COST AND MANAGEMENT ACCOUNTING

Cost and management accounting is a form of accounting that aims to maximise

profit by managing revenues and expenses. It provides data and reports used by
managers to inform their strategies around long-term profit and growth.
Cost management accounting is a form of accounting that aims to improve a
company’s profitability by managing, controlling and eliminating expenses. Cost
accounting helps businesses determine the costs of products, projects and
processes, which shows the company where its earning and losing money and is an
integral part of budget planning. Cost and management accounting provides data
and analyses reports that can be used by managers to make decisions that will lead
to long term profits and growth.
Functions of Management Accounting
Functions and objectives of management accounting include the following:
Planning
Planning is an important function of management accounting which is most
effectively performed by the preparation of budgets and forecasts.
Forecasting is the process of estimation of the expected financial performance and
position of a business in the future. Common types of forecasts include cash flow
forecast, projected profit and loss and balance sheet forecast. Forecasts assist in
determining the likely change in the financial performance and position of a
business when considered in the context of the various assumptions used in
forming the projections. Forecasting is the starting point in determining the
resource requirements of a business which are quantified into budgets.
Budgets quantify the financial targets to be achieved by the management of an
organization. Budgeting process often begins with the preparation of a master
budget which is then used as a basis for the preparation of departmental and
operational budgets. Budgeting helps in the effective allocation of resources of an
organization between competing needs (e.g. departments, products, etc) in order to
achieve the financial goals of a business. Budgets and forecasts help businesses to
deal with potential problems proactively and avoid foreseeable bottlenecks in
business resources.
Decision Making
Management accounting facilitates the provision of financial information to
management for decision making. Management accounting also involves the
evaluation of alternative strategies and actions by the application of techniques and
concepts such as relevant costing, cost-volume-profit analysis, limiting factor
analysis, investment appraisal techniques and client / product profitability analysis.
Monitoring & Control
Control process in management accounting system starts by defining standards
against which performance may be measured such as standard costs and budgets.
Actual results are measured and any variance between targets and results are
analyzed and where necessary, corrective actions are taken. Management
accounting plays a vital role in the monitoring and control of cost and efficiency of
the routine processes and as well as one-off jobs and projects undertaken by an
organization.
Accountability
Management accounting lays great emphasis on accountability through effective
performance measurement. By setting targets for strategic business units and as
well as for departments, management accounting assists in the assignment of
responsibility for the achievement of business targets by individual managers.
Responsibility accounting is achieved by appraising the performance of managers
responsible for their business units while giving due consideration for factors not
within their control or influence.

What is the difference between a budget and a standard?

A budget usually refers to a department's or a company's projected revenues, costs,
or expenses. A standard usually refers to a projected amount per unit of
product, per unit of input (such as direct materials, factory overhead), or per
unit of output.
For example, a manufacturer will have budgets for its manufacturing or factory
overhead departments. Let's assume that the budgeted manufacturing overhead for
the upcoming year is expected to be $1,000,000 in order to produce the expected
100,000 identical units of product. The standard cost of manufacturing overhead
per unit of product is $10 ($1,000,000 divided by 100,000 units). When the
products are not identical, the $1,000,000 of manufacturing overhead might be
divided by the expected number of machine hours required to manufacture the
units of product. Assuming it will take 50,000 machine hours, the standard cost of
the manufacturing overhead will be $20 per machine hour ($1,000,000 divided by
50,000 machine hours).
Advantages and Disadvantages of Standard Costing
Five of the benefits that result from a business using a standard cost system are:
 Improved cost control.
 More useful information for managerial planning and decision making.
 More reasonable and easier inventory measurements.
 Cost savings in record-keeping.
 Possible reductions in production costs.
Improved cost control Companies can gain greater cost control by setting
standards for each type of cost incurred and then highlighting exceptions or
variances—instances where things did not go as planned. Variances provide a
starting point for judging the effectiveness of managers in controlling the costs for
which they are held responsible.

Assume, for example, that in a production center, actual direct materials costs of $
52,015 exceeded standard costs by $ 6,015. Knowing that actual direct materials
costs exceeded standard costs by $ 6,015 is more useful than merely knowing the
actual direct materials costs amounted to $ 52,015. Now the firm can investigate
the cause of the excess of actual costs over standard costs and take action.
Further investigation should reveal whether the exception or variance was caused
by the inefficient use of materials or resulted from higher prices due to inflation or
inefficient purchasing. In either case, the standard cost system acts as an early
warning system by highlighting a potential hazard for management.

More useful information for managerial planning and decision making When

management develops appropriate cost standards and succeeds in controlling
production costs, future actual costs should be close to the standard. As a result,
management can use standard costs in preparing more accurate budgets and in
estimating costs for bidding on jobs. A standard cost system can be valuable for
top management in planning and decision making.
More reasonable and easier inventory measurements A standard cost system
provides easier inventory valuation than an actual cost system. Under an actual
cost system, unit costs for batches of identical products may differ widely. For
example, this variation can occur because of a machine malfunction during the
production of a given batch that increases the labor and overhead charged to that
batch. Under a standard cost system, the company would not include such unusual
costs in inventory. Rather, it would charge these excess costs to variance accounts
after comparing actual costs to standard costs.

Thus, in a standard cost system, a company assumes that all units of a given
product produced during a particular time period have the same unit cost.
Logically, identical physical units produced in a given time period should be
recorded at the same cost.

Cost savings in record-keeping Although a standard cost system may seem to

require more detailed record-keeping during the accounting period than an actual
cost system, the reverse is true. For example, a system that accumulates only actual
costs shows cost flows between inventory accounts and eventually into cost of
goods sold. It records these varying amounts of actual unit costs that must be
calculated during the period. In a standard cost system, a company shows the cost
flows between inventory accounts and into cost of goods sold at consistent
standard amounts during the period. It needs no special calculations to determine
actual unit costs during the period. Instead, companies may print standard cost
sheets in advance showing standard quantities and standard unit costs for the
materials, labor, and overhead needed to produce a certain product.
Possible reductions in production costs A standard cost system may lead to cost
savings. The use of standard costs may cause employees to become more cost
conscious and to seek improved methods of completing their tasks. Only when
employees become active in reducing costs can companies really become
successful in cost control.

DISADVANTAGES OF STANDARD COST

Three of the disadvantages that result from a business using standard costs are:

 Controversial materiality limits for variances.

 Nonreporting of certain variances.
 Low morale for some workers.
Controversial materiality limits for variances Determining the materiality limits
of the variances may be controversial. The management of each business has the
responsibility for determining what constitutes a material or unusual variance.
Because materiality involves individual judgment, many problems or conflicts may
arise in setting materiality limits.
Nonreporting of certain variances Workers do not always report all exceptions
or variances. If management only investigates unusual variances, workers may not
report negative exceptions to the budget or may try to minimize these exceptions to
conceal inefficiency. Workers who succeed in hiding variances diminish the
effectiveness of budgeting.
Low morale for some workers The management by exception approach focuses
on the unusual variances. Management often focuses on unfavorable variances
while ignoring favorable variances. Workers might believe that poor performance
gets attention while good performance is ignored. As a result, the morale of these
workers may suffer.
METHODS OF COSTING AND IMPORTANT TERMS
Costs can be simply defined as the money or resources associated with a purchase /
business transaction or any other activity. Different industries adopt different
methods of ascertaining costs of their products depending on the nature of the
production and the type of output.
Cost sheet is the statement that shows various components of total cost of a
product. It indicates per unit cost in addition to total cost. Cost sheet is prepared on
the basis of historical cost and estimated cost.

IMPORTANT METHODS OF COSTING:

Unit costing:
It is also called the single output costing. It is used in costing of products that are
expressed in identical units and suitable for products that are manufactured by
continuous activity.
Example: Cement manufacturing, Dairy, Mining etc.

Job costing:
Under this method, costs are ascertained for each work order separately as each has
its own specification and scope. Tailor made products also get covered by this type
of costing.
Example: Repair of buildings, Painting etc

Contract costing:
In this method costing is done for jobs that involve heavy expenditure and stretches
over long period and across different sites. It is also called as terminal costing.
Example: Construction of roads and bridges, buildings etc

Batch costing:
Through this method the costing is done for units that are produced in batches that
are uniform in nature and design.
Example: Pharmaceuticals
Process costing:
It is used for the products which go through different processes. Like in the process
of manufacturing cloth, different processes are involved namely spinning, weaving
and finished product. Each process gives an output that is a finished product in
itself and can be sold. That is why; process costing is used to ascertain the cost of
each stage of production.

Service or operating costing:

It is the method used for the costing of operating a service such as Public Bus,
Railways, Nursing home. It is used to ascertain the cost of a particular service.

Multiple costing:
When the output comprises different assembled parts like in televisions, cars or
electronic gadgets, cost has to be ascertained for the component as well as the
finished product. Such costing may involve different / multiple methods of costing.

Product Costing:
Product costing methods are used to assign cost to a manufactured product. The
main costing methods available are process costing, job costing and direct costing.
Each of these methods apply to different production and decision environments.
The main product costing methods are:
 Job costing: This is the assignment of costs to a specific manufacturing job.
This method is used when individual products or batches of products are
unique, and especially when jobs are being billed directly to customers or
are likely to be audited by customers.
 Process costing: This is the accumulation of labor, material and overhead
costs across departments or entities, with the total production cost then being
allocated to individual units. Process costing is used when large quantities of
the same product are manufactured, usually in long production runs.
Inventory Costing:
Different inventory costing methods are best suited to different situations and
financial goals.
 First In, First Out
Under the First In, First Out (FIFO) method, the oldest costs are assigned to
inventory items sold, regardless of whether the sold items were actually
purchased at that cost. When the number of inventory items purchased at the
oldest cost is sold, the next oldest cost is assigned to sales.
 Last In, First Out
The last in, first out method (LIFO) is the exact opposite of the FIFO
method, assigning the most recent inventory costs to items sold
 Average Cost Method
The average cost method assigns inventory costs by calculating a moving
average of all inventory purchase costs.
 Specific Identification Method
The specific identification method perfectly matches inventory costs with
units sold, assigning the exact cost of each sold inventory item when the
specific item is sold.

COSTING METHODS FOR MANUFACTURING:

TRADITIONAL METHODS: PROCESS AND JOB-ORDER COSTING:

There are two conventional costing approaches used in manufacturing, namely
process and job order costing. Process costing method analyzes the net cost of a
manufacturing process. Since most manufacturing processes involve more than one
step, calculation is made for each step to arrive at a unit cost average for the entire
production system.
The second major costing method, job-order costing, involves costing based on an
individual product basis. This is useful where each unit of production is
customized or where there are very few units produced. Under this method, the
exact costs incurred in the production of a particular unit are calculated and are not
necessarily averaged with those of any other unit, since every unit may be
different.

ACTIVITY-BASED COSTING:
Activity-based costing (ABC) is a secondary / somewhat complementary method
to the two traditional costing techniques.
While traditional methods classify costs into categories like direct materials, labor
and other overheads, ABC considers all the costs associated with a single
manufacturing task, regardless of whether they fall under the headings of labor or
materials or something else.
The benefit of this method is that management can keep track of tasks that cost the
most versus which add the most value; indicating any disproportionate amount of
money being spent on low-value activities, thereby indicating the need for process
change.

Steps for Performing ABC:

1. Analyze the Activities

2. Gather all the Costs
3. Trace Costs to the Activities
4. Set up Output Measures
5. Analyze the Costs

Features of ABC:

 Indicates High Cost activities

 Helps in establishing and monitoring performance measures
 Is useful for forecasting financial baselines
 Captures the current cost of performing any activity

TYPES OF COSTING:

A. Marginal Costing:
Through this method only the variable cost is allocated i.e. direct materials,
direct expenses, direct labour and variable overheads to production. It does
not include the fixed cost of production.

B. Absorption Costing:
It is the technique to absorb the fixed and variable costs to production. In
this method, full costs i.e. fixed and variable costs are absorbed to the
production.

C. Standard Costing:
When the costs are predetermined on certain standards in a given set of
operating conditions, it is called standard costing.

D. Historical Costing:
 In this method the costs are determined in terms of actual costs and not
predetermined standard costs. Costs are determined only after it is incurred.
Almost all organizations adopt this method of costing.

TERMS ASSOCIATED WITH COSTING:

1. Fixed cost:
Fixed costs are those costs that do not vary with respect to changes in output
and would accrue even if no output was produced. E.g. Rent, interest
payments, property taxes and employee salaries. However, fixed costs are
restricted to specific time frame, since over the long run fixed costs can vary.
For example, a manufacturer may decide to expand capacity in tandem to the
increase in demand for its product, requiring a higher level of expenditure on
plant and equipment.

2. Variable Cost:
Variable cost changes proportionately to the level of output. For
manufacturers, the key variable cost is the cost of materials.

3. Total Cost:
It is defined as the sum of fixed, variable and semi variable costs.

4. Direct and Indirect cost:

Direct costs typically include the major components for manufacturing
goods and the labor directly required to produce those goods. Direct costs
are also referred to as prime costs. On the other hand, indirect costs include
plant-wide costs such as those resulting from the use of energy and fixed
capital. Indirect costs are also referred to as overhead.

5. Incremental cost:
It is mainly the extra cost associated with manufacturing one additional unit
of production. It is also referred to as differential cost.
6. Opportunity cost:
Opportunity cost is the potential profit or gain that is lost out on when an
entity opts for one alternative over another. Essentially opportunity cost is
the cost of decision making. When business entities are faced with decisions,
there may often be several alternatives to choose from. Each alternative
comes with its own set of incomes and expenses. In the bargain of choosing
one alternative over the other, the entity loses out on the profit potential of
the alternative foregone – this is the opportunity cost of choosing the
selected alternative.

Example
 ABC Inc owns a large piece of industrial land. Currently, ABC Inc. earns an
annual rent of $100,000 from leasing out this land. ABC Inc. is now
considering a proposal of building a bottling plant on this industrial land.
Once this land is used for the bottling plant, it will no longer earn the rent
that it currently receives. Thus, while doing a cost-benefit analysis of the
proposition of putting up the bottling plant, ABC Inc. must also consider the
opportunity cost of foregoing the rental from the land. Primarily this means
that the bottling plant must earn a revenue of at least $1,00,000 to recoup the
opportunity cost.

Opportunity cost is an implicit cost as it does not result in any actual cash
outflow for the entity. It is thus not accounted for nor does it reflect in any
financial statements. It, however, may find its way into management reports
that reflect the rationale for management decision making.

7. Sunk cost:
Sunk cost represents those costs that have already been incurred by the
entity and cannot be recouped. As sunk costs relate to an action that has
already taken place, they are past costs and thus their analysis has no place
in decision making. Identifying sunk costs is important because management
must distinguish between these costs and potential future costs that are to be
evaluated for decision making.
When taking any decision, sunk costs already incurred must have no bearing
on the future decision making.

Example
ABC Inc. is considering launching one of two new product lines. To gauge
the depth of their marketability, it hires a marketing firm to carry out an
extensive public survey. The cost of conducting this survey is $50,000. The
result of the survey elaborates the likely cash flows that can be generated
from sale of both the product lines. While choosing between the two product
lines, ABC Inc. must ignore the cash outflow of $50,000 being the cost of
conducting the survey. As this cost has already been incurred, it will remain
so irrespective of the product line chosen or irrespective of whether ABC
Inc. even chooses to launch any new product line at all.
Sunk costs are actual out-of-pocket expenses and are thus explicit costs.

METHODS OF PRICING ISSUE OF MATERIALS

The important methods followed in pricing of issue of materials are:-

1. Actual Cost Method
2. First-In First-Out (FIFO) Method
3. Last-In First-Out (LIFO) Method.
4. Highest-in First-Out (HIFO) Method.
5. Simple Average Cost Method.
 6. Weighted Average Cost Method.
7. Periodic Average Cost Method.
8. Standard Cost Method.
9. Replacement Cost Method.
10.Next in First Out (NIFO) Method.
11.Base Stock Method.

1. Actual Cost Method:

Where materials are purchased specially for a specific job, actual cost of materials
is charged to that job. Such materials will normally be stored separately and issued
only to that particular job.
2. First-In First-Out (FIFO) Method:
CIMA defines FIFO as “a method of pricing the issue of material using, the
purchase price of the oldest unit in the stock”. Under this method materials are
issued out of stock in the order in which they were first received into stock. It is
assumed that the first material to come into stores will be the first material to be
used.
Advantages:
 It is easy to understand and simple to price the issues.
 It is a good store keeping practice which ensures that raw material leave the
stores in a chronological order based on their age.
 It is a straight forward method which involves less clerical cost than other
methods of pricing.
 This method of inventory valuation is acceptable under standard accounting
practice.
 It is a consistent and realistic practice in valuation of inventory and finished
stock.
 The inventory is valued at the most recent market prices and it is near to the
valuation based on replacement cost.

Disadvantages:
 There is no certainty that materials which have been in stock longest will be
used, if they are mixed up with other materials purchased at a later date at
different price.
 If the price of the materials purchased fluctuates considerably, it involves
more clerical work and there is possibility of errors.
 In a situation of rising prices, production cost is understated.
 In inflationary market, there is a tendency to underprice material issues. In
deflationary market, there is a tendency to overprice such issues.
 Usually more than one price has to be adopted for a single issue of materials.
 The method makes cost comparison difficult of different jobs when they are
charged with varying prices for the same materials.

This method is more suitable where the size of the raw materials is large and bulky
and its price is high and can be easily identified in the stores separately. This
method is useful when the frequency of material receipts is less and the market
price of the material are stable and steady.

3. Last-In First-Out (LIFO) Method:

Under this method most recent purchase will be the first to be issued. The issues
are priced out at the most recent batch received and continue to be charged until a
new batch received is arrived into stock. It is a method of pricing the issue of
material using the purchase price of the latest unit in the stock.

Advantages:
 Stocks issued at more recent price represent the current market value based
on the replacement cost.
 It is simple to understand and easy to apply.
 Product cost will tend to be more realistic since material cost is charged at
more recent price.
 In times of rising prices, the pricing of issues will be at a more recent current
market price.
 It minimizes unrealized inventory gains and tends to show the conservative
profit figure by valuation of inventory at value before price rise and provides
a hedge against inflation.

Disadvantages:
 Valuation of inventory under this method is not acceptable in preparation of
financial accounts.
 It is an assumption of a cash flow pattern and is not intended to represent
the true physical flow of materials from the stores.
 More than one price may have to be adopted for an issue.
 It renders cost comparison between jobs difficult.
 It involves more clerical work and sometimes valuation may go wrong.
 In times of inflation, valuation of inventory under this method will not
represent the current market prices.

4. Highest-in First-Out (HIFO) Method:

Under this method, the materials with highest prices are issued first, irrespective of
the date upon which they were purchased. The basic assumption is that in
fluctuating and inflationary market, the cost of material are quickly absorbed into
product cost to hedge against risk of inflation. This method is used when the
material is in short supply and in execution of cost plus contracts. This method is
not popular and not acceptable under standard accounting practices.

5. Simple Average Cost Method:

Under this method all the materials received are merged into existing stock of
materials, their identity being lost. The simple average price is calculated without
any regard to the quantities involved. The simple average cost is arrived at by
adding the different prices paid during the period for the batches purchased by
dividing the number of batches. For example, three batches of materials received at
Rs. 10, Rs. 12 and Rs. 14 per unit respectively.

The simple average price is calculated as follows:

Rs. 10 + Rs. 12 + Rs. 14/3 batches = Rs. 36/3 batches = Rs 12 per unit

This method is not popular because it takes into consideration the prices of
different batches but not the quantities purchased in different batches. This method
is used when prices do not fluctuate very much and the stock values are small in
value.

6. Weighted Average Cost Method:

It is a perpetual weighted average system where the issue price is recalculated
every time after each receipt taking into consideration both the total quantities and
total cost while calculating weighted average price. For example, three batches of
material received in quantities of 1,000 units @ Rs. 15, 1,300 units @ Rs. 16 and
800 units @ Rs. 14.
The weighted average price is calculated as follows:
(1,000 units x Rs. 15) + (1,300 units x Rs. 16) + (800 units x Rs. 14)/1,000 units +
1,300 units + 800 units

= Rs. 15,000 + Rs. 20,800 + Rs. 11,200/3,100 units = Rs. 47,000/3,100 units = Rs.
15.16 per unit

This method tends to smooth out the fluctuations in price and reduces the number
of calculations to be made, as each issue is charged at the same price until a fresh
batch of material is received.
This method is easier as compared to FIFO and LIFO, as there is no necessity to
identify each batch separately. But this method increases the clerical work in
calculation of new average price every time a new batch is received. The issue
price calculated rarely represents the actual purchase price.

7. Periodic Average Cost Method:

Under this method, instead or recalculating the simple or weighted average cost
every time there is a receipt, an average for the accounting period as a whole is
computed.
The average price for all the materials issued during the period is computed as
follows:

8. Standard Cost Method:

Under this method, material issues are priced at a predetermined standard issue
price. Any variance between the actual purchase price and standard issue price is
written off to the Profit and Loss Account. Standard cost is a predetermined cost
set by the management prior to the actual material costs being known and the
standard issue price is used for all issues to production and for valuation of closing
stock.

If initially the standard price is set carefully then it reduces all the clerical work
and errors tremendously and the stock recording procedure is simplified. The
realistic production cost comparisons can be made easier by eliminating
fluctuations in cost due to material price variance. In a situation of fluctuating
prices, this method is not suitable.

9. Replacement Cost Method:

This method is also called as ‘market price method’. The replacement cost is a cost
at which material identical to that can be replaced by purchasing at the date of
pricing material issues; as distinct from the actual cost price at the date of
purchase. The replacement price is the price of replacing the material at the time of
issue of materials or on the date of valuation of closing stock.

This method is not acceptable for standard accounting practice, since it reflects a
cost which has not really been paid. If stocks are held at replacement cost, for
balance sheet purposes when they have been bought at a lower price, an element of
profit which has not yet been realized will be built into the Profit and Loss
Account.

This method is advocated by charging the market price of material to the job or
process, make it easier to determine the profitability of the job or process. This
method is suitable particularly in the inflationary tendency of market prices of
materials. Where there is no precise market for particular materials, it would be
difficult in ascertainments of replacement prices for the material issues.

10. Next in First Out (NIFO) Method:

This method is a variant of replacement cost method. Under this method the price
quoted on the latest purchase order or contract is used for all issues until a new
order is placed.

11. Base Stock Method:

Under this method, a specified quantity of material is always held in stock and is
priced at its original cost as buffer or base stock; and any issue of materials above
the base stock quantity is priced under any one of the methods discussed above.

This method indicates how prices are moving over a longer period of time. But this
method is not popular and also not accepted under standard accounting practice
since it would result in stock valuation totally unrealistic.

Product Costs
Product costs are the direct costs involved in producing a product. A manufacturer,
for example, would have product costs that include:
  Direct labor
 Raw materials
 Manufacturing supplies
 Overhead that is directly tied to the production facility such as electricity

For a retailer, the product costs would include the supplies purchased from a
supplier and any other costs involved in bringing their goods to market. In short,
any costs incurred in the process of acquiring or manufacturing a product are
considered product costs.

Product costs are often treated as inventory and are referred to as inventoriable

costs because these costs are used to value the inventory. When products are sold,
the product costs become part of costs of goods sold as shown in the income
statement. 

Period Costs
Period costs are all costs not included in product costs. Period costs are not directly
tied to the production process. Overhead or sales, general, and
administrative (SG&A) costs are considered period costs. SG&A includes costs
of the corporate office, selling, marketing, and the overall administration of
company business.

Period costs are not assigned to one particular product or the cost of inventory like
product costs. Therefore, period costs are listed as an expense in the accounting
period in which they occurred.

Other examples of period costs include marketing expenses, rent (not directly tied
to a production facility), office depreciation, and indirect labor. Also, interest
expense on a company's debt would be classified as a period cost.

What is Overhead? Classification of Overhead

The overhead costs are incurred not for any particular job, work-order, process or
unit but for the business as a whole and include all costs other than direct material
costs, direct wages and direct expenses.
Overhead costs are also denoted by ‘supplementary costs’ ‘non-productive costs’,
‘indirect costs’, ‘on cost’, ‘burden’ etc. Of all the terms, ‘overhead’ is the most
common and the Institute of Cost and Management Accountants, London, does not
recommend the use of the terms ‘on cost’ and ‘burden’.
Overhead expenses, unlike chargeable expenses, are indirect expenses which
cannot be identified with particular products, job, processes or work orders and
hence cannot be allocated. These costs do not relate to any one specific cost
centre.
However, for proper cost ascertainment, accounting as well as control of overhead
costs is essential.
Classification means determination of categories, classes or groups in which
overhead costs may be subdivided. CIMA has defined classification as “the
arrangement of items in logical groups having regard to their nature (subjective
classification) or the purpose to be fulfilled (objective classification)”.
The overheads can be classified under the following heads:-

1. Element 
2. Behaviour
3. Function
4. Control
5. Nature
6. Selling and Distribution
7. Office
8. Production.

Element wise classification of overheads includes:-

1. Indirect Materials
2. Indirect Labour
3. Indirect Expenses.

Behaviour wise classification of overheads includes:-

1. Fixed Overheads
2. Variable Overheads
3. Semi-Variable or Semi-Fixed Overheads
4. Step Overheads.

Function wise classification of overheads includes:-

1. Factory Overheads
2. Administration Overheads
3. Selling Overheads
4. Distribution Overheads
5. Manufacturing Overheads
6. Research and Development Overheads.

Control wise classification of overheads includes:-

1. Controllable Overheads
2. Uncontrollable Overheads.

1. Function-Wise Classification:
It refers to the classification of overhead costs with reference to the various major
activity divisions of a concern.
The main groups of overhead on the basis of functions are:
(a) Factory Overhead;
(b) Office and Administration Overhead;
(c) Selling Overhead; and
(d) Distribution Overhead.
(a) Factory Overhead:
Factory overhead refers to all expenses other than direct material costs, direct
wages and direct expenses incurred in a factory in connection with manufacturing
operations.
Examples of factory overhead are – Rent of factory building, municipal taxes and
insurance of factory building, depreciation of factory building, depreciation and
insurance of factory plant and machinery, repairs and maintenance of factory
buildings and machinery, salary of factory manager and other factory staff, factory
power and lighting, cost of small tools, consumable stores, lubricating oil, cotton
waste, salary of store-keeper, expenses of store-keeping, fuel, gas, water, drawing
office salaries, factory stationery, cost of idle time, overtime wages (if not treated
as direct cost), telephone charges of factory, cost of training of new workers,
labour welfare expenses etc.
(b) Administration Overhead:
Administration overhead refers to all expenses relating to the direction, control and
administration (not connected directly with production, sales or distribution) of an
undertaking.
Examples of administration overhead are – General management salaries, salaries
of general office staff, office rent, depreciation of office building, rates and
insurance of office building, office lighting and air-conditioning, depreciation of
office furniture and office machinery, repairs and maintenance of office building,
office furniture and office machinery, audit fees, legal charges, office stationery,
telephone charges of office, bank charges, directors’ fees, counting office salaries
etc.
(c) Selling Overhead:
Selling overhead refers to all costs of seeking to create and stimulate demand or of
securing orders.
Examples of selling overhead are – Sales office expenses, advertisement, salary of
sales manager, salaries of other selling staff, commission on sales, travelling
expenses, expenses of travelling agents, cost of price lists, catalogues and samples,
bad debts, rent of show-room, depreciation of showroom, rates and insurance of
show-room, lighting and cleaning of show-room, expenses of branch
establishments, expenses of sales and publicity department, cost of training to
salesmen, postal expenses relating to sales, legal expenses for recovery of bad
debts, cost of entertainment of customers, market research expenses, cost of
preparation of tenders etc.
(d) Distribution Overhead:
Distribution overhead refers to all expenses incurred from the time the product is
finished in the factory till its delivery to ultimate customers or consumers.
Examples of distribution overhead are – Rent of warehouse, depreciation of
warehouse, insurance, rates and lighting of warehouse, depreciation, running and
maintenance of delivery vans, salary of van men, carriage on sales, packing
materials and packing charges, cost of after-sales service, salary of warehouse-
keeper, and the like.

What is Overhead Under Absorption and Over Absorption?

When a company uses standard costing, it derives a standard amount of
overhead cost that should be incurred in an accounting period, and applies it to
cost objects (usually produced goods). If the actual amount of overhead turns
out to be different from the standard amount of overhead, then the overhead is
said to be either under absorbed or over absorbed. If overhead is under
absorbed, this means that more actual overhead costs were incurred than
expected, with the difference being charged to expense as incurred. This
usually means that the recognition of expense is accelerated into the current
period, so that the amount of profit recognized declines.  

If overhead is over absorbed, this means that fewer actual overhead costs were
incurred than expected, so that more cost is applied to cost objects than were
actually incurred. This means that the recognition of expense is reduced in the
current period, which increases profits. For example, if the overhead rate is
predetermined to be $20 per direct labor hour consumed, but the actual amount
should have been $18 per hour, then the $2 difference is considered to be over
absorbed overhead.

Reasons/causes for Overhead Under Absorption and Over Absorption

There can be several reasons for overhead under absorption or over absorption,
including:

 The amount of overhead incurred is not the same as the amount expected.
 The basis upon which overhead is applied is in an amount different than
expected. For example, if there is $100,000 of standard overhead to be
applied and 2,000 hours of direct labor expected to be incurred in the
period, then the overhead application rate is set at $50 per hour.
However, if the number of hours actually incurred is only 1,900 hours,
then the $5,000 of overhead associated with the missing 100 hours will
not be applied.
 There may be seasonal differences in the amount of overhead actually
incurred or in the basis of application, versus a standard rate that is based
on a longer-term average.
 The basis of allocation may be incorrect, perhaps due to a data entry or
calculation error.

What Is Cost-Volume-Profit (CVP) Analysis?

Cost-volume-profit (CVP) analysis is a method of cost accounting that looks at
the impact that varying levels of costs and volume have on operating profit.
The cost-volume-profit analysis, also commonly known as break-even analysis,
looks to determine the break-even point for different sales volumes and cost
structures, which can be useful for managers making short-term economic
decisions. CVP analysis makes several assumptions, including that the sales
price, fixed and variable cost per unit are constant. Running this analysis involves
using several equations for price, cost and other variables, then plotting them out
on an economic graph.

The CVP formula can be used to calculate the sales volume needed to cover costs
and break even. The break-even point is the number of units that need to be sold,
or the amount of sales revenue that has to be generated, in order to cover the costs
required to make the product.

CVP analysis also manages product contribution margin. Contribution margin is

the difference between total sales and total variable costs. For a business to be
profitable, the contribution margin must exceed total fixed costs. The contribution
margin may also be calculated per unit. The unit contribution margin is simply the
remainder after the unit variable cost is subtracted from the unit sales price. The
contribution margin ratio is determined by dividing the contribution margin by
total sales.

The contribution margin is used in the determination of the break-even point of

sales. By dividing the total fixed costs by the contribution margin ratio, the break-
even point of sales in terms of total dollars may be calculated. For example, a
company with $100,000 of fixed costs and a contribution margin of 40% must earn
revenue of $250,000 to break even.

Profit may be added to the fixed costs to perform CVP analysis on a desired
outcome. For example, if the previous company desired an accounting profit of
$50,000, the total sales revenue is found by dividing $150,000 (the sum of fixed
costs and desired profit) by the contribution margin of 40%. This example yields a
required sales revenue of $375,000.

CVP analysis is only reliable if costs are fixed within a specified production level.
All units produced are assumed to be sold, and all fixed costs must be stable in a
CVP analysis. Another assumption is all changes in expenses occur because of
changes in activity level. Semi-variable expenses must be split between expense
classifications using the high-low method, scatter plot or statistical regression.
FINANCIAL ACCOUNTING
Financial accounting refers to collecting, summarizing and presentation of the
financial information resulting from business transactions. It reports the operating
profit and the value of the business to the stakeholders. In other words, financial
accounting is used for reporting financial transactions to the stakeholders in a
format that is acceptable and adaptable by all businesses.

Accounting Concepts
Accounting Concepts that form the basis of financial accounting are:

 Accrual concept
Financial accounting can be done on an accrual basis or cash basis. Accrual basis is
highly accepted. An organization may also use a combination of both. Cash basis
of accounting requires transactions to be recorded only when the transaction results
in a flow of cash.  However, under accrual basis, a transaction is recorded when the
transaction occurs and revenue is recognized. Once an organization selects the
method, cash or accrual, it should consistently use the same.

 Economic entity concept

This concept assumes that the owners are separate from the business and there are
no personal transactions recorded in business.

 Going concern concept

Under this concept, it is assumed that the organization will remain in business for a
long time and hence the revenue can be deferred to a different period.  

 Matching concept
This concept stresses that the expenses relating to a particular income must be
recorded in the same period. This ensures that a transaction is fully accounted for.

 Materiality Concept
Reporting of all material transactions should be the aim of reporting. Material
transactions are those transactions if omitted can alter an investors analysis of the
business.
  Conservatism
A revenue must be recorded only when it is reasonably certain that it will be
realized in the near future.   The heart of financial accounting is the Double entry
system of bookkeeping. Double entry system refers to recording two aspects of the
same transaction. The recording of the aspects will be as per the Golden Rules for
Accounting.

COST ACCOUNTING
Cost Accounting is a method of accounting wherein all the costs involved in
performing any process, project or product are noted and analyzed. Such analysis
helps the management in taking strategic decisions. Cost accounting uses various
techniques to make an organization cost effective.
MANAGEMENT ACCOUNTING
Management accounting, or managerial accounting, is, by definition, the process of
identifying, analysing, recording, and presenting financial information that can be
used internally by managers for planning, decision-making, and operational
control.
Management Accounting Concepts
The main concepts of management accounting are related to estimating and
tracking costs. In tune with this, management accounting concepts include cost
analysis, cost behaviour, and cost variances.
For a manufacturing business, the applications of these concepts include dealing
with the costs of acquiring raw materials, developing new products, and recruiting
new workers, for example.
For a service business, the application of costs may include technical support and
customer service training.
Cost-benefit analysis
Cost-benefit analysis (CBA), also known as benefit-cost analysis, is a systematic
approach to estimating the benefits or advantages of implementing a business
project or taking a course of action and comparing them with the costs involved.
It is a tool that helps business managers choose the best option from a set of
alternatives in terms of benefits in labour, time, and cost savings. 
The CBA is a procedure for ascertaining whether benefits outweigh costs or vice
versa, and allows managers to determine whether an investment or another
decision is justified.
In using CBA, monetary values are assigned to assumed costs of a project and
benefits from it. The time taken for the benefits to repay the costs is also
calculated.
How is cost accounting different from financial accounting?
 In traditional accounting, the profit and loss is derived by deducting
expenses from income whereas in cost accounting the motive is to be
cost effective by reducing costs of process, production or project.
 Financial accounting views an organization in entirety whereas cost
accounting segregates the organization into various processes, projects
or production units.  
 Financial accounting is used to present the position of the organization
to its stakeholders whereas cost accounting is used for internal review
of costs.
 Financial accounting is uniform across various businesses, however,
cost accounting methods vary based on the type of business.
COMPARISON OF MANAGEMENT ACCOUNTING WITH FINANCIAL
ACCOUNTING AND COST ACCOUNTING
We have already seen that financial accounting differs from management
accounting mainly in the fact that while it is aimed at external stakeholders of a
business, such as creditors and investors, management accounting is meant for
internal use by business managers.
While financial accounting provides information for decisions such as how to
allocate funds and human resources among companies, management accounting
provides data for decisions about how to allocate resources within a company.
There are other differences, too, as follows.

 While financial accounting is legally mandatory for companies, they

may or may not go in for managerial accounting, depending on their
requirements.
 Financial accounting follows the Generally Accepted Accounting
Principles (GAAP) or other norms standardised in the country where the
business is operating, whereas management accounting does not follow
any set rules but are specific to the company and its strategies.
 Financial accounting is “historical,” as it processes information from
past events; management accounting, however, is futuristic, as it
interprets data to predict future business situations.
 Because financial accounting is historical and draws data from events
that have already occurred, there is more objectivity in it than there is in
management accounting, which involves prediction and is forward-
looking, and can, therefore, be subjective.
  Management accounting tends to be confidential and restricted to
internal circulation, whereas financial accounting serves external
stakeholders.
 Management accounting is a more complex exercise than financial
accounting as managers require more specific information than external
stakeholders.
 Management accounting reports are prepared more frequently—
monthly, weekly, or even daily—than financial accounting reports
(which are issued quarterly or annually), so that they convey information
in real time.
 
How does management accounting differ from cost accounting, the third
major type of accounting?
Cost accounting determines the costs of specific activities within a production
process.
Management accounting includes this element of cost accounting and uses it in
decision-making and strategy planning. Therefore, cost accounting can be said to
be a part of management accounting with a much smaller scope.
INCENTIVE WAGE PLAN?

An incentive wage plan offers an increased level of compensation when

employee performance exceeds a threshold level. These plans are intended to
incentivize employees to become more efficient and effective in completing
their designated tasks. A plan could involve either an increase in output or a
reduction in expenses. These plans can be quite effective for improving
company performance, but only if incentives are set at a level that employees
consider to be achievable. The best incentive wage plans are designed to
benefit both the employer and the employee in equal measure.