Cost Accounting

Chapter One

TOPIC 1: INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING

Introduction
Accounting is the method of identifying, measuring and communicating economic information to
permit informed judgment and decision making by the users of the information.

It’s that part of information system of business enterprise which provides financial information
concerning the business activities of an enterprise to diverse groups of people such as:
shareholders, managers, creditors, tax authorities etc

On the basis of purpose for which the information is required, accounting is divided in 2 parts:
i) Financial Accounting
ii) Management Accounting

Financial Accounting
Financial accounting is mainly concerned with recording business transactions in the books of
accounts for the purpose of presenting final reports to the management, shareholders, and tax
authorities.

The information supplied by financial accounts is summarized in the following statement at the
end of given period generally one year:
 Profit and loss account (the income statement).
 Balance sheet.
 Cash flow statement.
 Statement of change in equity.

Management Accounting
It’s that part of management that is concerned with identifying and presenting information for
formulating strategies, planning and controlling activities, decision making on alternative decision,
optimizing use of resources for interested parties and safeguarding assets of the business.

Cost Accounting
It’s that part of management that deal with ascertaining cost of product, operation, process etc

It’s the combination of accounting and costing technique in the accumulating analysis and control
of costs and revenue.

Cost
Refers to the resource sacrificed so as to achieve a given objective

Difference between Financial Accounting & Cost Accounting

1. Users of the information- Financial Accounting information is used by external parties as well
as internally by managers whereas Cost Accounting information is used internally by managers.
2. Compliance with GAAP- Financial Accounting statements are prepared in compliance with
GAAP (Generally Accepted Accounting Principles) whereas cost accounting statements do not
need to comply with any principles.
3. Format- Financial Accounting statements are prepared in the format presented by the (IAS)
International Accounting Standards whereas Cost Accounting statements are prepared in the
format internally decided by the management.
4. Periodicity of Reporting- Financial Accounting reports are issued periodically e.g. annually,
semi-annually etc. Cost Accounting reports can be prepared when the management requires
them.
5. Audit Requirements- Financial Accounts should be audited by an external or independent
party. Cost Accounts needs not be audited unless they contain vital information for the audit.
6. Legal Requirement- Financial Accounting reports are compulsory by law (under CAP 486). Cost
Accounting reports are prepared when management require them.
7. Sources of Information- Data used to prepare financial statement is historical by nature i.e.
based on past transactions. Cost Accounting uses historical, current and sometimes future
data to prepare its statement.
8. Precision- Financial Accounting requires accurate information otherwise external parties will
not have confidence in the content of the report. Cost Accounting may allow for approximation
of certain information required.
9. Unit of Measurement- All information under Financial Accounting is in terms of money value.
Cost Accounting applies any unit of measurement that is useful in a given situation e.g. Labour
hours, output, machine hours etc

Cost Accounting System.

Due to differences in organisations, there cannot be a standard Cost Accounting System etc. the
system installed must meet the organisation needs. It must be effective, economical and must
have the support of all parties and managers must feel the need for it.
When installing the system, the following factors must be considered:

i) Investigations should be done relating to the technical aspects of the b/s, production
methods and nature of the products etc. to understand the organisation.
ii) Organisation structure should be known to ascertain the scope of authority etc. the head
of the system will be incorporated in the structure.
iii) Current method of purchase, storage and issue of materials should be examined for the
purpose of improving.
iv) Existing methods of labour remuneration should be examined for the purpose of
introducing incentives.
 v) Accounting records should be designed so as to involve minimal clerical labour and
expenditure. [Less paperwork].
vi) The system must be effective in cost control and cost reduction.
vii) Installation and operation of the system must be economical ie. Cost should not outweigh
benefits.

Difficulties in installation.
1) Lack of support from top management.
2) Resistance especially from accounting staffs.
3) Non-cooperation by supervision staff.
4) Lack of qualified personnel to operate the system.
5) Records designed for the system may not be applicable in reality.

Conditions for effective Cost Accounting System.

i) Meet the needs of organisation.
ii) There must be co-operation and co-ordination among the staff the system must be
supported.
iii) There must be proper systems of control (I.C.S).
iv) Wages procedures must be proper and satisfactory.
v) Records can be applicable and with minimal clerical work.
vi) CA department must be established and responsibilities clearly defined.
vii) CA ad FA must be maintained in such a way that their results are reconciled.

Purpose / Objectives of Cost Accounting.

1) Cost control – Cost should be kept at minimum at all operations.
2) Decision making – Managers are responsible for internal decisions such as what to produce
and in what quantities. In this case CA system assists in making such decisions.
3) Planning – CA uses budgets generated from past experiences. Planning is the process of
deciding what to do and identifying desired results and budgets prepared for the coming
periods will incorporate future plans for the purpose of their implementation.
4) Cost ascertainment – Cost of producing a commodity or providing a service must be
accurately ascertained so that they can be kept at a minimum.
5) Disclosure of waste – Expected results are compared with actual results. If actual costs
are less than expected, the department is considered efficient otherwise, it’s considered
wasteful (inefficient).
6) Performance evaluation – Standards of performance are normally set at the beginning of
the period. At the end of the period, actual results are compared with the standards for
evaluation. This helps in showing areas in need of improvement.
7) Setting of selling price – It’s advisable that cost of the product be ascertained first and
then a profit mark-up added to the cost to determine the selling price covers all the
relevance costs of the product.
 8) Profit determination. Profits made on good s and services be established by asnalysing the
revenues and costs of production.

Basic terminologies.

1. Cost Unit – A unit of product or service to which cost can be related. It’s the basic control
unit for costing purpose. It’s a unit of measure of a product eg a student in a university, a
kg of sugar, a litre of milk, patient in hospital, a guest in a hotel etc.
2. Unit Cost – (Cost per Unit) it refers to the cost of production per unit of output. It’s in
monitory value for example material cost per kg, per litre or fees per student.
3. Incremental cost- refers to the change in total cost (both variable and fixed when
comparing 2 alternatives or when among a decision.
4. Marginal cost- refers to the change in variable cost when comparing 2 alternatives or when
making a decision.
5. Discreet cost – are cost which incurred at the discretion of management i.e. the
management has the freedom to decide whether the cost should be incurred or not.
6. Imputed cost- these are hypothetical cost which are not cost in the strict sense of the
word because there are no financial obligations to pay any money e.g. the rent of premised
which are owned by the organization can sometimes be included as a cost in their books.
7. Cost Centre – Any part/unit of the organisation responsible only for cost control; it only
incurs cost for example procurement department, production, accounting, stalls, registry.
8. Profit Centre – That part of the organisation responsible for both cost control and
revenue maximisation that is, the earn revenue and incur cost.
9. Revenue Centre – That part of the organisation responsible only for revenue generation
for example it’s not accountable for cost but responsible for maximisation of income for
example sales and marketing department.
10. Investment Centre – The part of the organisation charged with an additional responsibility
of capital investment and financing of the investment. Performance is normally measured
using Return On Investment (ROI) and Residual Income (RI).
11. Responsibility Centre – is a department / division of an organisation whose performance is
the direct responsibility of specific managers.

LIMITATIONS OF MANAGEMENT ACCOUNTING.

1. It is used on accounting information.

Management Accounting reports are based on accounting information, both internal and

external sources, correctness and effectiveness of managerial decisions will depend on the

quality and accuracy of the data on which the decisions are to be based.
 If the data is not reliable, management accounting reports will not provide correct analysis of

actual situation.

2. Lack of knowledge on related subjects.

The application of management accounting will be useful to management and related subjects

such as statistics, economics, calculus, principle of management, management information

system needed etc.

In Management Accounting, decisions should be based on facts and figures but not past

experiences and past decisions.

3. Management decisions are not alternative to administration.

That is the tools and techniques of management only provides information but not decisions.

4. Decisions should always be made by management after taking into consideration other

factors.

5. Evolutionary nature of Management Accounting.

Management Accounting is only in its developmental stage. The techniques and tools used may

give different results and recommendations.

FUNCTIONS OF MANAGEMENT ACCOUNTANT.

i. Collecting accurate, reliable and sufficient information for decision-making.

ii. Designing cost accounting information system.

iii. Maintaining accounting records and preparation of financial estimates.

iv. Helps in preparation of budgets.

v. Preparation of performance reports, control reports and special management reports.

vi. Interpreting accounting data based on a particular requirement of a manager in the

organization.

vii. Ensuring that accounting information systems is adequate and useful in accordance to the

budget and decision requirement.

viii. Helps or aids other managers in making operation decisions.

ETHICAL STANDARDS OF MANAGEMENT ACCOUNTANT.

Each member of CIMA should behave ethically. Below are some of the ethical standards:
1. Competence.

Each member has a responsibility to;

i. Maintain an appropriate level of professional expertise by continuously developing

knowledge and skills.

ii. Perform professional duties in accordance with relevant rules, regulations and technical

standards.

iii. Provide decision support information and recommendations that are accurate, clear,

concise and timely.

iv. Recognize and communicate professional limitations and other constraints that would

prevent responsible judgement and successive performance of an activity.

2. Confidentiality.

Each member has a responsibility to;

i. Keep information confidential except when disclosure is authorized or legally required.

ii. Refrain from using confidential information for unethical or illegal advantage.

iii. Inform all relevant parties regarding appropriate use of confidential information.

3. Integrity.

Each member has a responsibility to mitigate actual conflict of interest and communicate with

business associates. Avoid apparent conflict of interest and refrain from engaging in any

conduct that prejudice carrying out duties ethically.

4. Credibility.

Each member has a responsibility to;

i. Communicate information fairly and objectively.

ii. Disclosure all relevant information that could be reasonable and expected to affect the

intended understanding of the user on the reports and the recommendation.

iii. Disclose delays or deficiency information.

5. Professionalism

6. Objectivity
TOPIC 2: CLASSIFICATION OF COSTS

Cost may be classified on the following bases:

 Functions
 Behaviour
 Traceability to end product
 Time
 Identify with stock
 Controllability
 Relevance for decision making

1. Classification by Function
On the basis of function, costs may be classified into production cost, administration cost, selling
and distribution cost and research and development cost.

a) Production Cost
These are cost incurred in the factory in the production of goods e.g. Raw materials, labour,
factory rent etc.

b) Administration Cost
These are costs incurred in the general management of the business e.g. office rent, salaries of
office staff, depreciation of office machinery etc.

c) Selling and distributing cost

These are costs incurred in making the final products available in the market and convincing/
persuading customers to adopt them e.g. advertisement, delivery and sales commissions etc.

d) Research and development

These are costs incurred in developing new products and also improving on existing ones.

2. Classification by traceability to end products

a) Direct cost
Are costs that can be traced to the final products i.e. they can specifically be identified with the
end products e.g. direct materials like timber in furniture, direct labour like wages paid to
carpenters and direct expense like the hire of special equipment.

b) Indirect Cost (Overheads)

Are costs which are not traceable to the final products or may be traceable but constitute small
proportions of the overall cost. They include:
 Indirect material like the cost of lubricating oils, paper, rivets, vanish etc.
 Indirect labour e.g. the salaries paid to indirect workers like watchmen, cleaners etc.
 Indirect expense like factory rents, factory power and other utilities, depreciation of
factory plants and equipment etc.
Classification by Cost Behaviour/nature of cost
Cost behaviour refers to the changes in the cost arising from the changes in activity level.
Activity level in an enterprise may be measured using the number of unit produced, sales volume,
labour hour etc.

On the basis o behaviour cost can be classified into: -

i) Variable costs: Are cost which change with a change in the level activity. Variable costs can be
described by a straight line equation of the form y = bx

Where:
y = total cost.
b = variable cost per unit.
X = number of unit (activity level)

Graphically Variable costs are represented as: -

Cost y = bx

ii) Fixed cost - are costs which remain constant irrespective of the changes in the level of
activity. They are represented by a straight line equation of the form y = a

Where:
y = Total cost
a = Total fixed cost

Activity level
Graphically, fixed cost can be represented as follows

Cost

a Y= a
iii) Mixed cost: - Are cost with characteristic of both variables and fixed cost hey are
further classified into semi-variable cost and semi-fixed cost.

a) Semi- variable cost: - Are cost where some components are fixed and some varies with
activity level. It can be described by a straight line e.g… of the form.
Y= a + bx where y= total cost, b = variable cost per unit
x = number of units (activity level)
a= fixed cost.

Graphically semi-variable costs are represented as follows.

Cost y = a +bx

Activity level

b) Semi-fixed costs – Are cost which remain fixed within a given range of activity beyond
which the cos changes to the new level where it remains constant within another new range
of activity in a stepped /faction.
Cost

Activity level
Classified by time
On the basis of time cost can be classified into: -
- Sunk cost- is the cost that has already been incurred i.e. cost relating to 2 past transaction.
- These are historical costs which are considered to be irrelevant for classification making
purpose because they cannot affect future decision.
- Future cost- are estimated for decision making purpose because the can affect future
decision.

Classifications based on identification with stock.

1. Product cost: - refers to costs that are used in the valuation of the stock finishes gods.
They’re also referred to as inventoriable cost, since they form part of product cost. Such
costs are into charged to the P&L a/c until the gods produced have been sold. If the goods
are not sold, the cost is carried forward in the form of stock to be written off against future
sales.
2. Period cost - there’re cost that arise by virtue of passage of time and are W/off through the
P&L a/c whether the good produced have been sold or e.g. insurance cost.

Classifications on the basis of controllability

1. controllable costs- are costs which can be influenced by management in the long run without
negatively affecting the business operating e.g. research cost, marketing costs a/c cost etc
2. Uncontrollable cost- they cannot be influenced by managerial decision in the short run e.g.
insurance cost.

Classification based on the relevance for decision making

ii) Relevant cost – Are cost that result in a unique alternative in a decision making
environment such cost usually differ between alternatives e.g. future cost, controllable
costs etc.
iii) Irrelevant cost- They may not give a unique alternative in a decision making situation
either because they’re already been incurred or they do not differ between the
alternative e.g. sunk cost, uncontrollable.

CPA Benjamin Kinuthia