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Introduction to cost accounting

Management accounting is concerned with the collection of data, its analysis and processing into
information, and the interpretation and communication of that information so as to assist
management with planning, decision making and control.

Cost accounting is a part of management accounting. Cost accounting is a management information

system which analyses past, present and future data to provide the basis for managerial action. In
particular, cost accounting involves the establishment of budgets, standard costs and actual costs of
operations, processes, activities or products; and the analysis of variances and profitability.

Management accounting Financial accounting

Information mainly Internal users: e.g. managers External users: e.g. shareholders,
produced for creditors, bankers, government
Purpose of To aid planning, controlling and To record financial performance and
information decision making financial position
Legal requirement None Limited companies must produce
financial accounts
Formats No strict rules; management decide Should following GAAP; format and
on the information they require and content of financial accounts
the most useful way of presenting it intending to give a true and fair view
Nature of information Financial and non-financial Mostly financial
Time period Historical and forward looking Mainly historical
Frequency Reports are prepared more Reports are prepared less frequently,
frequently, e.g. monthly, weekly or e.g. yearly, half-yearly
daily
Useful management information should be relevant, reliable, complete and accurate for its
purpose. It should be communicated timely to the appropriate manager and should not be excessive.
The cost of obtaining the information should not exceed the benefits deriving from it (i.e. cost
effective after performing a cost-benefit analysis).

Cost classification
Cost is a resource sacrificed or forgone to achieve a specific objective. It is usually measured as the
monetary amount that must be paid to acquire goods and services.
A cost object is anything for which a separate measurement of costs is desired.
Example: For a car manufacturer, the cost object can be:
a product: a particular model of the car
a service: 24-hour telephone hotline
a process: research and development on enhancing the Hi-fi system in the car
a department: marketing department.
A cost unit is 'a unit of product or service in relation to which costs are ascertained'.
Examples: For a car manufacturer, the cost unit can be a car (used for calculating production cost) or
canteen meals (used for calculating catering cost for staff).
A cost centre is 'a production or service location, function, activity or item of equipment for which
costs are accumulated' (e.g. production department, canteen, packing machine, etc.). To record actual
costs, costs are allocated to cost centers. Once traced to cost centers, costs can be further analysed
into cost units.
N. B. In general, for cost accounting purposes, departments are termed cost centres and the product
produced by an organization is termed the cost unit.

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Cost Classification for Inventory Valuation and Profit Measurement (financial accounting)
Direct costs and indirect costs
A direct cost is a cost that can be traced in full to the cost object. It is an ‘expenditure which can be
economically identified with and specifically measured in respect to a relevant cost object’. (e.g. cost
of steel and labour cost in spending work on each car for a car manufacturer; cost of wood for a
furniture manufacturer; cost of plastic for a toy maker)
Direct cost = Direct materials + Direct labour (Direct wages) + Direct expenses
N.B. The total of all direct manufacturing costs is known as prime cost.
Direct materials
Direct materials consist of all those materials that can be identified with a specific product. They are the costs
of materials that have been used in making and selling a product (or providing a service).
Direct labour (Direct wages)
Direct labour consists of those labour costs that can be specifically traced to or identified with a particular
product (or a service).
Examples:
 Employees engaged in actually producing the good or providing the service
 Inspectors, analysts and testers specifically required for such production
 Foremen whose wages are specifically identified with a production of a product
Direct expenses
Any expenses which are incurred on a specific product or service other than direct material cost and direct
wages are direct expenses.
Examples:
 Depreciation / Cost of non-current assets acquired specifically for the production of a product
 Hire of tools or equipment specifically for the production of a product
 Cost of any royalties / special design of a particular product
 Patent / Copyright of a logo

An indirect cost or overhead is a cost that cannot be traced directly and in full to the cost object. It is an
'expenditure on labour, materials or services which cannot be economically identified with a specific
saleable cost unit'. (e.g. supervisor's wages, depreciation of machines, cleaning materials, building
insurance)
N.B. Conversion cost is the cost of converting material into finished products, i.e.
Conversion cost = Direct labour + Direct expenses + Production overhead.
Product costs and period costs
Product costs are costs identified with goods produced or purchased for resale. They are 'the costs of a
finished product built up from its cost elements'. Such costs are initially identified as part of the value
of inventory. They become expenses (in the form of cost of goods sold) only when the inventory is sold.
(e.g. prime cost, conversion cost)
Period costs are costs that are deducted as expenses during the current period without ever being included
in the value of inventory held. They are 'costs which relates to a time period rather than to the output of
products or services' (matching). (e.g. administrative expenses, selling and distribution expenses)
Functional costs (Classification by function)
Costs are classified as follows:
 Production/Manufacturing costs
 Non-production/Non-manufacturing costs
e.g. Administration costs, Selling and distribution costs, Finance costs
N.B. Direct costs are production costs. Indirect costs can be either production or non-production costs.

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Cost Classification for Decision Making

A knowledge of how cost and revenues will vary with different levels of activity is essential for decision
making.
Cost behaviour is 'the variability of input costs with activity undertaken. A number of cost
behaviour patterns are possible, ranging from variable costs whose cost level varies directly with the
level of activity, to fixed costs, where changes in output have no effect upon the cost level'. The level
of activity may refer to volume of production in a period, the number of items sold, the value of items
sold, the number of invoices issued and so on.

Cost behaviour patterns

A fixed cost is a cost which tends to be unaffected by changes in the levels of activity (output or
turnover).
Examples:
 Salaries of the managing director per month
 Rent of a factory building per month
 Straight line depreciation of a machine per annum
A variable cost is a cost which tends to vary directly with the levels of activity.
Examples:
 Cost of raw materials (Assume no discount for bulk purchases)
 Sales commission (Variable in relation to the volume or value of sales)
N.B. Fixed costs are only constant at all levels of activity within the relevant range of activity.
Variable cost may not change proportionately with changes in levels of activity outside the relevant
range. The relevant range is the range of activity within which the cost behavior assumptions remain
valid. It is the normal range of production or sales that can be expected for a particular product or
company.
Summary of fixed and variable cost behaviour
Cost In Total Per Unit
Fixed Total fixed cost remains the same even Fixed cost per unit goes down as activity
when the activity level changes within the level goes up
relevant range
Variable Total variable cost is proportional to the Variable cost per unit remains the same
activity level within the relevant range over wide ranges of activity

Step costs
A step cost is 'a cost which is fixed in nature but only within certain levels of activity'.
N.B. Fixed cost will increase in a stepwise manner after the level of activity exceeds the relevant
range.
Examples:
 Depreciation of machines (When production increases, a second machine is required)
 Rent (Accommodation requirements increase as output level gets higher)
 Wages (As output rises, more employees are required)

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Semi-variable costs (Mixed costs)

A semi-variable/mixed cost is 'a cost containing both fixed and variable components and which is thus
partly affected by a change in the level of activity'. (Total cost = Fixed cost + Total variable cost)
Examples:
 Electricity and gas bill (Basic charge plus a charge per unit of consumption)
 Salesman's salary (Basic amount plus percentage commission of value of sales made)
 Cost of running a car (Fixed costs such as insurance, licence fees plus variable costs such as petrol)

N.B. Costs are assumed to rise in a linear fashion as the volume of activity increases. The assumption of
linear costs is justified because it is only used in practice within normal ranges of output, i.e. within
a relevant range of activity.

Determining the fixed and variable elements of semi-variable costs

High-low method: a method used to estimate a cost function that includes using only the highest and
lowest observed values of the cost driver (or output) within the relevant range and their respective
costs.

Step 1: select the highest and lowest activity levels, and their associated costs

Step 2: find the variable cost per unit =

Step 3: find the fixed cost by substitution, using either the high or low activity level
Fixed cost = Total cost at high or low activity level – Total variable cost
Example:
Output (units) Total cost ($)
Lowest activity level 100 6 000
200 7 000
300 8 000
Highest activity level 400 9 000

Variable cost per unit $10 per unit

Fixed cost = $6000 - $10 x 100 = $5000 (using lowest activity level)
= $9000 - $10 x 400 = $5000 (using highest activity level)

To find the cost of 220 units of output:

Total cost = Fixed cost + Variable cost

= $5000 + $220 x $10
= $5000 + $2200
= $7200

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Appendix:

To find production cost of finished goods:

$ $
Direct Materials
Opening Inventory of direct materials X
Add: Purchases of direct materials X
Less: Returns outwards X X
Carriage inwards X
X
Less: Closing Inventory of direct materials X
Cost of direct materials consumed X
Direct Labour(direct/manufacturing/factory wages) X Direct costs
Direct Expenses X
PRIME COST A
Add: Factory overheads:
Conversion Indirect labour X
costs Factory rent X
: : Indirect costs
: :
Depreciation of machinery / Loss on sale of machinery X
Gain on sale of machinery (X) B
PRODUCTION COST of finished goods (before WIP adjustment) Y = (A+B)
Add: Opening Work in Progress X
X WIP
adjustment
Less: Closing Work in Progress X
PRODUCTION COST* of Finished Goods (after WIP adjustment) X

*=Cost of Goods Manufactured/Factory Cost of Finished Goods Produced

Income statement of a manufacturing company:

$ $
Sales X
Less: Returns inwards X
Net Sales X
Less: Cost of Goods Sold
Opening Inventory of finished goods X
Add: Production cost of finished goods Y
X
Less: Closing Inventory of finished goods X X
Gross Profit X
Less: Expenses
Administrative expenses X
Non-production Selling and distribution expenses X
costs Finance expenses X X
Net profit X