AF 211: TOPIC ONE:

INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING

Learning Objectives
1. Nature and objectives of cost and Management accounting
2. Objectives of cost accounting
3. Benefits of cost accounting
4. Differences between cost, management and financial accounting
5. Cost classifications
6. Cost Behaviors
7. Limitations of cost accounting.

INTRODUCTION
 Cost is defined as “the amount of expenditure incurred on or attributable
to specified thing or activity”.
 It is measurement in monetary terms, of the amount of resources used
for the purpose of production of goods or rendering services.
 Is the price attached to an object.
 Is the resources consumed/ sacrificed to obtain something (product,
service)

Cost Accounting
 Cost accounting is the application of accounting and costing principles,
methods and techniques in the ascertainment of costs.
 Cost accounting is the process of tracking, recording and analyzing
costs associated with the products or activities of an organization.

A Cost Accounting System

 Is concerned with the provision of information that is required to relate
costs incurred to products, operations and services.

OBJECTIVES OF INTRODUCING COST ACCOUNTING SYSTEM

 Ascertainment/allocation of cost in the organisation
 Determination of selling price
 Cost Control and Cost reduction
 Ascertainment of profit of each activity
 Assisting in managerial decision-making

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ESSENTIAL FACTORS FOR DESIGNING A COST ACCOUNTING SYSTEM
a) A rough understanding of–Organizational structure; manufacturing
procedure.
b) Selection of a suitable costing technique (Standard or actual, marginal or
absorption etc.)
c) Pricing method suitable, for the material, to be issued to production.
(FIFO, LIFO & Avg Methods)
d) Method suitable for booking labor cost on jobs. (Efficiency plan, Halsey &
Rowan etc.)
e) A sound plan should be devised for the collection, allocation,
apportionment and absorption of overheads.
f) Deciding on ways of treating waste, scrap and idle time.
g) Designing of suitable forms to be used for collecting and dissemination of
cost data/information.

ESSENTIALS OF A GOOD COST ACCOUNTING SYSTEM

a) The Cost Accounting System should be tailor made, practical, simple and
capable of meeting the requirements of a business concern.
b) The method of costing should be suitable to the industry and serve its
objectives.
c) The Costing System should receive co-operation and participation of
executives from various departments.
d) The cost of installing and operating the system should justify the results.
e) The system of costing should not sacrifice the utility by introducing
meticulous and unnecessary details.
f) The system should consider the organizational structure of the business
and it should be designed as a sub-system of the overall organization.
g) There should be a harmonious relationship between costing system and
financial accounts. Unnecessary duplication should be avoided. A
single integrated accounting system would be ideal.

NATURE OF COST ACCOUNTING

i. The cost accounting system of any organization is foundation of the
internal financial information system.
ii. Information regarding the financial aspect of performance is provided by
costing system.
iii. Management needs variety of information to plan, to control and to
make decisions.

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  In the planning phase-cost accounting deals with the future. It helps
management to budget the future out of predetermined material cost,
wages and salaries and the other cost of manufacturing and marketing a
product. These costs might be used to assist in setting price and
disclosing the profit.
 In the control phase-cost accounting deals with the present accounting.
Current results with the predetermined standards and budget cost control
to be effective depends upon proper cost planning for each activity
function and condition.

COST AND COST ACCOUNTING

 Costing means ascertainment of costs. All aspects relating to the
ascertainment of cost are the subject matter of costing.
 However, cost accounting has wider scope than costing because its
main objective is to establish budget and standard cost and to analyze
the variances between actual and budgeted results.
 Therefore costing is part of cost accounting, which is the wider
subject that covers cost methods and costing techniques in additional to
ascertainment of costs.

COST AND MANAGEMENT ACCOUNTING COMPARED

 Management accounting is the application of the principles of accounting
and financial management, to protect, preserve and increase value so as
to deliver that value to stakeholders of both profit and not-for profit
enterprise, both private and public,
 Management accounting is thus the provision of information required by
management for purposes such as:
 Formulation of policies
 Planning and controlling the activities of the enterprise
 Decision-making
 Safeguarding assets
 Performance improvement and value enhancement
 Efficient resources usage
 Corporate governance and internal control

 Both management and cost accounting are mainly concerned with the
provision of information for internal planning, control, and decision-making

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 purposes with considerable emphasis on the costs of functions, activities,
processes and products.
 However, management accounting is wider in scope and uses more advanced
techniques.
 Cost accounting is just a part of management accounting.

FINANCIAL ACCOUNTING V/S COST ACCOUNTING

 Purpose
 The main purpose of financial accounting is the preparation of
financial reports (profit and loss account and balance sheet) at the end
of the accounting period for reporting various interested parties,
whereas,
 The cost accounting provides information to the management for proper
planning, operation, control and decision-making

 Forms of accounts
 These accounts are kept in such a way as to meet the requirements of
companies act and income tax act.
 But the maintenance of cost account is voluntary account in certain
industries where the company’s act has made it obligatory to keep cost
accounts.

 Recording transaction
 In financial accounting the transactions are recorded, classified and
analyzed on a subjective manner i.e. according to the nature of
accounts.
 In cost accounting the transactions are recorded and classified in
objectives manner-according to the purpose for which the cost is
incurred.

 Control
 Financial accounting lays emphasis on recording aspect (Double Entry)
without attaching any importance to control.
 Cost accounting provides a detailed system of control for material, labour
and overhead costs with the help of standard accounting and budgeting
control.

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 Analysis of profit
 Financial accounts are the accounts of the whole business. They are
independent in nature and disclose the net profit or loss of the business
as whole
 Cost accounting is a part of financial accounting and reveals the profit or
loss of each product, departments, process jobs and services.

PURPOSES OF COST ACCOUNTING (WHY COST ACCOUNTING)

a) Disclosing profitable and unprofitable activities. The cost accounting
system provides data about profitable and unprofitable products and
activities.
b) Establishing budgets and standards costs to enhance planning and
control. All items of costs can be analyzed to minimize the losses and
wastage emerging from the manufacturing process and reduce the costs
associated with the different activities.
c) Identify waste and efficiency. Production methods can be improved or
changed so that costs can be controlled and profit increased.
d) Estimating selling prices. Provides cost data and information that can
be used to determine prices.
e) Valuation of stock for balance sheet purposes and control of working
capital.
f) Evaluating the cost affects of police decisions - e.g. lab our intensive
or capital intensive methods.
g) Cost data can be obtained and compared with industry standards.
h) Negotiations with government and labor unions can easily be made
with the information provided by the cost accounting system.
i) Helps management in knowing the costs of different alternatives and
selecting the most advantageous course of action.
j) More accurate and reliable financial accounts can be prepared promptly
for use of management.
k) An adequate cost accounting system ensures maximum utilization of
physical and human resources, checks fraud and manipulations, and
helps employees as well as the employer in their basic goal of getting
higher earnings and maximizing the profit of the organization.

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ADVANTAGES OF COST ACCOUNTING
A good costing system serves the needs of a large section of people. The
advantages of cost accounting are discussed below:
Advantages of Cost Accounting to Management
1. Fixation of Responsibility: Whenever a cost centre is established, it implies
establishing a kind of relationship between superior and subordinates.
Thus, responsibilities are fixed on every individual who is concerned with
incurrence of cost.

2. Measures Economic Performance: By applying cost control techniques

such as budgetary control and standard costing it helps in knowing the
performance of business.

3. Fixation of Price: By providing cost data it helps management to fix the

selling price in advance. Hence, quotations can be supplied to prospective
customers to secure orders.

4. Aids in decision-making: It helps management in making suitable

decisions such as make or buy, replace manual labor by machines, shut down
or continue operations based on cost reports.

5. Helps in the preparation of interim/temporary final accounts: By the

process of continuous stock taking it enables to know the value of closing stock
of materials at any time. This facilitates preparation of final accounts wherever
desired.

6. Helps in minimizing wastages and losses: Cost accounting system enables

to locate the losses relating to materials, idle time and underutilization of plant
and machinery.

7. Facilitates comparison: It facilitates cost comparison in respect of jobs,

process, and departments and also between two periods. This reveals the
efficiency or otherwise of each job, process or department.

8. Assists in increasing profitability: Costing reports provide information

about profitable or unprofitable areas of operation. The management can
discontinue that product line or those departments which are responsible for
incurring losses and only profitable line of activities alone are retained.

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9. Reconciliation with financial accounts: A well maintained cost accounting
system facilitates reconciliation with financial accounts to check the
arithmetical accuracy of both the systems.

10. It guides future production policy: Cost data help management in

determining future production policy. Any expansion or contraction of
production for the future is based on past cost data.

Advantages to Employees
 Cost accounting system enables employees to earn better wages through
overtime wages and incentive systems of wage payment.
 By providing better facilities it ensures job security to employees.
 Employees benefit by merit rating techniques which is conducted by
scientific process.

Advantages to Creditors
 It increases the confidence of creditors in the capital employed in the
business.
 The frequent preparation of reports and statements help in knowing
solvency position of the business.

Advantages to Government
 It helps government in formulating policies regarding export, import,
taxation, price control measures, wage fixation, etc.
 It helps in assessing excise duty, sales tax and income tax of the
business.
 Costing information helps in preparing national plans.

Advantages to Society
 Cost reduction and cost control programmes go to minimize cost of
production of goods and services. A portion of the reduced cost of
production is shared by customers by paying fewer prices for goods and
services.
 It offers employment opportunities in the cost accounting department in
the capacity of cost accountants and cost clerks.

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 OTHER BASIC COST CONCEPTS
a) Cost unit / object
 This is any activity, product or service for which a separate measurement
of cost is desired.
 In other words, a cost object is a unit of product or service in relation to
which costs are ascertained or expressed.
 It is a unit of a product or service to which costs are ascertained by
means of allocation, apportionment and absorption.
 To guide decisions, managers need the cost of something. This
something can be referred to as the cost object.
 Examples of cost objects include: a product, service, a project, a
customer, a brand category, an activity, a department, and a program.
Cost objects are chosen to guide in decision making.
The establishment of the cost per object is useful for:
(a) Making decisions about pricing, acceptance of orders.
(b) Measuring changes in costs and relative levels of efficiency.
(c) Inventory valuation for financial reporting.
(d) Budgeting and standard costs.

Examples of Cost Objects

Business Cost Object

Brewing Barrel/bottle/carton
Coal mining Tonne
Petroleum Barrel
Electricity KWH
Paper Ream
Transport Tonnage per km, passenger
mile
Hotel & Catering Room/cover
Health care (hospitals) Bed occupied

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 Education Full Time and Part time
Students
Entertainment (Theatres) Seat

b) Responsibility Centre
It is defined as an activity centre of a business organization entrusted with
special task. Responsibility centers can broadly be classified into 2 categories:
Cost Centers and Profit centers

(i) Cost Centre / Pool

 This is a production or service location, function, activity or item of
equipment for which costs are allocated or accumulated.
 This may range from an entire factory to a single machine.
 In addition to ascertaining unit costs, cost pool costs are important in as
much as control is concerned.
 In other words it can be refers to a production or service department in
an organization where costs are incurred for the production of goods or
the provision of services.
 Cost centers accumulate the cost directly incurred and the costs
apportioned.
 Cost centers enable the ascertainment of total cost accumulated by a
department for a particular period of time.

Types of cost centers

 Cost centers may be divided into broad types i.e. Production Cost Centre
and service Cost Centre.
 Production Cost Centres are those which are engaged in production like
Machine shop, Welding shop, assembling shop etc.
 Service Cost Centres are for rendering service to production cost centre
like Power house, Maintenance, Stores Purchase office etc.

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(ii) Profit centre
 This refers to a production or service department where costs as well as
revenues are accumulated.
 Profit centres measure the revenue and the cost accumulated over a period
of time, thus giving the profit earned by the centre for the period.
 A profit centre is any sub-unit of an organization to which both revenues
and costs are assigned, so that the responsibility of sub-unit may be
measured.

c) Cost Driver
This is any factor that affects costs. That is a change in the cost driver will
cause a change in the total cost of a related cost object.

Business function Examples of cost drivers

Research and Development No. of projects
Personnel hours on a project
Technical complexity of a project
Design of products, services and processes No. of products
No. of parts per product
No. of engineering hours
Production No. of units produced
No. of set-ups
No. of engineering change orders
Direct manufacturing labour cost
Marketing No. of advertisements run
No. of sales personnel.
Distribution No. of items distributed
No. of customers

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CLASSIFICATION OF COSTS
 This process refers to grouping of costs according to established criteria.

There are three broad classifications of costs:

1. Behavioral classification
2. Natural classification
3. Functional classification

1. Behavioral Classification
This grouping is done in accordance with how costs react/behave to certain
conditions. This classification is further subdivided into 3 categories.
(a) According to variability
(b) According to normality
(c) According to traceability
(d) According to controllability

(a) Classification of costs according to variability

This grouping of costs is done according to how costs change/respond
with changes in the activity levels in the short run. There are three ways
in which costs can respond to changes in activity levels:

(i) Fixed Costs

These costs remain constant in the short run irrespective of
change in the Activity levels

Fixed
Costs

0 Activity Level

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 Examples of Fixed Costs: salaries of management & production staff, rent,
insurance

(ii) Variable Costs

These are costs that change with activity levels, e.g. materials, production and

Variable Costs x
y z

labour, etc.
Activity Levels
Curve x = costs changing faster that activity
Curve y = costs changing proportionately with activity
Curve z = costs changing slower than activity

(iii) Semi-variable Costs/Semi-fixed Costs

These are costs that contain both variable and fixed elements.
They change with activity at one point and remain constant at other points,
e.g. production overheads like factory power, fuel, and water and electricity
bills.

(b) Classification of costs according to normality

(i) Normal costs - these are costs that are incurred in the usual conditions in
which normal production is attained. These costs are vital for routine
decision making, e.g. hydroelectric power would be a normal cost if this is
the power usually used for production.

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(ii) Abnormal costs - these are costs that are incurred in unusual conditions
from those that normal production is attained. These costs would not
influence routine decisions, e.g. thermal power being used to clear
production in case of hydroelectric power failure.

c) Classification of costs according to variability

Traceable costs – I e TRACEABILITY TO THE FINAL PRODUCT
 These are costs that can easily be identified in the final product, e.g.,
materials
Direct costs: Costs that can be traced directly to a particular cost object (a
separate aspect of operations such as a product, department, or a region).
In a manufacturing firm, direct material, direct labour and direct expenses
are examples of direct costs.
 Untraceable costs - these are costs that cannot be easily identified in the
final product. Indirect costs:: These cannot be traced directly to the cost
objects. They are also referred to as overheads.

d) Classification of costs according to controllability

(i) Controllable costs - these are costs that can be easily controlled by
the actions of a cost pool/cost centre, e.g. direct materials, direct
labour, fuel costs, power, telephone and fax bills.

(ii) Uncontrollable costs - these are costs that cannot be easily

influenced by the actions of a cot pool/cost centre, e.g. rent, salaries,
and depreciation.

2. Functional Classification
This classification is based on what segments or functions of the
organization the costs relate. I.e. How cost have been used, these may be:
(a) Production costs

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 (b) Administration costs
(c) Selling and distribution costs
(d) Research and development costs
(e) Advertising costs.

The main objective of this classification is to determine the cost of each

function and to foster cost control. In addition, it may serve as a way of
justifying the existence of a certain function vis-à-vis the benefits derived
from them.

3. Natural Classification
This grouping is done according to what the costs are: the nature of the
costs. Costs can be categorised naturally into 3 groups.
(a) Materials
(b) Labour
(c) Expenses
Materials - inputs to be worked on directly or indirectly in the process of
producing output.
Labour - human effort to product.
Expenses - costs that cannot fall under materials or labour.
The natural classification is further subdivided into two: Direct costs and
Indirect costs.

Direct costs
These are costs that are attributed to a particular cost object or cost pool.
These are costs that are avoidable if the cost object in question is not
produced. These costs include:
(a) Direct materials - e.g. raw materials
(b) Direct labour - e.g. production wages
(c) Direct expenses - e.g. royalties, carriage inwards, subcontracting
Indirect costs

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 These are costs that are incurred in an organization for its wellbeing but
cannot be attributed to a particular cost object or cost pool. These costs are
referred to as overheads. They include:
(a) Indirect materials - e.g. sand paper
(b) Indirect labour - e.g. administrative salaries
(c) Indirect expenses - e.g. rent and rates, electricity, telephone.

N.B.: Although indirect costs (overheads) cannot be easily identified with

particular cost objects, they are part of costs incurred in the production of
output. They are supposed to be charged to output (cost object) and cost pools
through a process known as overhead analysis.

OVERHEADS
Overheads are costs that cannot be economically attributed to a cost unit or
cost objects.
These are costs that are incurred for the well being of the organization. These
include:
 Indirect materials
 Indirect wages
 Indirect expenses
Since overheads are costs incurred in production, the need to be charged
thereto. This implies that cost units or objects must share out this cost.

OTHER TYPES OF COSTS THAT AFFECT COST DECISIONS

Relevant / Irrelevant costs
 Relevant costs are those future costs that will be changed by a decision.
Irrelevant costs on the other hand are those costs that will not be affected
by the decision. E.g. when one is faced with a choice of making a journey
either by car or by public means, the cost of petrol will be irrelevant in this
particular instance.

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SUNK COSTS
 These are costs incurred in the past and any decision made does not alter
them. There are costs of resources already acquired and the total will be
unaffected by the choices between various alternatives. E.g. the written
down value of assets previously purchased are sunk costs. If a machine
was purchased 4 years ago for 10m with an expected life of 5 years and nil
scrap value, then the written down value after the first year cannot be
changed by future decisions.

OPPORTUNITY COST
 Costs that measure the opportunity lost when a choice of one course of
action requires that an alternative course of action be taken up.
Opportunity costs are of vital importance for decision making.
Unfortunately it is difficult to practically calculate opportunity cost, but
some attempt must be made to obtain a reasonable approximation for
instance by use of linear programming techniques.

ACTIVITY BASED COSTING (A-B-C)

This is the cost allocation method, based on activities of the firm.
Benefits derived by using ABC
i. It adopts several cost drivers.
ii. It assumes that activities cause costs that products create the
demand for the activities.
iii. Costs are assigned to production based on their consumption for each
activity.
Note: Costs are influenced by many activities of the organization rather
than overheads, therefore several costs drivers are necessary to each
activity.

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LIMITATIONS OF COST ACCOUNTING
1) It is expensive: The system of cost accounting involves additional
expenditure to be incurred in installing and maintaining it. However,
before installing it, care must be taken to ensure that the benefits
derived are more than the investment made on this system of
accounting.

2) The system is more complex: As the cost accounting system involve

number of steps in ascertaining cost such as collection and classification
of expenses, allocation and apportionment of expenses, it is considered
to be complicated system of accounts.

3) Moreover the system makes use of several documents and forms in

preparing the reports. This will tend to delay in the preparation of
accounts.
4) Inapplicability of same costing method and technique: All business
enterprises cannot make use of a single method and technique of
costing. It all depends upon the nature of business and type of product
manufactured by it. If a wrong technique and method is used, it misleads
the results of business.
5) Not suitable for small-scale units: A cost accounting system is
applicable only to a large-sized business but not to small-sized one.
Hence, there is limitation to its application to all types of business.
6) Lack of accuracy: The accuracy of cost accounts get distorted owing to
the use of notional cost such as standard cost, estimated cost, etc.
7) It lacks social accounting: Cost accounting fails to take into account
the social obligation of the business. In other words, social accounting is
outside the purview of cost accounts.

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