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COST AND MANAGEMENT ACCOUNTING I

CHAPTER ONE
1.1.1 Definition and Objectives
Definition: Cost accounting measures, analyzes, and reports financial and nonfinancial information
relating to the costs of acquiring or using resources in an organization. It provides the detailed cost
information that management needs to control current operations and plan for the future. Cost accounting
provides information regarding production process for goods and services. Management uses this
information to decide how to allocate resources to the most efficient and profitable areas of the business.

Cost accounting provides information for management accounting and financial accounting. For example,
calculating the cost of a product is a cost accounting function that answers financial accounting’s
inventory-valuation needs and management accounting’s decision-making needs (such as deciding how to
price products and choosing which products to promote).

Modern cost accounting takes the perspective that collecting cost information is a function of the
management decisions being made. Thus, the distinction between management accounting and cost
accounting is not so clear-cut, and we often use these terms interchangeably. We frequently hear business
people use the term cost management. Unfortunately, that term has no uniform definition.

Objectives of Cost accounting

Responsibility accounting is an integral part of a cost control system because it focuses attention on
specific individuals who have been designated to achieve the established goals. Cost accounting has three
main objectives.

- cost control,
- product costing, and
- inventory pricing
1.1.2 Uses of Cost Accounting Information for decision making

The information produced by a cost accounting system provides a basis for determining product costs and
selling prices, and it helps management to plan and control operations.

Determining Product Costs and Pricing- Cost accounting procedures provide the means to determine
product costs that enable the preparation of meaningful financial statements and other reports needed to
manage a business.

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The cost accounting information system must be designed to permit the determination of unit costs as
well as total product costs. For example, the fact that a manufacturer spent $100,000 for labour in a
certain month is not, in itself, meaningful; but if this labour produced 5,000 finished units, the fact that
the cost of labour was $20 per unit is significant. This figure can be compared to the company’s unit
labour cost for prior periods and, often, to the labour cost of major competitors.

Unit cost information is also useful in making a variety of important marketing decisions such as:

1. Determining the selling price of a product. Knowing the manufacturing cost of a product aids in
determining the desired selling price. It should be high enough to cover the cost of producing the item and
the marketing and administrative expenses attributable to it, as well as to provide a satisfactory profit to
the owners.

2. Meeting competition. If a product is being undersold by a competitor, detailed information regarding

unit costs can be used to determine whether the problem can be resolved by reducing the selling price, by
reducing manufacturing and selling expenses attributable to the product, or by some combination of the
above that will still result in profitable sales.

3. Bidding on contracts. Many manufacturers must submit competitive bids in order to be awarded
contracts. Knowledge of the unit costs attributable to a particular product is of great importance in
determining the bid price.

4. Analysing profitability. Unit cost information enables management to determine the amount of profit
that each product earns, thereby allocating the company’s scarce resources to those that are most
profitable.

1.2 Financial Accounting Vs Management Accounting

Financial accounting and management accounting have different goals. As many of you know, financial
accounting focuses on reporting to external parties such as investors, government agencies, banks, and
suppliers. It measures and records business transactions and provides financial statements that are based
on international financial reporting standard (IFRS). The most important way that financial accounting
information affects managers’ decisions and actions is through compensation, which is often, in part,
based on numbers in financial statements.

Management accounting measures analyzes, and reports financial and nonfinancial information that
helps managers make decisions to fulfil the goals of an organization.

Managers use management accounting information to develop, communicate, and implement strategy.
They also use management accounting information to coordinate product design, production, and

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marketing decisions and to evaluate performance. Management accounting information and reports do not
have to follow set principles or rules. The key questions are always (1) how will this information help
managers do their jobs better, and

(2) Do the benefits of producing this information exceed the costs?

Major Differences between Management Accounting and Financial Accounting

Point of difference Management Accounting Financial Accounting

Purpose of information Helps managers to make decision Communicate organization’s
to fulfil organizational goals financial position to investors,
banks, regulators, and other
outside parties
Primary users Internal users usually managers External users such as investors,
of an organization banks, regulators, and other
outside parties
Focus and emphasis Future oriented(budget for 2011 Past oriented (reports on 2010
prepared in 2010) performance prepared in 2011)
Rules of measurement and Internal measures and reports Financial statements must
reporting Do not have to follow IFRS but prepared in accordance with
are based on cost-benefit analysis IFRS and certified by
independent external auditors
Time span and type of report Varies from hourly information Annual and quarterly financial
to 15-20 years, with financial and reports, primarily on the
non financial reports on products, company as a whole
departments, territories, and
strategies
Behavioural implication Desired to influence the Primarily reports economic
behaviour of managers and other events but also influence
employees behaviour because managers
compensation is often based on
reported financial results

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Self test question

1. What is difference between cost accounting and financial accounting?

2. What is the relevance of cost information to financial accounting?
3. What is the relevance of cost accounting for decision making?
Business Sectors, Types of Inventory, Inventoriable Costs, and Period Costs

Manufacturing-, Merchandising-, and Service-Sector Companies

We define three sectors of the economy and provide examples of companies in each sector.

1. Manufacturing-sector companies purchase materials and components and convert them into various
finished goods. Examples are automotive companies, food-processing companies, and computer
companies.

2. Merchandising-sector companies purchase and then sell tangible products without changing their
basic form. This sector includes companies engaged in retailing, distribution, wholesaling.

3. Service-sector companies provide services (intangible products)—for example, legal advice or audits
—to their customers. Examples are law firms, accounting firms

Types of Inventories

A. Manufacturing-sector -companies purchase materials and components and convert them into
various finished goods. These companies typically have one or more of the following three types of
inventories:

1. Direct materials inventory. Direct materials in stock and awaiting use in the manufacturing
process (for example, computer chips and components needed to manufacture cellular phones).
2. Work-in-process inventory. Goods partially worked on but not yet completed (for example,
cellular phones at various stages of completion in the manufacturing process). This is also called
work in progress.

3. Finished goods inventory. Goods (for example, cellular phones) completed but not yet sold.

B. Merchandising-sector -companies purchase tangible products and then sell them without changing
their basic form. They hold only one type of inventory, which is products in their original purchased
form, called merchandise inventory.

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C. Service-sector companies -provide only services or intangible products and so do not hold inventories
of tangible products.

1.3. Cost classification concepts and terms

Cost, a frequently used word in all types of organizations- manufacturing, non-manufacturing,
business, service and retail. The process of management functions involves planning, control,
decision making as well as co-ordination. One of the most important inputs in managerial
decision making is cost data. Managerial decision making is the process of choosing among
alternative courses of action; if there is no alternatives, there is no decision to make. Before
communicating information effectively to others, management accountants must clearly
understand the differences among various types of costs, their computations, and their usage.
Successful managers are certainly aware that it is the level of cost relative to revenue that
determines the firm's overall profitability. Different types of costs are used in different situations.
So in any business activity concerned with making maximum profit from available resources,
some information on cost is essential. An important first step in studying management
accounting is to gain an understanding of the various types of costs incurred by organizations. In
this unit we will learn the widely recognized cost terms, concepts, and their classifications that is
necessary to understand and communicate cost and management accounting information.

The Concepts of Cost

Cost reflects a monetary measure of the resources given up to attain some objectives such as
acquiring a good or service. Cost is a monetary measure of the amount of resources used for a
cost object. So a cost object or objectives is an objective where cost is measured i.e. it is an
activity or item for which a separate measurement of cost is desired. Broadly speaking cost is the
amount measured by the current monetary value of economic resources given up or to be given
up in obtaining goods and services. Economic resources may be given up by transferring cash or
other property, issuing capital stock, performing services, or increasing liabilities.

An actual cost is the cost incurred (a historical or past cost), as distinguished from a budgeted
cost, which is a predicted or forecasted cost (a future cost). When you think of cost, you
invariably think of it in the context of finding the cost of a particular thing. We call this thing a
cost object, which is anything for which a measurement of costs is desired.

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How does a cost system determine the costs of various cost objects? Typically in two basic
stages: accumulation, followed by assignment. Cost accumulation is the collection of cost data
in some organized way by means of an accounting system. For example, companies may collect
(accumulate) costs in various categories such as different types of materials, different
classifications of labor, and costs incurred for supervision.
Managers and management accountants then assign these accumulated costs to designated cost
objects, such as the different products produced. Managers use this cost information in two main
ways:
1. When making decisions, for instance, on how to price different models of cars or how much to
invest in R&D and marketing and
2. for implementing decisions, by influencing and motivating employees to act and learn, for
example, by rewarding employees for reducing costs.
Costs, Expenses and Losses:

It is important to distinguish costs, expenses and losses. But before that it is necessary to
understand what and asset is Normally a cost is viewed as an asset if it can be shown that it has
future service potential that can be identified. For example, prepayment of insurance premium.
Now as we have already understood a cost is the value of assets given up, or to be given up, to
acquire other assets, i.e. cost is a sacrifice of resources. Expenses are costs that are applicable to
the current accounting period. Expenses in its broadest sense includes all expired costs, i.e. costs
which do not have any potential future economic benefit. The term expense is the cost of
services or benefits received, or resources consumed during an accounting period. The term "cost
is not synonymous with expense". Expense means a decrease in owners equity that arises from
the operation of a business during a specified accounting period, whereas cost means any
monetary sacrifice whether or not the sacrifice affects the owners equity during a given
accounting period. Example, cost of good sold and selling and distribution expenses. A loss is an
unplanned cost expiration and for this reasons is often included in the broad definition of
expense. When assets are given up for nothing in return, the value of the assets given up
becomes a loss. A more precise definition restricts the use of the term loss, stating that the cost
expiration which does not benefit the revenue producing activities of a firm. Examples,

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unrecovered book value on the sale of fixed assets, the

Classifications of cost

Direct Costs and Indirect Costs

We now describe how costs are classified as direct and indirect costs and the methods used to
assign these costs to cost objects.
1. Direct costs of a cost object are related to the particular cost object and can be traced to
it in an economically feasible (cost-effective) way. Example of direct costs is direct
material and direct labor costs. The term cost tracing is used to describe the assignment
of direct costs to a particular cost object.
2. Indirect costs of a cost object are related to the particular cost object but cannot be
traced to it in an economically feasible (cost-effective) way. For example, the salaries of
plant administrators (including the plant manager) who oversee production of the many
different types of products. The term cost allocation is used to describe the assignment of
indirect costs to a particular cost object. Cost assignment is a general term that
encompasses both (1) tracing direct costs to a cost object and (2) allocating indirect costs
to a cost object.
Classification according to changes in the volume/levels of activity

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Within a period, a particular cost may be observed changing with corresponding changes in
some measures of activity. Hence, costs are classified according to their behaviour in relation to
changes in the volume of output (production), which others, as they are incurred in relation to
time, remain more less fixed in amount. Accountants describe a given cost behaviour pattern
according to the way its total cost (rather than its unit cost) reacts to changes in a related measure
of activity. On this basis, costs are classified into the 2categories, fixed and variable costs

1. Fixed Costs:

A cost that is not immediately affected by changes in the cost driver. Activities that affect costs
are often called cost driver. A fixed cost is that which tends to remain unchanged despite often
wide changes in output or activity. On a per unit basis, a fixed cost varies inversely with changes
in the level of activity. This means that the per unit fixed cost decreases with increase in the
activity level, and increases with decrease in the activity level. The rent of buildings of an
organization, supervisor’s salaries, taxes on real estate, maintenance and repairs of buildings and
grounds, depreciation (other than that computed under the units of production method),
insurance are good examples of fixed costs. Fixed costs are sometimes termed as "capacity cost"
because fixed costs are generally incurred to create facilities.

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The graph illustrates that total fixed cost remains unchanged irrespective of whether activity
changes. When activity doubles or triples, from 100 to 200 to 300, total fixed cost remains
constant at Tk.25,000. However, the fixed cost per unit does change level as activity changes. If
activity level is 20 units, then the fixed cost per unit declines to Tk.1,250 and Tk.250
respectively. Algebraically, a fixed cost graphs is represented by: y = a, where; 'y' is the total
cost and 'a' is the fixed cost.

2. Variable Costs:

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A cost that changes in direct proportion to changes in the cost driver. A cost that varies in total
in direct proportion to changes in activity levels, a variable cost must be a constant amount per
unit. The cost of raw materials, wages, sales commission, use of machine on rental basis are the
good examples of variable costs. Thus, as activity changes, total variable cost increases or
decreases proportionately with the activity changes, but unit variable cost remains the same.

The graph illustrates that total variable cost increases proportionately with activity. When
activity doubles from 100 to 200 units, total variable cost doubles, from Tk.1,000 to Tk.2,000
and so on. However, the variable cost per unit remains the same as activity changes. The
variable cost associated with each unit of activity is Tk.10 whether the activity level is 100 units,
400 units or 700 units. Algebraically, a variable cost line in the graph is represented by : y = bx
where; 'y' is the total cost 'b' is variable cost per unit; and 'x' is the number of units of output.

Classification according to association with product of period:

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An important issue in both managerial and financial accounting is the timing with which the
costs and services are recognized as expenses. Costs are also classified by time period to provide
some bases of comparison of the firm's financial position from period to period. Costs related to
time periods are either period costs or product costs.

1. Period Costs:

Period costs refer to those items of cost which are recognized as expenses for the period in
which they are incurred and are charged against the revenue for the period. So period costs are
charged in the profit and loss account in the period in which they are incurred because they
relate to the passage of time, rather then being associated closely with the manufacturing
process. It should be remembered that period costs are not assets, because they are not expected
to provide any future economic benefits to the organization. Examples of period costs are
salaries of sales personnel, sales representatives’ commission, administrative expenses, selling
expenses, distribution expenses, depreciation of the office equipment, and finance expenses etc.

2. Product Costs:

Product costs refer to those items of cost that are included in the costs of inventory and become
expenses when the product is sold subsequently. So product costs are those costs that are
assigned to inventory because they are closely associated with production activities rather than
with the passage of time. It should be remembered that product costs are considered assets when
incurred, because they are resources that are expected to provide future economic benefits to the
organization. Product costs associated with making or acquiring inventory are also called
“inventoriable costs”, which means the amount of inventory remains unsold that is the portion of
product cost stored. During the time period of sale, the product costs are recognized as an
expense called “cost of goods sold”. For examples, the cost of direct materials, direct labor, and
manufacturing overhead consist product costs for manufactured goods.

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It is important to classify period costs and product costs with due care. As shown in the above
flow diagram, marketing and administrative costs are not product costs either in merchandising
or manufacturing companies. Merchandise company inventory represents merchandise purchase
for sale while manufacturing company inventory consists of cost of material, labour and
manufacturing overhead that are used to manufacture product. So if the period costs and product
costs are classified incorrectly, the financial statement for the period will be inexact.

Illustrating the Flow of Inventoriable Costs and Period Costs

We illustrate the flow of inventoriable costs and period costs through the income statement of a
manufacturing company, for which the distinction between inventoriable costs and period costs is most
detailed.

Manufacturing-Sector Example

The income statement and schedule of cost of goods manufactured of a manufacturing company:

Step 1: Cost of direct materials used in 2011. Beginning inventory is $11,000 and direct material
purchases are $73,000, and ending inventory of direct materials of $8,000 that becomes the beginning
inventory for the next year.

The cost of direct materials used is calculated as follows:

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Note how in Exhibit 2-7, these costs increase work-in-process inventory.

Prime Costs and Conversion Costs

Two terms used to describe cost classifications in manufacturing costing systems are prime costs
and conversion costs. Prime costs are all direct manufacturing costs. For Cellular Products,

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Conversion costs are all manufacturing costs other than direct material costs. Conversion costs
represent all manufacturing costs incurred to convert direct materials into finished goods. For
Cellular Products,

Direct Direct Manufacturi

material manufacturi ng overhead
costs ng labor costs
costs

Prime cost = Conversion cost =

DMC+DMLC DMLC +MOHC

Controllable Costs and Uncontrollable Costs:

The controllability of a particular cost depends upon the level of management, that is, it is
related to a special center of managerial responsibility. Controllable costs are those which can be
influenced by the decisions and actions of a specified member of an undertaking and
uncontrollable costs are those which cannot be influenced by a specified member of an
undertaking. The distinction is not absolute because many costs are not completely under the
control of one individual. In classifying costs as controllable or uncontrollable, managerial
accountants generally focus on a manager’s ability to influence costs. Examples of controllable

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costs are indirect labor, lubricants, power costs while depreciation, rent, and property tax are
uncontrollable costs. The time period factor and the decision-making authority can make a cost
controllable or uncontrollable. If the time period is long enough, all costs can be controllable.
Similarly, whether a cost is controllable or not should be decided by the decision-making
authority.

Avoidable and Unavoidable Costs

If you want to go out in public, what do you absolutely need to do? There are many answers to that
question. For example, you need to move. You need to walk out of your house/apartment. You also need
to put on clothes. The need for clothing is unavoidable. The cost of clothing then is an unavoidable cost.
You need to buy clothes if you want to go out in public. An avoidable clothing cost though is to spend
money on something extravagant like expensive, designer-clothes. So, there is a difference between
essential, unavoidable costs, and non-essential, avoidable costs

An avoidable cost is a cost that is not incurred if the activity is not performed. For example, supply
expenses are avoidable costs. You can simply decide to not buy the supplies, and no expense will be
incurred. These costs are often identified as variable costs, which vary based on production. If there is no
production, there is no cost.

An unavoidable cost, on the other hand, is a cost that is still incurred even if the activity is not
performed. For example, if a manufacturing plant shuts down, its avoidable costs (i.e. variable costs), like
materials or supplies, will be $0, but it still needs to pay for idle equipment, property taxes, lease
payments, etc. These costs are often considered fixed costs. Fixed costs are expenses that do not depend
on production.

Sunk Costs

A sunk cost refers to money that has already been spent and cannot be recovered. A manufacturing firm,
for example, may have a number of sunk costs, such as the cost of machinery, equipment, and the lease
expense on the factory. Sunk costs are excluded from a sell-or-process-further decision, which is a
concept that applies to products that can be sold as they are or can be processed further.

Budgeted cost

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A budgeted cost is a forecasted future expense that the company is expected to incur in the
future. In other words, it’s an estimated expense that management anticipates will be incurred in
a future period based on projected revenues and sales. It’s common practice for management to
make budgets and forecasts to predict future needs based on growth trends and customer
demand. The budgeting process also allows management to plan operations to meet the increased
product demand. For instance, management might predict a doubling of sale next year that can’t
be produced in the current facility. Either another facility will need to be built to meet the
demand or the current factory will have to double in size in order to produce enough products for
the period.

Standard cost

Standard costs are estimates of the actual costs in a company’s production process, because
actual costs cannot be known in advance. This helps a business to plan a budget. Later, when the
actual costs are determined, the company can see if it has a favorable budget variance (meaning,
actual costs did not exceed standard costs) or unfavorable budget variance (the standard costs
were exceeded). Companies use standard costs for budgeting because the actual costs cannot yet
be determined. This is because in the manufacturing process, it is impossible to predict the
demand of a product or all the variables that will affect the costs of manufacturing it.

This does not mean the actual costs will never be used, typically a company’s accountant will
periodically update the variances as that information becomes available.

Standard costs not only help a company to budget for their expenses but to establish prices for
their products.

Standard costs are also known as “pre-set costs”, “predetermined costs” and “expected costs”.

At the end of the year (accounting period), if the standard costs are higher than the actual
expenses, than the company is considered to have a favorable variance. If the company’s actual
costs were higher, then the company would have an unfavorable variance. These variances can
be drilled down to find specifically where in the manufacturing process the actual cost

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differences lie between standard and actual; for instance, labor cost variances, material cost
variances, etc.

Actual cost

Actual cost is an accounting term that means the amount of money that was paid to
acquire a product or asset. It’s exactly what it sounds like—the actual cost. This cost
could be either a historical, past, or present day cost of product

Actual cost also applies to manufacturing products as well. The actual cost of manufacturing a
product is the total expenditures required to build or manufacture the product. Think of actual
cost as the end result of a manufacturing process.

First, a company starts planning the production and forecasts what the expenses will be. Second,
the company budgets what it will be able to afford and adjusted to the production levels to meet
the budget. If everything goes according to plan, the actual costs will equal the budgeted costs. In
the real world, things can go wrong and budgets are not always met. The end result is the actual
cost. It could be plus or minus the budgeted or forecasted cost.

Methods of cost estimation could be:

A. Account analysis: Estimating costs using account analysis involves a review of each account
making up the total costs being analyzed. Then, each cost should be identified as either
fixed or variable, depending on the relation between the cost and some activity. Fixed costs
are those costs that are fixed in total regardless of the activity level and variable costs.
Variable costs are those costs that vary in total as activity changes.

B. Engineering estimate: estimates through detailed Study of the different operations in the
production process, engineering cost estimates are based on measuring and then pricing the
work involved in a task.

C. statistical or mathematical (mostly regression Analysis): Quantitative, objective

measures of the precision and reliability of the model, usually in the form of Y = ax + b;

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where, y is the cost estimate, a is the slope of the line (variable cost per unit) and b is the Y
intercept (fixed Cost)

Cost center and cost unit

Cost centre: It is defined as a section of business such as location, person, or item of equipment (or a
group of these) for which costs may be ascertained and used for the purpose of control.

Cost centers are the smallest segment of activity or area of responsibility or a division of the
organization for which costs are accumulated or ascertained.

Cost unit: It is defined as a unit of product, service or time in relation to which cost may be
ascertained or expressed.

 It is the unit of measurement of cost.

 Cost units may be of two types:
 Units of Production
 Units of Services
 Cost units is device for the purpose of breaking up cost in to smaller sub-divisions
 Cost unit is a unit of quantity of product, service, or time in relation to which cost may be
ascertained or expressed.
 Cost unit is the unit of measurement of different types of products. For example, ton in case or
coal, Yards in case of cloth, Liter in case of petrol etc.

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