LEVEL 1

PAPER 7

Cost and Management Accounting

December 2022 Examination

Introduction &
Cost classifications
Lecturer: Samuel Mukobe
INTRODUCTION;

MANAGEMENT ACCOUNTING

THE NATURE AND SCOPE OF MANAGEMENT ACCOUNTING;

Management Accounting

This refers to the application of professional knowledge and skills in the preparation of
accounting information so as to assist management in the effective running of an enterprise.

Management Accounting is an integral part of an organization that deals with the formulation of
strategy, planning and controlling of activities in an organization, optimal use of resources and
decision making among others.

Cost Accounting

This refers to the making available accessible cost data to advise management in planning and
controlling the enterprise

Financial Accounting

This refers to the analysis, classification and recording of financial transactions and
ascertainment of how such transactions affect the performance and position of an enterprise.

Differences between Financial Accounts and Management Accounts

Financial Accounts Management Accounts

• These detail the performance of an • These aid managements in planning,
organization over a defined period and recording and controlling of
the state of affairs as at the end of that organization activities to help in the
period. decision-making process.
• Limited companies must by law • There is no legal requirement to
prepare Financial Accounts. prepare management Accounts.
• The format of the published Financial • The Format of management Accounts
Accounts is prescribed by law i.e. is solely determined by management.
companies Act, IASs, IFRS • Management Accounts can focus on
• Financial Accounts concentrate on the specific areas of organizations
business as a whole. activities.
• Financial Accounting information is • Management accounts incorporate
expressed in monetary terms. non-monetary measures.
• Financial Accounts present an • Management Accounts are both an
essentially historic picture of past historic record and a future planning
operations. tool.
The role of a Management accountant

• Planning. A Management Accountant establishes, coordinates and administers a

systematic plan so as to enable an organization achieve its intended objectives. This
involves setting targets and laying strategies on how to achieve the set targets.

• Controlling. This involves comparing the set targets with the plan so as to ensure that the
organization is moving towards the right direction. Effective control measures must be
put in place to ensure that an organization achieves the intended targets.

• Coordinating. The Management Accountant consults all segments of an organization to

ensure that all their independent activities are geared towards achievement of a common
goal.

• Organizing. He/she ensures that all functions have got sufficient resources and are well
equipped to effectively perform their activities that are geared towards achievement of
the Organization goals.

• Evaluation. The Accountant compares actual performance with the set targets in order
to measure performance for effective future decision making.
• Policy Formulation. The accountant helps in designing policies that serve as guidelines
during the

Users of Accounting information and their information needs

• Investors. These are the providers of risk capital. They are concerned with the risk
inherent in and the return provided by their investments. They need information to
determine whether they should buy, hold or sell their holdings.

• Shareholders. These are interested in in the information so as to assess the entity’s

ability to pay dividends.

• Financial institutions. They are interested in the information to ascertain whether their
loans and interest attached to them will be paid will be paid when due. In other words
they are interested in assessing the credit worthiness of an entity.

• Suppliers and other Trade creditors. They are interested to ascertain whether the
amounts owing to them will be paid when due.
 • Customers. These are interested in the going concern status of an organization so as to
be assured of continued supply of goods and services that they depend on and are
provided by a specific entity.

• Government. These require this information for regulatory purposes, determination of

taxation policies and providing a basis for National income and other related statistics.

• The public. Enterprises affect the public in many ways. For example, provision of
employment opportunities, learning purposes, provision of information about trends and
recent developments among other needs.

• Employees. They need to ascertain the profitability and stability of their employers so
that they are assured of employment tomorrow. They also need to assess the ability of an
enterprise to provide adequate remuneration and retirement benefits. They however also
need the information so as to evaluate their performance.

• Management. Accounting information helps them control and thus improve the firms
operations.

• Competitors. They are interested in comparing their own efficiency and performance
with that of other companies operating in the same industry.

Ethical requirements of a Management accountant

All accountants are required to uphold certain ethical principles during the execution of their
duties. These are clearly stipulated in the Accountants code of Ethics.

The following five fundamental principles as form the basis of the code;

• Integrity. This means being straight forward, honest and truthful in all professional and
business relationships. You should not associate with any information that you believe
contains materially misleading statements.

• Objectivity. This means not allowing bias, conflict of interest or the influence of other
people to override your professional judgment.

• Professional competence and due care. This requires one to have the commitment to
maintain a high level of professional knowledge and skill while carrying out professional
duties so that the clients or employees receive a competent professional service.
 • Confidentiality. This means respecting the confidential nature of information you
acquire through professional relationships whether past or current employment. Such
information should not be disclosed unless there is specific permission or a legal or
professional duty to do so.

• Professional behavior. This requires you to comply with the relevant laws and
regulations. You must also avoid any action that could negatively affect the reputation of
the profession.

Threats

To apply the ethical principles, you need to be able to identify and evaluate existing or potential
threats to them.

There are five categories of common threats as shown below;

• Self-interest threats. This occurs as a result of your own or your close family’s interests-
financial or otherwise. This normally result from what is commonly called a ‘conflict of
interest’ situation. It could result from concern over job security, fear of losing a client or
having a financial interest in a client.

• Self-review threats. These occur when you are required to reevaluate your previous
judgment. For example, if you have been asked to review and Justify a business decision
you made. Or if you are reporting on the operation of financial systems that you were
involved in designing or implementing.

• Familiarity threats. This arises when you become so sympathetic to the interests of
others as a result of a close relationship that your professional judgment becomes
comprised.

• Intimidation threats. This occurs when you are deterred from acting objectively by
perceived or actual threats. It may arise when a dominant personality tries to influence
the decision making process.

• Advocacy threats. This arises when you are promoting a position or opinion to the point
that your subsequent objectivity is compromised. It could include acting as an advocate
on behalf of an assurance client in litigation or dispute with third parties.
Cost accounting system

The Cost accounting system of any organization is the foundation of the internal financial
information system. Management needs a variety of information to plan, control and make
decisions. Information regarding the financial aspects of performance is provided by the costing
system.

Cost accounting is a part of management accounting providing a bank of data for the management
accountant to use in order to determine the following;

• The cost of goods produced or services provided.

• The cost of a department or work section.

• Revenues that have been realized.

• The profitability of a product, service, department, or the organization in Total.

• Selling price with some regard for the cost of sale.

• The value of inventories of goods (raw materials, work in progress, finished goods) that
are still held in store at the end of a period, thereby aiding the preparation of a statement
of financial position of the company’s assets and liabilities.

• Future costs of goods and services (costing is an integral part of budgeting (planning)
for the future).

COST CLASSIFICATIONS;

A Cost represents the amount of resources that are usually sacrificed in

pursuing an objective or given up in exchange for goods and services.

A cost unit is a unit of product which has costs attached to it. The cost unit
is the basic control unit for costing [Link]. price for a kg of sugar.
Cost centers are a location, person, item of equipment for which costs
can be ascertained. They are the essential building blocks of a costing
system? They act as a collecting place for certain costs before they are
analyzed further

A cost center might be a place, On the other hand it might be a person, or

it might be an item of equipment such as a machine which incurs costs
because it needs to be maintained
Cost objects/objective
A cost object is any activity for which a separate measurement of costs is
required. For example, the cost of a product or a service
Cost behavior
Cost behavior is the way in which costs are affected by changes in the
volume of output. It is important for planning, control and decision-
making.
Management decisions will often be based on how costs and revenues
vary at different activity levels. Examples of such decisions are as follows.
• What should the planned activity level be for the next period?
• Should the selling price be reduced in order to sell more units?
• Should a particular component be manufactured internally or
bought in?
• Should a contract be undertaken?

If the accountant does not know the level of costs which should have been
incurred as a result of an organization’s activities, there is no way he/she
can control costs.
Knowledge of cost behavior is essential for the tasks of budgeting,
decision making and effecting controls.
Basic principles of cost behavior
The basic principle of cost behavior is that as the level of activity rises,
costs will usually increase. It will cost more to produce 2,000 units of
output than it will cost to produce 1,000 units.

Cost behavior patterns

Fixed costs/overheads/indirect
A fixed cost is a cost which remains constant regardless of the level of
activity.
Fixed cost are a period charge, in that they relate or a span of time; as the
span increases, so too will the fixed costs. A sketch graph of a fixed cost
would look like this.
Indirect materials x
Indirect labour x
Indirect expenses x
Illustration
Shs
Cost

Fixed
cost

Level of activity QTY

Examples of a fixed cost would be as follows.

• The salary of the managing director (per month or per annum)

• The rent of a single factory building (per month per annum)

• Straight line depreciation of a single machine (per month or per

annum)
However, the fixed cost per unit will reduce as the volume of activity
increases as illustrated below;
Eg.

Graph of fixed cost per unit

Cost/unit
shs

fixed cost per unit

Step costs/step fixed costs
A step cost is a cost which is fixed in nature but only within certain levels
activity.
Consider the depreciation of a machine which may be fixed if production
remains below 1,000 units per month. If production exceeds 1,000 units,
a second machine may be required, and the cost of depreciation (on two
machines) would go up a step.

Illustration

Costs (Shs)

Volume of output
Other examples of step costs are as follows.
a) Rent is a step cost in situations where accommodation requirements
increase, as output levels get higher.

b) Basic pay of individual employees is nowadays usually fixed, but as

output rises, more employees (supervisors, managers and so on) are
required.

Variable costs/prime/direct
Variable cost is a cost which varies directly with the volume of output.
The variable cost per unit is the same amount for each unit produced. Total
variable cost will increase or decrease in proportion to any change in
activity.
Eg
Direct materials x
Direct labour x
Other direct expenses x
Total variable costs xx
Illustration
costs(Shs)

Volume of output
Bonus payments for productivity to employees might be variable once a
certain level of output is achieved,
Semi-variable costs
A semi-variable/semi-fixed/mixed cost is a cost which contains both
fixed and variable components and so is partly affected by changes in the
level of activity.
Examples of these costs include the following.
(a) Electricity and gas bills
• Fixed cost = standing charge
• Variable cost =charge per unit of electricity used

(b) Salesman’s salary

• Fixed cost = basic salary
• Variable cost = commission on sales made.
(c) Costs of running a car
• Fixed cost = road tax, insurance
• Variable costs = petrol, oil, repairs (which vary with miles
travelled)
Illustration

Shs
Cost
Variable Element
Fixed Element

Level of Activity

Classification in relation to cost center or cost unit

Direct costs/prime costs
A direct cost is a cost that can be traced in full directly to the product or
service.
Direct costs include,
Direct Materials, this refers to all materials that are fully directly traceable
to a product. they include; component parts, primary parking materials
among others.
Direct Labor. Refers to wages paid to labour as a result of working directly
on the production of a product.
Direct expenses Refers to all expenses incurred in the production of a
product. For example, the cost of a special design or layout
Indirect cost/overhead costs/fixed costs.
These are costs that are incurred in the course of making a product or
providing a service, but cannot be traced directly and in full to the product
or service.
Examples include;
Indirect labour
Indirect materials
Indirect expenses like rent, depreciation, insurance among others.

Classification by function
Classification by function involves classifying costs as
production/manufacturing costs, administration costs or marketing/selling
and distribution costs.
In a ‘traditional’ costing system for a manufacturing organization, costs
are classified as follows.
a) Production costs are the costs which are incurred by the sequence of
operations beginning with the supply of raw materials, and ending
with the completion of the product ready for warehousing as a
finished goods item. Packaging costs are production costs where they
relate to ‘primary’ packing (boxes, wrappers and so on).
b) Administration costs are the costs of managing an organization that
is, planning and controlling its operations.

c) Selling costs sometimes known as marketing costs are the costs of

creating demand for products and securing firm orders from
customers.

d) Distribution costs are the costs of the sequence of operations with

the movement of finished goods from the production department to
the Final consumers.

e) Research costs are the costs of searching for new or improved

products,

f) Development costs are the costs incurred between the decision to

produce a new or improved product and the commencement of full
manufacturing of the product.

g) Financing costs are costs incurred to finance the business such as

loan interest.

Classification by responsibility
• Cost centers are collecting places for overhead before they are
further analyzed
.
• A cost unit is a unit of product or service to which direct costs can be
related.

• A cost object is any activity for which a separate measure of costs is

required.

• Profit centers are accountable for both costs and revenues.

• Revenue centers are accountable for revenues only.

• An investment center is a profit center with additional

responsibilities for capital investment and possibly financing.

• A responsibility center is a department or organizational function

whose performance is the direct responsibility of a specific manager.

Other types;
Product costs; These are costs that are identified with goods purchased
or produced for resale. In a manufacturing organization, they are
attached to a product and are included in inventory valuation for finished
goods, work in progress until they are sold. For example, direct labour,
direct materials etc.
Period; These are costs that are not included in inventory valuation and
as a result are treated as expenses in the period in which they are
incurred. For example, fixed overheads
Relevant costs; These are future costs that will be changed by a
decision. For example, if you are faced with a choice of making a
journey using your own car or by public transport, the petrol costs will
differ depending on the which alternative Is chosen and this cost is
relevant for decision making.
Irrelevant costs; These are costs that will not be affected by a decision.
For example, if you are faced with a choice of making a journey using
your own car or public transport, the insurance costs are irrelevant costs
since they will remain the same whatever alternative is chosen.
Avoidable costs; These are costs that may be saved by not adopting a
given alternative.
Unavoidable costs; These are costs that cannot be saved by not
adopting a given alternative.
Sunk costs; These are costs that have been created by a decision made
in the past and cannot be changed by any decision that will be made in
the future. They are costs of resources acquired where the total will be
unaffected by the choice between various alternatives. For example, the
written down values of assets previously purchased. Sunk costs are
irrelevant for decision making.
Opportunity costs; This is a cost that measures the opportunity that is
lost or sacrificed when the choice of one course of action requires that an
alternative course of action be given up.
Differential/incremental; these are the difference between costs for the
corresponding items under each alternative being considered. For
example, the incremental costs of increasing output from 1000 to 1050
units per week are the additional costs of producing 50units per week.
They may or may not include fixed costs. If fixed costs do not change as
a result of a decision, the incremental costs will be zero.
Marginal costs; These represent the additional costs incurred in the
production of one extra unit of output.
Controllable costs; these are costs that can be regulated or influenced
by a manager. It is a cost over which the manager has got direct and
complete decision authority.
Uncontrollable costs; These are costs which cannot be controlled or
regulated by a specific member of an undertaking. For example, fixed
costs like rent.
Normal costs; these are costs that are usually incurred under normal
operating conditions and are always expected to be incurred in the
process of providing goods and services.
Abnormal costs; these are unexpected costs that are incurred during
normal operating conditions. They are normally not charged to costs of
production but transferred to the costing profit and loss account.
Historical costs; these are costs that are ascertained after they have been
incurred and such costs are available only when production of a
particular product has been completed.
Pre-determined costs; these are estimated costs set in advance of the
production of a product or provision of a service
Replacement costs; this refers to the current cost of an item in the
market for purposes of replacement.
Notional costs; these are imputed or hypothetical costs that do not
involve cash outlay but computed for purposes of decision making. For
example, opportunity costs, payments that are not actually paid out like
use of family labour in a family business.
Discretionary costs; these are costs which are set at fixed amounts for
specific time periods by management in the budgeting process. These
reflect top management policies and have no direct relationship with
output. For example, sales promotion expenses, consultancy fees etc
Out-of-pocket costs; this is the portion of costs associated with an
activity that involve cash outlay to other parties as opposed to costs
which do not require any cash outlay like depreciation.
Elements of manufacturing costs
Prime costs = direct material + Direct labour + direct expenses
Factory costs = Prime costs + Factory overheads
Cost of production = Factory costs + other administrative overheads
Cost of sales = cost of production + selling and distribution overheads.
Illustration of a cost
statement/sheet

USH
Direct Materials X
Direct Labour X
Direct Expenses X
Prime Cost XX

Production Overheads
Absorbed X

Total Production Cost XXX

Selling & Distribution

O/Hs X
Administration O/Hs X
Research & Dev't O/Hs X
Full Cost of Sales XXXX
Profit Margin X
Selling Price XXXXX
Example;

Using the data provided below; prepare a cost sheet for the books of ABC
Ltd

Particulars Shs000
Raw materials purchased 240,000
Material transport expenses 20,000
Wages 70,000
Other direct expenses 50,000
Factory overheads 20% of prime costs
General and administrative 4% of factory costs
overheads
Selling and distribution expenses 5% of production
costs
Profit 20% of sales

Opening stock
Raw materials 30,000
Work in progress 35,000
Finished goods 40,000
Closing stock
Raw materials 40,000
Work in progress 48,000
Finished goods 55,000