CIMA P1 Notes: A3.

Profit or Loss | aCOWtancy Textbook

Cost accounting for decision and control

Rationales for costing:

Management accounting: application of principle of accounting and financial management to create,

protect, preserve and increase value for the stakeholders.

Cost accounting is a sub set of management accounting. It is more focused on calculating the costs of
a product or service and extending this into potentially controlling and managing this cost. It means
that the focus is often on short term improvements and decisions.

CIMA terminology is gathering of cost information and its attachement to cost object, the
establishment of budget, standard costs and actual costs of operations, processes, activities or
products and the analkysis of variances, profitability or social use of the funds.

Financial accounting is the classification and recording of the monetary transactions of an entity in
accordance with established concepts, principles, accounting standards and legal requirements in
their presentation

There is legal requirement to have financial accounting but no legal requirement to have
management accounting

The main role of financial accounting is to produce the statutory financial statements, whereas
management accountants provide any information needed by management.

Management accountants provide information internally to managers. The statutory financial

reports produced by financial accountants are available to public and anyone else interested in the
organization.
If production (units) is equal to sales (units)

 there will be no difference in profits

If inventory levels increase

between the beginning and end of a period, absorption costing will report the higher profit.
 This is because some of the fixed production OH will be carried forward in closing inventory
(which reduces cost of sales and therefore reduces Expenses and therefore increases the
Profit).

LESS expenses you have .... MORE Profit you get

If inventory levels decrease

absorption costing will report the lower profit because as well as the fixed OH incurred, fixed
production overhead which had been carried forward in opening inventory is released and is also
included in cost of sales.
MORE expenses you have .... LESS Profit you get

Therefore:

1. If inventory levels increase, absorption costing gives the higher profit

2. If inventory levels decrease, marginal costing gives the higher profit
3. If inventory levels are constant, both methods give the same profit

OAR= Overhead absorption rate

Activity based costing:

ABC has been developed to solve the problems that traditional costing methods create in
these modern environments.
Traditional costing problems:
Charge OH to product or services in an arbitrary way
The assumptions of absorption rate in traditional way is outdated because production is
based on smaller customized batches of products, indirect costs are high in relation to direct
costs
It cannot calculate a true product costs that has a valid meaning
Problems with marginal costing:
In marginal costing, products or services are valued at their marginal cost and profitability is
assessed by calculating the contribution earned from each product or service. Fixed costs
are assumed to be time related and are charged against profits as a cost for the period. This
can be a useful costing method when variable costs are a large proportion of total costs.
However:

 Variable costs might be small in relation to fixed costs

 Fixed costs might be fixed in relation to production volume but they might vary with other
activities that are not volume related or even production related

ABC is an alternative approach to product costing. It is a form of absorption costing but rather than
absorbing OH on a production volume basis, it first allocate them to cost pools before absorbing
them into unit using cost drivers

 Cost pool is an activity that consumes resources and for which OH costs are identified and
allocated. For each cost pool there should be a cost driver
 Cost driver is a unit of activity that consumes resources. An alternative definition of cost
driver is a factor influencing the level of cost

ABC reduces the incidence of arbitrary apportionments.

There are 5 basic steps to calculating an activity based cost:

 Group production OH into activities according to how they are driven

 Identify cost drivers for each activity, what causes these activity costs to be incurred
 Calculate a cost driver rate for each activity
 Absorb the activity costs into the product
 Calculate the full production costs and/or the profit or loss