Module 1

1.1 Strategic Variables in Management 1.2 Management by Objectives 1.3 Management control and operational control 1.4 Concept of cost centers 1.5 Classification of costs 1.6 Cost analysis for management decision making

1.1 Accounting is the process of identifying, measuring and communicating economic information to permit the decisions by users of information. y The basic accounting system consists of three parts: (i) Financial Accounting, (ii) Cost Accounting and (iii) Management Accounting. y The accounting information specifically prepared to aid managers is called Management Accounting Information. y This information is used in three managerial functions: (i) Planning, (ii) implementation and (iii) control.

y Planning is the process of deciding what action should

be taken in the future. An important form of planning is budgeting. y Implementation involves specific actions planned in advance to fulfill the budget y Control is the process to ensure that employees perform properly.

1.4 Concept of cost centers y In small organizations decision making and management of the business are often done by a single individual. In large organization, especially organizations engaged in manufacturing multiple products become more difficult. y In order to overcome this difficulty, the large organizations may be decentralized, that is different responsibility centres may be created where individual managers have the authority over a given area of operation and freedom to make their own decisions.

y A cost or expense centre is a segment of an organization in

which the managers are held responsible for the costs incurred in that segment. Evaluation of cost centre is guided by a variance of actual and budgeted cost for a given period. y In manufacturing organizations, production and service departments are classified as cost centres. In marketing department, a sales region or a single sales representative can be defined as a cost centre.

y Revenue Centre

It is a segment of the organization which is primarily responsible for generating sales revenue. A revenue centre manager usually has control on some of the expenses that the control on investments.
y Profit Centre

It is a segment of organization for which both revenue and costs are accumulated. The main purpose of profit centre is to earn profit. Profit centre managers aim at both the production and marketing of a product. A division of the company which produces and markets the products may be called a profit centre.
y Investment Centre

As investment centre is responsible for both profits and investment. The investment centre manager has control over revenues, expenses and the amounts invested in the centre s assets.
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1.5 Classification of costs y Natural classification

y Direct material y Direct labour y Direct expenses y Factory overhead y Administrative, Selling and distribution overhead

y According to behaviour y Fixed costs y Variable costs y Mixed costs (semi variable costs)
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y According to traceability with the product y Direct cost y Indirect cost y According to association with the product y Product costs y Period costs y According to function y Manufacturing cost y Selling and distribution cost y Administrative cost

y According to accounting period y Capital cost y Revenue cost y Costs for control y Controllable and uncontrollable cost y Standard cost y Fixed, variable and mixed cost

Costs for decision making and planning

y Opportunity cost y Sunk cost y Relevant cost y Differential cost y Imputed cost y Out-of-pocket cost y Fixed, variable and mixed cost y Shutdown cost

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Methods of costing y The term costing refers to the techniques and processes of determining costs of a product manufactured or service rendered. Different methods are applied in business enterprises to ascertain costs. There are two methods of costing: y Job costing
y Batch costing y Contract costing y Multiple costing

y Process costing y Unit costing or output costing y Operating costing

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y y y y

Techniques of costing: It refers to the manner of controlling the costs of a product. Historical costing Standard costing Absorption costing Variable costing

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1.6 Cost analysis for management decision making y Opportunity Cost: it is the cost of opportunity lost. It is the benefit lost by rejecting the best competing alternative to the one chosen. y It is important in decision-making and evaluating alternatives. Decision making is selecting the best alternative which is facilitated by the help of opportunity costs.
y Sunk cost: it is the cost that has already been incurred.

Generally known as unavoidable costs, when once the cost is incurred it cannot be changed. It has been created by a decision in the past and cannot be changed by any decision that is made in the future.
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y Relevant Cost: are those different costs which differ

between alternatives. It is defined as the cost which are affected and changed by a decision. y On the contrary, irrelevant costs are those costs which remain the same and not affected by the decision whatever alternative is chosen. Relevant costs are future costs and not historic (sunk) costs.

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y Differential Cost: is the difference in total costs

between any two alternatives. These are equal to the additional variable expenses incurred in respect of the additional output. These are also known as incremental costs. y Imputed Cost: are those costs that are not actually incurred in some transaction but are relevant as they pertain to a particular situation. Interest on internally generated funds, rental value of company-owned property and salaries of owners. y Out-of-pocket Cost: it signifies the cash cost incurred on an activity. This cost concept is significant for management in deciding whether or not they return the cost incurred on it.
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y Module 2 2.1 Cost elements for product costing 2.2 Accounting for factory overheads 2.3 Principles of allocation and absorption 2.4 Ascertaining product costs under job costing and process costing 2.5 Theoretical concepts of Activity Based Costing (ABC)

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2.1 Cost: is the amount of expenditure incurred in relating to a specific thing or activity. The specific thing or activity may be a product, job, service, process or any other activity. y Basically, when cost is incurred, it could be in the form of deferred cost (asset) or expired cost (expense). y Deferred costs are unexpired costs, capitalized costs, which provide benefits in the future period and known as assets. Expired costs are costs which have been used up totally in generating revenue.

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y Costing: is the process of identifying the cost. It is of

methods and techniques. Methods are used in the manufacturing sectors or any service sectors to identify the cost of the one unit. y Techniques are the process of controlling the cost of the product in order to minimize the waste and increase the output. In practice it is known that 5 per cent of saving in wastage will increase the output by 35 per cent.

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Elements of cost: basically cost is made up of three elements; y Material y Labour y Expenses

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y Material: it is generally used in manufacturing

concerns, refers to raw materials used for production, sub-assembles and fabricated parts. Material cost constitutes a prime part of the total cost of production of manufacturing firms. Material cost is divided into two parts.
y Direct material: refers to the cost of materials which are

conveniently and economically traceable to specific units of product. y Indirect material: refers to the cost of material which is not conveniently and economically traceable to specific units of product. It cannot be allocated but can be apportioned or absorbed to cost units.
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y Labour: it generally consists of the remuneration paid

to workers. Labour cost is further divided into two parts:

y Direct labour: it consists of the wages paid to labour

which convert raw materials into some form of finished output. It comprises the wages which can be identifies with, and allocated to cost units. y Indirect labour: is the labour which is not engaged in converting raw materials into finished goods. The indirect labour cost is the cost which cannot be allocated but can be apportioned or absorbed to cost units.

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y Expenses: it includes any expenditure other than

material and labour. The expenses can be identified with product or job and are charged directly to the product. Expenses are further divided into two:
y Direct expenses: this include any expenditure other than

direct material and direct labour incurred on a specific product of job. y Indirect expenses: it includes all indirect cost of elements

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Elements of cost MATERIAL LABOUR ESPENSE TOTAL DIRECT MATERIAL DIRECT LABOUR DIRECT EXPENSE PRIME COST INDIRECT MATERIAL INDIRECT LABOUR INDIRECT EXPENSE OVERHEAD

From the above analysis it is clear that the sum of all direct elements of cost is known as prime cost and the sum of all indirect elements of cost is known as overheads.

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2.2 Accounting for Factory Overheads y The term overhead is preferable to manufacturing expenses, because manufacturing expenses often refer to all manufacturing costs, both direct and indirect. y Factory overheads costs are operating costs of a business enterprise which cannot be traced directly to a particular unit of output. y Factory overhead is an aggregate of indirect materials, wages and expenses. Factory overhead costs can be divided into fixed, semi-variable and variable costs.

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Accounting of factory overheads y Factory overheads by nature cannot be identified or associated directly with specific products or jobs. The following steps are important in distribution of overhead costs among products or jobs. y Collection and codification of overheads y Allocation and apportionment of overheads y Absorption of overheads

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Collection and codification of overheads: in manufacturing department all the costs which are incurred should be grouped together. The grouping of overhead costs is done through a technique known as codification 2.3 Allocation and Apportionment of overheads y Departmentalization of factory overheads means dividing the company into segments called department or centers where expenses are incurred. y In a manufacturing concern, there are mainly two types of cost centers:
y Production department y Service department
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y Production department: it represents a subunit of the

company where manufacturing activity takes place. Example: finishing, blending, painting and grinding departments. These departments are directly involved in production
y Service department: it represents the cost centers

which provide support for the production departments. For e.g, materials handling, personnel, plant maintenance, inspection, storage, purchase, etc. These activities are not directly involved in production.
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y Distribution of Overhead: allocation of overheads to

cost centers is not as easy as allocating the direct costs to production and service departments. y In allocating the overheads to respective cost centers, we need to identify the common overheads which are incurred in both production and service departments. y The common overheads incurred in these department are power, light, rent, depreciation, expenses share by all departments, cannot be charged directly to a department. y These expenses do not originate to any department in specific. They are incurred in common.
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y Therefore,

the common expenses should be apportioned to their respective departments in the basis of their allocation. Apportionment of overheads are of two types:
y Primary distribution y Secondary distribution

y Primary distribution: it is the distribution of common

overheads to both production and service department.

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y Secondary distribution: it is the distribution of service

department overheads to production overheads. The secondary distribution is of following types: y Direct Distribution Method y Reciprocal Methods
y Repeated distribution method y Simultaneous equation method

y Non-reciprocal method

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2.4 Ascertaining product costs under Job Costing and Process Costing: y Job Costing is a costing method applied to determine the cost of specific job.
y Generally,

the job order system is used by manufacturing concerns where an order is produced to a customer s specification.

y Process Costing is that form of operation costing

which is used where standardized goods are produced in large volume with continuous flow.
y Generally, this method is used in those manufacturing

concerns where goods are produced for stock purpose and customer order purpose.
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2.5 Theoretical concepts of Activity Based Costing (ABC): is that costing in which costs are first traced to activities and then to products. It mainly focuses on activities performed to produce products. y Stages and flow of costs in ABC: there are mainly two stages in ABC;
y Tracing costs to activities y Tracing activities to products

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The different steps in the two stages of ABC are explained below: y Identify the main activities in the organization. Examples include, material handling, purchasing, receipt, dispatch, matching, assembling and so on. y Identify the factors which determine the costs of an activity. These are known as cost drivers. For Eg. Number of purchase orders, numbers of orders delivered and so on. y Collect the cost of each activity. These are known as cost pools and are directly equivalent to cost centers.
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Module 3
3.1 Cost Volume Profit relationship 3.2 Profit Planning 3.3 Assumptions of the CVP model

y 3.1 Cost Volume Profit Relationship: before going in

detail about CVP analysis, it is important to know about the basic components of CVP analysis.

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y Marginal cost: it is the cost which tends to vary in

direct proportion to the change in the production level.

y If an extra unit produced, the cost which is incurred for

producing this extra unit is known as marginal (variable) cost. In this only variable cost is considered as the total cost of the product.

y Absorption cost: it is also known as full costing. It

considers all costs (variable and fixed cost) in calculating the cost of the product. y Fixed costs are treated as period costs in marginal costing, where as variable cost is treated as product cost.
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y Applications of

marginal costing: it has great potentials for management in decision making processes. It is used to management in the following areas:
y Profit planning: it helps management in planning and

evaluating the profit resulting from a change in volume in short-term decision makings. y Cost control: it helps in controlling the costs as it separates cost into variable and fixed, which helps in taking the decisions. y Impact of fixed costs: managerial decisions can be easily made if fixed costs are separated from total costs.
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Cost-Volume-Profit (CVP) Analysis y Profits of business firms are the result of many factors such as:
y Selling prices y Volume of sales y Variable costs y Fixed costs y Product line

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y To study the Predictions of how profits will be affected

by a change in any one of the above factors is known as cost-volume-profit analysis. y The study of CVP analysis is useful to management in knowing how profit is influenced by sales volume, sales price, variable expenses and fixed expenses. Broadly speaking CVP analysis uses the techniques of;
y Break-even analysis, and y Profit-Volume analysis

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Break-even Analysis y A break-even analysis indicates at what level cost and revenue are equal and there is no profit and no loss. It is a device which portrays the effects of any type of future planning by evaluating alternative course of action. Break-even Point y The break-even point can be defined as the point or sales level at which profit and zero and there is no loss. That is, break-even point is that point at which total costs are equal to total sales revenue.
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Fixed Cost BEP (in units ) ! Contribution / unit

Fixed Cost x Sales BEP (in value) ! Contribution

(OR)

Fixed Cost BEP (in value) ! Pr ofit Volume Ratio

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y y y y

Assumptions of BEP Selling prices and pricing policy will remain constant at all levels All costs and expenses can be separated into fixed and variable components. Fixed cost is constant at all sales levels and unit rate variable costs remain the same. Volume is assumed to be the only important factor affecting cost behaviour.

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Margin of Safety y This is the difference between sales and the break-even point. If the difference is relatively short, it indicates that a small drop in production or sales will reduce profits considerably. y If the distance is long, it means that the business can still make profits even after a serious drop in production.

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M arg in of Safety ! Actual Sales  BEP Sales

(OR)

Pr ofit M arg in of Safety ! Pr ofit Volume Ratio

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ANGLE OF INCIDENCE y This is the angle at which the sales line cuts the total cost line. Management s aim will be to have a large angle of incidence as possible because it shows a high rate of profit. y A narrow angle would show that variable cost form a large part of cost of sales. PROFIT VOLUME RATIO (PVR) y It measures the percentage of contribution on sales. Larger the PVR, greater the profit and vice versa. y It is calculated in taking the managerial decisions for the short run. It is also known as contribution margin.
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y y y y

Profit Volume Ratio can be increased by the following possible courses of action: Increase the unit selling price of product. Reducing the variable cost/marginal cost per unit. Increasing the share of high contribution margin products in a multiproduct company. Reducing the share of low contribution margin products in the total sales.

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Contribution Pr ofit Volume Ratio ! x 100 Sales

(OR)

Change in profits Pr ofit Volume Ratio ! x 100 Change in Sales

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Marginal costing Equation Sales Less: Variable Cost Contribution Less: Fixed Cost Profit (loss) xxx xxx ----xxx xxx ----xxx -----

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y y y y y

From the above equation it can be analyzed that: Contribution = sales variable cost Contribution = fixed cost + profit Fixed cost = Contribution profit Profit = Contribution Fixed cost Sales Variable cost = Contribution = Fixed Cost + profit

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Contribution can be calculated in three different levels, they are as follows:

y Above Break even point: y Contribution = Fixed cost + profit y At Break even point : y Contribution = Fixed cost y Below Break even point: y Contribution = Fixed cost - loss

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DECISION MAKING y Decision making also known as decision model, is the process of evaluating two or more alternatives leading to a final choice, known as alternative choice decisions. y Decision making is closely associated with planning for the future and is directed towards a specific objective or goal.
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y y y y y

The overall decision process contains the following decision making steps or elements: Identify and define the problem Identify alternatives as possible solutions to the problem Eliminate alternatives that are clearly not feasible Collect relevant data (costs and benefits) associated with each feasible alternative. Identify costs and benefits as relevant or irrelevant and eliminate irrelevant costs and benefits from consideration.

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y Identify,

y y y y

to the extent possible, non-financial advantages and disadvantages about each feasible alternative. Total the relevant costs and benefits for each alternative. Select the alternative with the greatest overall benefit, that is, make the decisions. Implement or execute the decision Evaluate the results of the decision made.

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Relevant Revenues y Relevant revenue is the amount of increase or decrease in revenue expected from a particular course of action as compared with an alternative. Relevant revenues are like cash inflows. Relevant Costs y Relevant costs are also known as differential costs, decision making costs. Relevant or differential cost is the difference in the total costs between alternative choices.
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y When a decision results in an increased cost, the

differential cost may be referred to as an incremental cost. y If the cost decreases, the differential cost may be referred to as a decremental cost. The relevant costs vary with the type of decision. The common features of relevant costs are: y Relevant costs are expected future costs. y They differ between different alternatives.

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BUDGETORY CONTROL
One of the primary objectives of cost accounting is to provide information to business managements for planning and control. y Budgeting is a formal process of financial planning using estimated financial and accounting data. Definition of Budgeting y The Institute of Cost and Management Accountants defines a budget as a financial and/or quantitative statement, prepared and approved prior to a defined period of time, of the policy during that period for the purpose of attaining a given objective.
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y Planning is the basic managerial function. It helps in

determining the course of action to be followed for achieving organizational goals. It is decision in advance; what to do, how to do and who will do a particular task? y Every business enterprise needs the use of control techniques for surviving in the highly competitive and changing economic world. Budgets are the most important tool of profit planning and control. y A budget is the monetary or/and quantitative expression of business plans and policies to be pursued in the future period of time.
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y The term budgeting is used for preparing budgets and

other procedures for planning, co-ordination and control of business enterprise. y Budgetary control is the process of determining various budgeted figures for the enterprises for the future period and then comparing the budgeted figures with the actual performance for calculating variances, if any.

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y y y y y

Objectives of budgetary control: Budgetary control is essential for policy planning and control. Its main objectives are as follows: To ensure planning for future by setting up various budgets. To co-ordinate the activities of different departments. To operate various cost centers and departments. To anticipate capital expenditure for future. Correction of deviations from the established standards.

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