Aliyah Amisha Ali

Cost and Management Accounting- ACCT210

College of Science, Technology and Applied Arts of Trinidad and Tobago

1. General principles of cost accounting

a) Definition of cost accounting
b) Why cost accounting
c) Comparison of financial and cost accounting
d) Objectives and advantages of cost accounting
e) Definition of a cost
f) Cost units
g) Cost centres
h) Cost classification
i) Cost behavior (Basic High Low Method)
Management accounting is a key element of management. In particular it involves the
identification, generation, presentation, interpretation and use of relevant information to help
managers run their organizations.
As such it involves the application of accounting and financial management to create, protect and
preserve and increase value for the stakeholders of the organization concerned.
The main functions that management are involved with are
 Planning- Planning involves establishing the objectives of an organization and
formulating relevant strategies that can be used to achieve those objectives. In order to
make plans, it helps to know what achievable in the future can be made. For example, if
a manager is planning future sales volumes, he or she needs to know what sales volumes
have been in the past.
Planning can be either short-erm (tactical planning) or long-term (strategic planning).

 Decision Making- Decision making involves considering information that has been
provided and making an informed decision.
 In most situations, decision making involves making a choice between two
or more alternatives. Mangers need reliable information to compare the
consequences might be of choosing each of them.
 The first part of the decision making process is planning, the second part is
control.

 Control- Information relating to the actual results of an organization is reported to the

managers.
 Managers use the information relating to actual results to take control
measures and to re-assess and amend their original budgets or plans.
 Aliyah Amisha Ali
Cost and Management Accounting- ACCT210
College of Science, Technology and Applied Arts of Trinidad and Tobago

 Internally- sourced information, produced largely for control purposes is

called feedback.

1. Set objectives for achievement

2. Identify in which objectives can be
Planning
achieved.
3. Make a decision as to how objectives
can be achieved based on information
provided

Implement Decision Decision Making

1. Gather information about actual results

achieved.
2. Compare actual results and expected Control
results- evaluate outcome
3. Revise original objectives if necessary
 Aliyah Amisha Ali
Cost and Management Accounting- ACCT210
College of Science, Technology and Applied Arts of Trinidad and Tobago

Definition- Cost Accounting

Cost accounting is a system for recording data and producing information about costs for the
products by an organization and/or the services it provides. It is also used to establish costs for
particular activities or responsibility centers.

*Cost accounting involves a careful evaluation of the resources used within the enterprise.
* The techniques employed in cost accounting are designed to provide financial information
about the performance of the enterprise and possibly the direction that future operations should
take
*The term ‘cost accounting’ and ‘management accounting’ are often used to mean the same
thing but strictly speaking, cost accounting is one element of management accounting.

Difference between management accounting and financial accounting

Information mainly
produced for
Purpose of Information
Legal Requirements
Formats
Nature of Information
Management Financial Accounting
Accounting
Internal Use: eg. External use: eg. Shareholders,
Managers and creditors, lenders, banks,
employees. government.
To aid planning, To record the financial
controlling and decision performance in a period and the
making. financial position at the end of the
period
None Limited companies must produce
financial accounts
Management decide on Format and content of the financial
the information they accounts intending to give a true
require and the most and fair view should follow
useful way of presenting accounting standard and company
it. law.
Financial and non- Most financial
 Aliyah Amisha Ali
Cost and Management Accounting- ACCT210
College of Science, Technology and Applied Arts of Trinidad and Tobago

financial.
Time Period Historical and forward- Mainly a historical record.
looking

The main managerial processes

These Processes include:
 Costing -Cost accounting is identifying the cost of producing an item (or providing a
service) in order to, for example, assist in deciding on a selling price.
 Planning e.g. plan how many staff will be required in the factory next year
 Decision making e.g. decide on what selling price to charge for a new product
 Control e.g. check month-by-month whether the company is over or under spending on
wages
 Performance evaluation- Comparing the performance of mangers or departments
against budgets or targets
Cost Terminology
Definition- Cost Units
To help with the above purposed of planning, control and decision making, businesses often need
to calculate a cost per unit of output.
A key question, however is what exactly we mean by a ‘unit of output”, or “cost unit”. This will
mean different things to different businesses but we always look at what the businesses produces.
 A car manufacturer will want to determine the cost of each car and probably different
components as well.
 For a paint manufacturer, the unit could be a liter of paint.
 An accountancy firm will want to know the cost incurred for each client. To help with
this it is common to calculate the cost per hour of chargeable time spend by staff.
 A hospital might wish to calculate the cost per unit patient treated, the cost of providing a
bed for each day or the cost of a operation.
Definition-Cost Centre
A cost centre is a small part of a business for which costs are determined. This varies from
business to business but could include any of the following;
 The Research and Development department
 The human resource function
 A warehouse
 A factory in a particular location.
 Aliyah Amisha Ali
Cost and Management Accounting- ACCT210
College of Science, Technology and Applied Arts of Trinidad and Tobago

It is important to recognize that cost center costs are necessary for control purposes, as well as
for relating costs to cost units. This is because the manager of a cost center will be responsible
for cost incurred.

Cost, Profit and Investment Centers

Some businesses use the term “cost center” in a more precise way that that given above:
 A cost center is when the manager of the center (department or division or location) is
responsible for costs but NOT revenue or investment. This is usually because the center
has no revenue stream.
 For example: A research and development department.
Definition- Profit Centre
A part of the business for which both the costs incurred and the revenues earned are identified. A
profit center is when the manager of the center (department or division or location) is responsible
for costs and revenues but NOT investments.
For Example: A local supermarket where investment decisions are made by the main board.
 Profit centers are often found in large organizations with a divisional structure, and each
division is treated as a profit center
 Within each profit center, there could be several costs centers and revenue centers
 The performance of a profit center manager is measured in terms of the profit made by
the center.
 The manager must therefore be responsible for both costs and revenues and in a position
to both plan and control.
Definition- A Revenue Center
Revenue Center is a part of the organization that earns sales revenue. It is similar to a const
center, but only accountable for revenues, and not costs.
 Revenue centers are generally associated with selling activities, for example, a regional
sales managers may have responsibility for the regional sales revenues generated.
 Each regional manager would probably have sale targets to reach and would be held
responsible for reaching these targets.
 Sales revenues earned must be able to be traced back to individual (regional) revenue
centers so that performance of individual revenue center managers can be assessed.

Definition- Investment Center

 Aliyah Amisha Ali
Cost and Management Accounting- ACCT210
College of Science, Technology and Applied Arts of Trinidad and Tobago

Managers of the center (usually a division) is responsible for costs and revenues and the level of
investments in the division.
For example: The US subsidiary of a global firm. The CEO would usually have authority to open
new factories, close other.
 Investment center managers are therefor accountable for the performance of capital
employed as well as profits (costs and revenues).
 The performance of an investment center is measured in termed of the profit earned
relative to the capital invested (employed).

Definition- Cost Cards

The following costs are brought together and recorded on a cost card:
 Direct Materials
 Direct Labour
 Direct Expenses
 Prime Cost ( Total Direct costs)
 Variable Production overheads
 Fixed Production Overheads
 Non-Production Overheads
 Aliyah Amisha Ali
Cost and Management Accounting- ACCT210
College of Science, Technology and Applied Arts of Trinidad and Tobago

Understanding a cost card

 The total production cost is the marginal production cost (total direct costs) plus any
fixed production overheads.
 It is important that the total production cost of a product is clearly identified as being
such. Non-production costs must be analysed separately. This is because when finished
products are transferred to the warehouse as finished goods, they are transferred at a
value that reflects the direct manufacturing costs that were involved in producing them,
i.e. total production cost.
 When finished goods are transferred to the warehouse, this is where they remain until
they are sold to customers or held as inventory. When inventory is sold, it is important
that it is given a value that reflects the 'cost of sale' of the product, so that a profit can be
calculated and reported in the income statement.
 Similarly, at the end of an accounting period, inventory is valued and reported in the
balance sheet of an organisation at its total production cost.
 It is important, therefore, that the production costs and the non-production costs are
clearly distinguished for the purposes of valuing output and inventories.
 Aliyah Amisha Ali
Cost and Management Accounting- ACCT210
College of Science, Technology and Applied Arts of Trinidad and Tobago

Production and Non-Production Costs

Classifying Costs
Costs can be classified in a number of different ways
 Element costs are classified as materials, labour or expenses (overheads)
 Nature costs are classified as being direct or indirect
 Behavior cost are classified as being fixed, variables, semi-variable or stepped fixed
 Function costs are classified as being production or non-production costs.

 Purpose                                     Classification
 Financial accounts                   By function - Cost of sales, distribution costs, administrative
expenses
Cost control                                By element – materials, labour, other expenses
 Cost accounts  By relationship to cost units – direct, indirect
 Budgeting, decision making  By behaviour – fixed, variable

Classification by element
The main cost element that you need to know about are materials, labour and expenses.
 Labour costs all staff costs relating to employees on the payroll of the organizations.
 Expenses all other costs which are not material or labour. This includes all bought-in
services, for example, rent, telephone, sub-contractors, and costs such as the depreciation
of equipment.
Cost classification by element
The simplest classification is splitting costs according to element as follows:
 Materials - includes raw materials for a manufacturer or alternatively the cost of goods
that are to be resold in a retail organisation
  Labour - Labour costs can consist of not only basic pay but overtime, commissions and
bonuses as well.
 Other expenses – also known as overheads.  This includes electricity, depreciation, rent
and so on.
Cost classification by nature - direct and indirect
 Aliyah Amisha Ali
Cost and Management Accounting- ACCT210
College of Science, Technology and Applied Arts of Trinidad and Tobago

Direct costs
Direct costs are costs which can be directly identified with a specific cost unit or cost centre.
There are three main types of direct cost:
 direct materials - for example, cloth for making shirts
 direct labour - for example, the wages of the workers stitching the cloth to make the shirts
 direct expenses - for example, the royalties paid to a designer, or the freight charges for
imported special materials.
The total of direct costs is known as the prime cost.
Indirect costs
Indirect costs are costs which cannot be directly identified with a specific cost unit or cost centre.
Examples of indirect costs include the following:
 indirect materials - these include materials that cannot be traced to an individual shirt, for
example, cotton
 indirect labour - for example, the cost of a supervisor who supervises the shirt makers
 indirect expenses - for example, the cost of renting the factory where the shirts are
manufactured.
The total of indirect costs is known as overheads.
Cost classification by behaviour
Costs may be classified according to the way that they behave. Cost behaviour is the way in
which input costs vary with different levels of activity. Cost behaviour tends to classify costs as
one of the following:
 Variable costs are costs that tend to vary in total with the level of activity. As activity
levels increase then total variable costs will also increase.
 Variable Costs can be shown graphically as follows:
 Aliyah Amisha Ali
Cost and Management Accounting- ACCT210
College of Science, Technology and Applied Arts of Trinidad and Tobago

 Note that as total costs increase with activity levels,

the cost per variable costs remains the same
 Examples of variable costs include direct costs such
as raw material and direct labor.
 A fixed cost is a cost which is incurred for an accounting period, and which, within
certain activity levels remains constant.
 Fixed costs can be shown graphically as follows:

 Note that the total cost remains constant over a given level of activity but
the cost per unit falls as the level of activity increases.
 Examples of Fixed Costs include:
 Rent
 Business Rates
 Executive Salaries

 A stepped fixed cost- this is a type of fixed costs that is only fixed within certain levels
of activity. Once the upper limit of an activity is reached then a new higher level of
activity becomes relevant.
 Stepped fixed costs can be graphically as follows:
 Aliyah Amisha Ali
Cost and Management Accounting- ACCT210
College of Science, Technology and Applied Arts of Trinidad and Tobago

 Examples of stepped fixed costs:

 Warehousing costs (as more space is required and more
warehourses must be purchases or rented)
 Supervisors’ wages ( as the number of employees
increases, more supervisors are required)
 Semi-variable costs contain both fixed and variable cost elements and are therefore
partly affected by fluctuations in the level of activity.
 Semi- variable costs can be shown graphically as follows:

 Examples of semi-variable costs:

 Electricity bills (fixed standing charge plus variable cost per unit of
electricity consumed.)
 Telephone bills (fixed line rental plus variable cost per call).

Classification by function production costs.

Production costs are the costs which are incurred when raw materials are converted into finished
goods and part-finished goods (work in progress)
For financial accounting purposes costs are split into the following categories:
Cost of sales – also known as production costs. This category could include production labour,
materials, supervisor salaries and factory rent.
Distribution costs – this includes selling and distribution costs such as sales team commission
and delivery costs.
Administrative costs – this includes head office costs, IT support, HR support and so on.

Note that some costs impact each of the above - e.g. depreciation. This is a measure of how
much an asset is wearing out or being used up. The classification will depend on which asset is
being depreciated. For example,
 Cost of sales – depreciation on a machine in the production line
 Distribution – depreciation of a delivery van
 Admin – depreciation of a computer in the accounts department
 Aliyah Amisha Ali
Cost and Management Accounting- ACCT210
College of Science, Technology and Applied Arts of Trinidad and Tobago

Production Cost

Direct Direct Variable Fixed

Direct
Labor Expenses Production Production
Materials
Overheads
Overheads

Examples of Production Costs

 Direct materials- the direct materials that go into making a product. For example, cloth
in the manufacture of shirts
 Direct Labor- The cost of expenses directly involved in making a product. For example,
the royalties paid to a designer, or the freight charges for special materials used to make
the shirts
 Variable Production Overheads- Overheads that vary direct proportion to the quantity
of product manufactured, For example. Code of fuel used to run machinery.
 Fixed Production Overheads- Overheads that are fixed whatever the quantity of
product manufactured. For Example, rent of the factory.
Analysis of Costs into fixed and variable elements
Cost Estimation
A number of methods for analyzing semi-variable costs into their fixed variable elements. The
two main methods are:
 High/Low method
 Least Squares Regression
High/Low Method
 Step 1: Select the highest and lowest activity levels, and their associated costs.
Highest Cost Level Of Activity
Lowest
 Aliyah Amisha Ali
Cost and Management Accounting- ACCT210
College of Science, Technology and Applied Arts of Trinidad and Tobago

 Step 2: Find the variable cost per unit

 Step 3: Find the fixed costs by substitution, using either the high or low activity
*Finding the slope of the graph finds the variable cost of the per unit of activity
Rise Y 2−Y 1
Slope = = = Variable cost (per unit of activity)
Run X 2−X 1

Highest cost−Lowest cost

Variable Cost per unit =
Highest Activity−Lowest Activity

 Fixed cost = Total cost at activity -Total variable cost (variable cost per unit x no. of
units)

Total Cost
Variable Cost - Fixed Cost

Assumptions underlying the high/low method

Assumptions of the high/low method are as follows:
 The cost under consideration is potentially semi-variable (i.e. it has both fixed and
variable elements).
 The linear model of cost behavior is valid i.e. y= a + bx
 Making a distinction between fixed and variable costs might be used in product costing
 To analyze profitability.
 To help managers to make decisions about increasing/decreasing levels.