COST ACCOUNTING

Objectives
Cost aspects
Principles of accounting
Prepare various cost statements for decision making
Define accounting purpose of accounting
Methods used in cost estimation and forecasting
Costing techniques
Gross earning calculations
Method of labor remunerations
Overheads and overheads absorption
Basis for overhead apportionment

***there’ll be Cat at this point

Costing methods/systems
-job order costing
-contract costing
-process costing (WIP)
-service costing

Standard costing and variance analysis

-purpose of standard costing
-budgetary control and standard costing
-setting standard selling price and standard margin/profit
-variance analysis: -
-material cost variance
-labor cost
Variable method
Fixed overheads
Sales margin
Sales margin quantity

Cost volume profit analysis (CVP)

Break even analysis (BEP)
Flexible budgets and zero based budgeting
Relevant cost for management decisions and computerized costing systems

Cost accounting – the establishment of budgets, standard cost and actual cost of
operations activities or products and the analysis of variances, profitability or
social use of facts.

Scope
Cost – cost is the charge for a particular service/ product offered by an entity
Cost of running a section/department in an organization e.g. employees
Wage cost
Rectification cost/ scrap cost – helps in material cost control and production
planning.
 Cost behavior with varying levels of activity = helps in profit planning, cost
control
, make decision in terms of buying a product/service or making it locally

****Research the difference between Financial accounting and cost accounting

Management accounting and cost accounting

Purpose of cost accounting

- Cost ascertainment = cost of producing different products/services must be

ascertained accurately. Involves material cost/labor cost/ overheads.
- Controlling cost – involves the management making sure that the intended
desired results are continuously achieved. This consists of establishing the
standards, comparing results against standards and correction of
deviation/variances
- Disclosure of risks – cost incurred in production for any commodity can be
determined in advance in view of the past experience.
If the actual is higher than the expected, then this excessive costs can be
analyzed. This may be due to waste of raw materials or idle labor time
- Decision making – management is responsible for decisions regarding
goods/services they should produce and in which quality. Cost accounting
information provide information for making these decisions.
- Cost control – this is an important function of management. Material cost,
labor costs and overheads must be maintained at desirable levels. Cost
accounting principles are used to eliminate unnecessary costs
- Evaluation of alternatives - the management is frequently confronted with
decisions involving choice from different alternatives causes of action e.g.
whether to buy or make one locally, whether to continue or to discontinue a
 product or a service etc., cost accounting provides information on how future
costs and revenue will be affected under such alternatives thus assisting
management in taking an appropriate selection
- Planning- process of setting objectives and determining steps required to
attain them. When making this planning requirements appropriate
information and cost accounting makes analysis of past operations. This
costs are adjusted to reflect changes in the products in technology, volume,
production efficiency, input cost etc.
- Pricing of products and project – involves determining of prices of new
products, adjustments of prices of existing products as well as determining
prices of bid contracts. The decision of setting prices is based on the cost of
data collected. Measurement of efficiency – cost data are used to measure
efficiency of an organization in utilizing its resources employed in
production process.
- Inventory management- costing assists in this by keeping accurate and
complete records of materials from time they enter into premise till the time
they ‘re used in production.
- Evaluation of profitability – costing provides information for evaluating the
profitability of an activity of a department or entire organization.

Conditions for effective Costing system

A costing system is designed in accordance to the requirements of the
organization. The system should be simple, economical and practicable. The
main conditions for effective costing system are:
- There must be a proper system of store and stock control
- There must be a corporation and coordination among employees of the
organization
- The wages procedure must be proper and satisfactory. Labor costs should be
charged to respective jobs accurately.
- Standard printed forms must be use for recording receipts of materials and
issues, recording labor hours worked and calculating other activities of the
organization.
 - Overheads must be recorded accurately and these must be charged to
respective departments.
- The costing department – the responsibilities and duties of cost accountant
must be correctly stated.
- The cost accounts and the financial accounts should be maintained in a way
that the results can be reconciled easily

Cost classification
Cost is the amount of expenditure incurred on or attributed to a specified activity
or a product.
Cost includes 2 components – quantity and price.
Cost = quantity x price per unit
Cost unit – we use cost unit to ascertain the cost of a particular product or service.
Cost elements – raw materials, overhead, labor, depreciation on equipment, rent
etc.

Classification of cost is the process of grouping cost according to their

common characteristics.
It is done in order to be conscious of every cost incurred in the process of
manufacturing so that such costs can be accurately recorded, monitored and
controlled

Ways of classifying cost

 Function – a business performs various functions. On this basis, costs
are classified into the following
i. Manufacturing/production cost or factory cost – these costs relates to
the manufacturing process and include the following
-material cost
- labor cost,
-factory cost such as rent
- depreciation of machinery
-power and lighting, etc.
 ii. Administrative cost – includes all expenses incurred in formulating
policies, directing the organization and controlling the operations of
an undertaking such as office rent, salaries etc.
iii. Selling cost – are costs of seeking to create and stimulate demand and
to serve orders e.g. advertisement costs, salaries and commission of
salesmen, etc.
iv. Distribution costs = cost incurred to avail the products to the final
consumer e.g. packing cost, carriage outwards, warehousing costs.
v. Research and development cost – is a cost of searching for new and
improved products and methods. E.g. wages and salaries of research
staff, payment to outside research organizations etc.
 Classification according to cost behavior or
variability
i. Fixed cost – is one that does not change or vary with any level of activity or
output. It remains constant within the relevant range.
Relevant range is that range within which relationship between cost and
output or activity can hold.
Fixed cost Examples of fixed costs

- Rent
- Salaries
- Insurance premiums
- Interest on loans etc.

Activity
level/output

ii. Variable cost – is that cost that vary in direct proportion to the volume
of output. When activity levels go up… variable costs go up and vice versa.
e.g. labor unit employed verses output as well as cost incurred.

Cost
 Variable cost

Examples of variable costs

- Direct labor
- Raw materials
- Sales commissions
- Packing materials
- Utilities (electricity bills,
water bills, gas bills – just
their variable component)
etc.
Activity
level/output

iii. Semi-variable cost – are costs that are partially fixed and partially variable.
It has a fixed element below which it will not fall at any level of output. The
variable element is a semi variable cost that changes either at a constant rate
or in lumps/steps. Such us electricity bill has a variable element that changes
with consumption and a fixed element below which
it falls. Variable cost

Examples of semi variable costs

Cost - Utilities (electricity bills,

water bills, gas bills – just
their variable component)
etc.
Fixed Cost

Activity
level/output
Changing in lumps

Such as

Cost - rent
 Activity
level/output

 Classification according to Period cost/ Product

cost Period of production

i. Product cost – is cost incurred in the process of producing or

necessary for producing of a given product and cannot be incurred in case of
zero production e.g. cost of direct material, direct labor, and some of the
factory overheads.
They are called product costs bcos they are incurred in the cost of
production.
Period cost – are those that are not necessary for production and are
written/incurred as expenses in the period in which they are incurred. They
are incurred for a time period and are charged to the income statement for
the period e.g. rent, salary of company executives, travel expenses.

 Classification according to identifiability with the

product

i. Direct cost – are those incurred for and maybe conveniently identified
with a particular cost unit, process or department e.g. labor, direct materials
etc.
ii. Indirect costs – those which cannot be conveniently identified with a
particular cost unit, process or department. They are general costs incurred
 for the benefit of a number of a cost units or cost centers such as salary paid
to factory foreman.
 Classification according to controllability
i. Controllable costs – are costs that maybe directly regulated by a
given level of managerial influence e.g. variable cost by a particular
department.
ii. Uncontrollable costs – are those that cannot be influenced by
action of a specified member of the enterprise e.g. fixed cost, rent.

 Classification according to Managerial Decision

Making

i. Relevant cost – are those that changes from one decision to the
next and as such, relevant cost will be affected by decision being
made under different alternatives.
During decision making, management will be concerned with those
cost that differ from one decision to another
ii. Sunk/irrelevant costs – are cost already incurred in the past
and cannot be changed. They are relevant in decision making.
iii. Incremental cost or differential cost – is an increase or
decrease in cost as a result of an alternative cause of action.
iv. Marginal cost – cost of producing an extra unit of a
commodity.
v. Replacement cost – the market value of replacing an existing
asset.
vi. Opportunity cost – cost that is sacrifice that is involved in
accepting the alternative choice under consideration.
- Opportunity cost represents the cost of what you give up when you make a
decision
- It is the cost of a forgone opportunity, representing the value of the next best
alternative you didn't choose when making a business decision
  Classification according to Time
i. Historical cost – are costs ascertained after they have been
incurred. They are actual cost which are only available after
completion of the manufacturing process e.g. cost of any asset e.g.
machinery cost
ii. Predetermined cost – are future costs that are ascertained in
advance of production on the basis of all the specified factors
affecting costs.
Examples****

**Write notes on** Concepts of

cost accounting
- Cost per unit
- Cost center
- Cost behavior
- Profit center

**cost per unit – cost of each individual product in a cost center

**cost center – a division/function in an org. that deals/manages/produces a
given product/service/activity usually purposed for monitoring and assessing costs
of production
**cost behavior – the way cost change or respond to variations in level of
an org.’s level of activity/output levels.

categories
- Fixed cost
- Variable cost
- Semi variable cost

COST ESTIMATION AND COST FORECASTING

Cost estimation – is a procedure used to measure costs of various items used in
production.
Cost forecasting – is a process of accurately determining in advance the cost that
will be incurred in manufacturing of a given product over a period.
The various methods that can be used include:
 Accounts classification (separating mixed cost) – this entails examination
of accounts and classifying each item of expenditure into fixed and semi
variables.
Although this method is quick and inexpensive, it’s considerably subjective and
inaccurate.
 Industrial engineering (cost estimation and forecasting) – is considered as
the most scientific method of establishing a cost standard. Work study
techniques are applied to determine levels of input needed to satisfy given
levels of output. Those inputs are then turned into standards to estimate
production cost in future.
Advantages
- Enables an org to determine most effective way to use resources
- Standards can be set using efficient usage.
- There’s control of operations by comparing the actual with the expected
results
Disadvantages
- Costly as it involves experts.
- Not effective for controlling many types of overhead costs
- Not easy to apply in a non-manufacturing activities since relationship
between cost and output can’t be determined.

 High low method (used for separating cost, cost estimation and forecasting)

This method examines cost at high and low levels of output/activity making
an assumption that the increase in cost between the two levels is directly due
to the increase in activity and therefore represent the variable cost.
Two previous account periods are chosen, one with the highest activity level
and the other with the lowest activity level.

Steps used in this method to come up with this cost is

- Select the highest and lowest levels of activities.

- Select corresponding costs, highest and lowest
- Obtain the difference in cost and the difference in activity
level.
- Divide the difference in cost by the difference in activity
level/output to get the rate of the variable cost.
- Compute the fixed cost by subtracting the variable cost
from eh total cost.
- Formulate the linear prediction/estimation equation.

Advantages of High Low Method

- easy to use.
- The lowest and the highest items will cover the relevant range.
- Takes into account possible extremes of cost.
 Disadvantages

- not logical to use two points to represent all the points

- the estimated cost function poorly describes the actual cost relationship
- costs are not properly matched with the independent variables.

Linear Regression Analysis

Is mathematical technique from which the case function y = a + bx can be derived.
It is commonly known as the method of mixed squares bcos the method of
mathematics that is used tries to equate the sum of squared distances above the line
of best fit to those below it.
A regression equation utilizes historical data to estimate the relationship between
the independent variable y and the one or more independent variables.
The method tries to mathematically estimate the line of best fit. In obtaining the
value of a and b the following equations are used.

nΣ xy −Σ x Σ y
To get: b= 2
n ∑ x −( ∑ x )
2

∑ y−b
a= 1 where n is the no. of pairs of data

Some mathematical example here

 Coefficient of correlation
Correlation is the relationship between two variables. It measures the strength of
linear relationship between two variables which is determined by the coefficient of
correlation.
Two points of data can…

-ve correlation x
+ve correlation x

Normally range between 0 and -1.

The closer the correlation
The closer the correlation coefficient to -1 the stronger the
coefficient to +1 the stronger the -ve correlation
+ve correlation

The correlation coefficient is given by the following formula

n ∑ xy −∑ x ∑ y
r=
√¿¿ ¿

Correlation of Determination
Used to determine how much of the change in y is as a result of change in x.
Y is the total cost.
It is obtained by squaring the coefficient of correlation from the above example.
r2 = 87.4%

this means that 87.4% of change in overhead cost is due to output from other
factors which cause 12.6% change in the overhead cost.

The Scatter Plot

This is a graphical method of data or cost estimation. Two pairs of data are plotted
on single points on a graph and then joined using a line of best suit. The gradient of
that line is the rate of the variable cost and the y intercept represent the fixed cost
as indicated below.

Gradient = y = mx + c

y2
VC This method is subjective and
not accurate sometimes

y1 FC

y0
x

The Learning Curve theory/ improvement curve theory

Occurs when new methods are introduced or new products are made. It is based on
the provision that workers continue doing the same job over and over again,
experience is gained.
The time taken to complete a job or a unit of a product reduces by a certain contact
referred to as learning coefficient.

(*inaudible*)
It is therefore possible to determine time to be taken to complete certain
number of units and hence the cost of labor learning effect and effect labor cost
(*inaudible*)

MATERIALS ISSUE AND STOCK CONTROL

Objectives:
- Describe steps in purchasing materials
- Explain various types of purchasing systems
- Understand principles of material control
- Elements of store keeping and stock taking