs are accounted for as inventory and held on the balance sheet (subject to accounting
valuation rules) until the inventory is sold. Only when the Inventory is sold are product costs
expensed in the profit and loss account.

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Period Cost
Period costs are costs that are deducted as expenses during a particular period. They do not contribute
towards the value of inventory and are therefore not held on The balance sheet. They are therefore
expensed when they occur – i.e. In the period In which they occurred.

6. Cost Estimation: high/low method

The total costs associated with a business (or a part of a business, for example a Production line) are
the sum of the fixed costs and the variable costs.
Formula: Total costs

Y = a + bx

Where:
Y = total costs in a period
X = the number of units of output or the volume of activity in the period
A = the fixed costs in the period
B = the variable cost per unit of output or unit of activity.

The method
Step 1: Take the activity level and cost for:
the highest activity level
the lowest activity level
Step 2: The variable cost per unit can be calculated as:
Difference in total costs/difference in the number of units
Step 3: Having calculated a variable cost per unit of activity, fixed cost can be calculated by
substitution into one of the cost expressions. The difference Between the total cost at this activity
level and the total variable cost at this Activity level is the fixed cost.
Step 4: Construct the total cost function.
This is best seen with an example.

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Therefore: 2,400 units cost an extra Rs. 8,400.

Therefore: The variable cost per unit = Rs. 8,400/2,400 units = Rs. 3.5 per unit

Step 3: Substitute the variable cost into one of the cost functions (either High or low).

Total cost of 8,200 units:

Fixed cost + Variable cost = Rs. 48,700
Fixed cost + 8,200 / Rs. 3.5 = Rs. 48,700
Fixed cost + Rs. 28,700 = Rs. 48,700
Fixed cost = Rs. 48,700 - Rs. 28,700 = Rs. 20,000
Step 4: Construct total cost function
Total cost = a +bx = 20,000 + 3.5x

7. Cost estimation: linear regression analysis

Linear regression analysis is a statistical technique for calculating a line of best fit

From a set of data:

Y = a + bx

The data is in ‘pairs’, which means that there are a number of different values for X, and for each
value of x there is an associated value of y in the data.

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See an example below:

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 The End

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