CHAPTER ONE

1. Overview of Cost and Management Accounting

1.1 Objectives of Cost & Management Accounting
Cost accounting reports financial and other information related to the organization’s acquisition and
consumption of resources. It deals with the identification, accumulation, allocation, and control of costs. It
provides the information for both management accounting and financial accounting.
Cost accounting is the process of accumulating the cost of manufacturing and other functional process and
identifying these costs with unit produced or some other object.
Cost accounting is applied in any type of organization but primarily applied in manufacturing organization that
combine and process raw martial in to finished product.
Cost accounting provides information for both management accounting and financial accounting.
It is a subfield of managerial accounting that interfaces with both managerial and financial accounting
Objectives of cost accounting
1. Ascertainment of cost: - this is the primary objective of cost accounting. For cost ascertainment,
different techniques and systems of costing are used in different industries.
2. Control of cost: - cost control aims at improving efficiency by controlling and reducing cost.
3. Guide to business policy: - cost accounting aims at serving the needs of management in conducting the
business with utmost efficiency. Cost data provide guidelines for various managerial decisions like
make or buy, selling below cost, etc
4. Determination of selling price: - cost accounting provides cost information on the basis of selling
prices of products or services may be fixed.
1.2 Cost and management accounting in comparison with financial accounting
Financial and Management Accounting
Financial accounting includes all the principles that regulate the accounting for and reporting for financial
information that must be disclosed to people outside the company, to stockholders, bankers, creditors, and
brokers. In contrast, management accounting exists primarily for the benefit of those inside the company, the
people who are responsible for its operations.
Many of the procedures and principles that stem from financial accounting also apply to management
accounting. Depreciation techniques, cash collection and disbursement procedures, inventory valuation
methods, and the recognition of what is an asset or a liability are all essential to the study of management
accounting. But, because their output is communicated to different audiences for different reasons, financial
accountants and management accountants follow different rules. The rules of management accounting are
somewhat less defined and place fewer restrictions on the accountant’s day-to-day activities.

COMPARISON OF FINANCIAL AND MANAGEMENT ACCOUNTING

Areas of Comparison Financial Accounting Management Accounting

1. Primary users of Persons and organization Various levels of internal

information outside the business entity management
2. Types of accounting Double entry system Not restricted to double entry system;
systems any useful system can be used

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3. Restrictive guidelines Adherence to GAAP No formal guidelines or restrictions,
only criterion is useful
4. Units of measurement Historical (past) dollars Any useful monetary (historical and
future) or physical measure

5. Focal point for analysis Business entity as a whole Various segments of a business
entity.
6. Frequency of reporting Periodical on a regular basis When ever needed; may not be on a
regular basis

Management accounting can be defined as the process of identification, measurement, accumulation, analysis,
preparation, interpretation, and communication of financial as well as non financial information used by
management to plan, evaluate, control within the organization and to assure appropriate use and accountability
for its resources.
The management accountant is expected to provide timely, accurate information-.including budgets,
standard costs, variance analysis, support day-to-day operating decisions, and analyses of expenditures.
The management accounting consists of accounting techniques and procedures of gathering and reporting
financial, production, and distribution data in order to meet management’s information needs.
1.3 Cost classification concepts and terms, such as: Definition of Costs
The word ‘cost’ is usually used in our day to day conversation. It is a generic term that anyone needs to know.
Cost is the amount of resource given up in exchange for some present and future benefits. The resource given
up is always expressed in terms of money. Cost plays a significant role in managerial functions such as
planning, controlling, decision-making, and directing operation activities. To guide decisions, managers want to
know the cost of something. This ‘something’ may be a product, a service, a department, or any activity. We
call this ‘something’ cost object and is defined as anything for which a separate measurement of cost is desired.
Always activities consume resources and resources involve costs.
1.3.1 Classification of costs
Different cost concepts and classifications are used for different purposes. Understanding these concepts and
classifications enables the cost accountant to provide appropriate costs data to the managers who need it. The
purpose of the classification determines how the classification should be done.
These classifications are based on the following:
1. Relationship of the cost to the product.
2. The department where the cost is incurred.
3. The major Functional areas.
4. Relationship of the cost to the production process.
5. The period to which the cost is charged to income.
6. The ability to be traced
7. Relationship of cost to planning, controlling, and decision making.
1. Relationship of the cost to the product
Based on the relation ship of costs to the product, costs can be classified as direct material, direct labor, and
overhead costs. This classification provides management with information necessary for income measurement
and product pricing. The elements of a product cost are: - Materials, Labor and Others facilities (called factory
overhead costs)
I. materials: - are the principal substances used in production that are transformed into finished goods by the
addition of direct labor and factory overhead. The cost of materials may be divided into direct and indirect.

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Direct materials cost: -These are cost of all materials used in the production process that can be identified with
the finished product, that can be easily and economically traced to the product and that represent a major
material cost of producing that product. They are the integral part of finished products.
Indirect materials costs: - These are all materials used in the production of a product, that can not be easily
and conveniently traced to the product, and that do not represent significant material cost of the product. It is
difficult to determine such costs on a per unit basis as a result these will be considered as part of the factory
overhead.
II. Labor: - is the physical and/or mental effort expended in the production of a product. Labor costs are
divided into direct and indirect.
Direct labor cost: - It represents the cost of all labor actually involved in the production of a product, that can
be easily and economically traced to the product in an economically feasible way and that represent a major
labor cost of producing that product.” Economically feasible” means “cost effective “, in the sense that
managers do not want cost accounting to be too expensive in relation to expected benefits. It is the wage cost of
employees working directly on the product as assemblers, machinists, painters, welders, and some machine
operators. Direct labor is sometimes referred to as "touch labor" since it consists of the costs of workers who
"touch" the product as it is being made. Direct labor is declining as a percentage of total manufacturing cost as
automation increases in manufacturing facilities.
Indirect labor cost: -It is cost of labor expended in the production process indirectly and that can not be easily
traced to the product and is part of the manufacturing overhead. Indirect labor include factory line supervisors,
factory department heads, factory clerical workers, time keepers, janitors and factory, guards, receiving clerks
(material handlers), maintenance persons, fringe benefits to both direct and indirect laborers
III . Factory overhead (foh)
It consists of all manufacturing costs other than direct materials and direct labor. It is an all-inclusive cost pool
used to accumulate all indirect manufacturing costs, which cannot be directly identified with specific cost
object. These costs cannot be easily and conveniently traced to products. All indirect material and labor and
many other costs including depreciation on manufacturing facilities are synonymous with indirect
manufacturing cost. Overhead benefits some or all manufacturing activities but cannot be related to individual
products. FOH is sometimes called manufacturing overhead, factory burden, and indirect manufacturing
expenses.
Examples of FOH include indirect materials cost, indirect labor cost, factory rent, factory insurance, heat, light
and power, factory depreciation etc.
Therefore, the following equations hold true
FOH costs = Indirect Material + Indirect Labor + Other Indirect Manufacturing Costs
Manufacturing Cost = Direct Material Cost + Direct Labor Cost + FOH
Here is a partial listing of the most common costs in a typical factory operation.

Indirect materials Indirect labor Other manufacturing overheads

- Shop supplies - Factory line supervisors - Employee fringe benefits
- Lubricants - Factory clerical workers - Payroll taxes
- Factory office supplies - Timekeepers - Workers’ compensation insurance
- Small tools - Factory superintendents - Factory utilities
- Packaging materials - Janitors - Rent of factory building, warehouse, and
-Items used in small amounts - Receiving clerks equipment
in the manufacturing process - Storeroom supervisors/clerks -Depreciation of factory building
- Purchasing employees &equipment
-Idle-time costs of direct workers - Fire and casualty insurance

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 - Overtime premiums of direct - Property taxes
workers - Group insurance for factory employees
- Repairs and maintenance
- Spoiled goods

2. The department where the cost is incurred

In manufacturing businesses departments can be classified into manufacturing (or producing) and non-
manufacturing (or service) departments. The manufacturing/non-manufacturing cost classification is important
in all cost accounting functions.
Producing department costs: are costs incurred in departments that contribute directly to the production of the
item and include costs of departments in which conversion and production process takes place.
Service department costs: are costs incurred in departments which are not directly related to the production of
the item but provide services to other departments. The cost of maintenance, accounting, health and other
departments are considered as non-manufacturing or service department costs.
3. Major Functional areas
Costs can also be classified based on the functional areas of an organization. All costs of a manufacturing
organization may be divided into manufacturing, marketing, administrative and financing.
Manufacturing costs: are costs related to the manufacturing or production process of an item. It is the sum of
direct material, direct labor, and factory overhead.
Marketing costs: are costs incurred in promoting or selling a product or service. Examples include
advertisement costs, transportation costs, etc.
Administrative costs: are incurred in directing, controlling and operating a company. The salary of the general
manager is an example.
4. Relationship of the cost to the production process
Based on the relationship of the costs to the production process, we can classify costs into prime costs and
conversion costs.
Prime costs are costs which are directly related to the production of a product. Prime cost is the sum of direct
material costs and direct labor costs.
Conversion costs, called processing costs, are costs concerned with transforming direct materials into finished
products. They are the sum of direct labor and factory overhead costs. Therefore, the following equations hold
true:
Prime cost = DM + DL
Conversion Cost = DL + FOH
Manufacturing Cost = Direct Material Cost + Direct Labor Cost + FOH
Manufacturing Cost = PC + CC – DL
5. The period to which the cost is charged to income
Costs may also be classified on the basis of the time or accounting period they are to be charged against
revenue. Some costs are first recorded as assets and then expensed as they are used or expired. Other costs are
immediately expensed in the year of incurrence. Product costs and periodic costs are the two categories
according to this classification.
Product costs: are costs directly and indirectly identifiable with the product. These costs provide no benefit
until the product is sold and are therefore inventoriable, i.e. it is part of the finished product. Product costs are
added to units of product (i.e., "inventoried") as they are incurred and are not treated as expenses until the units
are sold. This can result in a delay of one or more periods between the time in which the cost is incurred and
when it appears as an expense on the income statement. Product costs are also known as inventoriable costs.

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Periodic costs: are neither directly nor indirectly related to the product. They are expensed (charged against
revenue) immediately and are therefore non- inventoriabl. All selling and administrative costs are typically
considered to be periodic costs. These costs are also called non-inventoriabl costs. Product costs become
periodic cost when products are sold.
6 The ability to be traced
A cost may be classified as direct and indirect based on management ability to trace it to specific jobs,
departments and units or generally to specific cost objects.
Direct costs: are costs that management is capable of tracing them to specific items or areas in an economically
feasible way. These are costs that could be traced to specific units in a cost-effective manner. Direct material
and direct labor costs are example of direct cost of products.
Indirect costs: are costs that are common to many items and are therefore not directly traceable to any specific
item (cost object). These costs are usually charged to items (cost objects) through allocation techniques. For a
product indirect material, indirect labor, other FOH costs are indirect costs. There are two reasons why a cost
would be considered indirect: either it is impossible or it is impractical to trace the cost to the cost object.
For example, it is impossible to trace the factory managers’ salary in a multi-product plant to any particular
product made in the plant. Even if a product were dropped entirely, we would ordinarily expect the factory
manager’s salary to remain the same. This is an example of a "common cost".
7. Relationship of cost to planning, controlling, and decision making
Every decision involves choosing from among at least two alternatives. Only those costs and benefits that differ
between alternatives are relevant in making the selection.
A. Relevant and Irrelevant Costs
A relevant cost is a future cost that differs among alternatives. Relevant costs also are called differential or
incremental costs. Restricting attention to relevant costs greatly simplifies the decision making process. When
deciding among alternatives, only those costs and revenues that change need be considered. Managers
appreciate simplified reports that include only the information they need to make decisions. An irrelevant cost is
one that is the same for all decision alternatives. These costs need not to be considered.
A direct or variable cost is not necessarily a relevant cost. For example, direct material is a variable cost and is
a direct cost with respect to output in units. But in a decision concerning whether to increase automation to
reduce direct labor in the production process, direct material is not a relevant cost. The amount of material per
unit is the same regardless of how units are produced.
B. Controllable and Uncontrollable Costs
Controllable costs are those which may be directly influenced by unit managers in a given time period. Non-
controllable costs are those costs which are not directly administered at a given level of management authority.
Primarily used for the evaluation of the segment management, this classification seeks to separate costs into
those that can be influenced by management, and those that cannot be. Managers perceive the evaluation
process to be more fair if they are evaluated only over those activities and costs they can influence. For
example, depreciation on existing equipment is not controllable because the cost of the equipment is sunk.
Again, a controllable cost is not necessarily direct or variable.
C. Standard and Budgeted costs:
Standard costs are those costs which should be incurred in a particular production process under normal
conditions. Standard costing is usually concerned with per-unit costs of direct material, direct labor and FOH,
whereas budgeted costs usually provide forecasted activity on a total cost basis.

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D. Opportunity Costs.
An opportunity cost is the potential benefit that is given up by selecting one alternative over another. An
opportunity cost is not an actual expenditure and it is rarely (if ever) shown on the accounting books of an
organization. It is, however, a cost that must be considered in decisions.

E. Sunk Cost.

A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in
the future. Since sunk costs cannot be changed and therefore cannot be differential costs, they should be ignored
in decision-making. While students usually intellectually accept the idea that sunk costs should be ignored, they
often have difficulty putting this idea into practice. A sunk cost is an amount of cash that has been spent and it
cannot be recovered. For example, if you are considering selling a used car, the amount you paid for it two
years ago is sunk. It should not influence the amount you accept when you sell the car. The value of a used car
is set by the market. There is an active market for all types of used cars. A sunk cost is by definition irrelevant
because it cannot differ across decision alternatives. The two alternatives here are: (1) sell the car, or (2) keep
the car. The amount paid for the car in the past is the same either way and cannot influence the decision.
1.4 The use of linear, curvilinear and step functions and how their calculations are used to analyze cost
behavior
Cost Classification for Predicting Cost Behaviour
Cost behaviour mans how a cost will react or respond to changes in the level of business activity. As the activity
level rises and falls, a particular cost may rises and fall as well or it may remain constant.
 Variable Cost
 A variable cost is a cost that varies, in total, in direct proportion to change in the level of activity. The
activity can be expressed in many ways such as units produced, units sold, miles driven, beds occupied,
hours worked and so on.
 A good example of a variable cost is direct materials. The cost of direct materials used during a period will
vary, in total, in direct proportion to the number of units that are produced.
 In variable cost, the total cost rises and falls as the activity level rises and falls. One interesting aspect of
variable cost behaviour is that a variable cost is constant if expressed on a per unit basis.
Let’s assume that we manufacture autos, each auto requires a battery that costs Br. 24 each. If only 1 auto is
manufactured the total variable cost for batteries is Br. 24.
No. of Autos Produced Cost for Battery Total VC-Batteries
1 Br. 24 Br. 24
500 24 12,000
1000 24 24,000

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  Fixed Cost
 A fixed cost is a cost that remains constant in total regardless of changes in the level of activity. Unlike
variable costs, fixed costs are not affected by changes in activity.
 Consequently, as the activity level rises and falls, the fixed costs remain constant in total amount unless
influenced by some outside force, such as price changes.
E.g.:- Rent Expense
 When we say a cost is fixed, we mean it is fixed within some relevant range. The relevant range is the
range of activity within which the assumptions about variable and fixed costs are valid.
 Fixed costs can create difficulties if it becomes necessary to express the costs on per unit basis. This is
because if fixed costs are expressed on a per unit basis, they will react inversely with changes in activity.
Monthly Rental Cost No. of Tests Performed Average Cost per Test
Br. 8,000 10 Br. 800
8,000 500 16
8,000 2000 4
Ex: 1 : Classify the following as variable cost or fixed cost.
a. President’s salary
b. Direct labour
c. Straight-line depreciation on factory building
d. Commissions paid to sales persons.
e. Direct material
f. Advertising
Ex 2: Guild Company manufactures and sells one product. The production can vary from 20,000 to 60,000 units. A
partially schedule of the company’s total and per unit costs for the coming year follows:
Units produced and sold
20,000 40,000 60,000
Total costs:
Variable costs $ 80,000 ? ?Fixed costs
100,000 ? ?
Total costs $ 180,000 ? ?
Cost per unit:
Variable cost ? ? ?
Fixed cost ? ? ?
Total cost per unit ? ? ?
Required:
1. Compute the schedule for Guild Company’s total and per unit costs.
2. Determine the cost formula in the format of Y=Mx +b
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1.5 The concepts of cost units, cost centers and profit centers
What Is a Cost Unit?
After costs have been ascertained, accumulated, classified, and recorded, they must be related to a convenient
measure of the quantity of the product or service. This measure of the quantity of a product or service is known
as the cost unit.
A cost unit is defined as "a unit of quantity of product, service, or time (or a combination of these) in relation to
which costs may be ascertained or expressed."
In other words, a cost unit is a standard or unit of measurement of the goods manufactured or services rendered.
A cost unit may be expressed in terms of number, length, area, weight, volume, time, or value.
Characteristics of a Cost Unit
A unit of cost must possess the following characteristics:
• It must be one that expenditure can be conveniently associated with.
• It must be appropriate or natural to business operations and the product.
• It must be certain or definite and not change over time.
• It must be simple to understand and to quote.
• It must be universally accepted
Types of Cost Units
• Cost units can be categorized as follows:
• Simple Unit: These use a single standard or unit of measurement of the goods manufactured (e.g., per
piece, per kilogram, per quintal, per ton, per gallon, or per meter).
• Composite Unit or Complex Unit: These combine two simple units (e.g., per passenger-kilometer, per
ton-kilometer, or per kilowatt-hour).
• The terms of measurement used in cost units are:
What Is a Cost Center? The Institute of Cost and Management Accountants (ICMA), which is based in
London, defined a cost center a location, person, or item of equipment (or a group of these) for which costs may
be ascertained and used for the purposes of cost control.
That's to say, a cost center refers to any place, person, machine, section, part, activity, or function within an
organization or undertaking by which costs are collected or accumulated, and to which costs are allocated.
Given the above, a cost center is, therefore, a natural division of an undertaking that helps to measure and
understand operational costs and apply costs to products.
A cost center in a company is formed by considering the convenience of cost accumulation, comparability, and
cost control.
If costs are accumulated for a person, machine, or department, then this entity will be treated as a cost center.
In an undertaking, cost centers may be divided into two parts:
• Production cost centers
• Service cost centers
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A production cost center refers to a cost center that is engaged in regular production (e.g., converting raw
materials into finished products).
A service cost center is a center that is not engaged in regular production, but which assists the production cost
centers in implementing their activities (e.g., store department, personnel department, or maintenance
department).
Cost centers can also be divided into operation cost centers and process cost centers, as well as personal cost
centers and impersonal cost centers.
Operation cost centers are cost centers that consist of machines and/or persons carrying out similar operations,
while a process cost center is one that consists of a specific process or a continuous sequence of operations.
A personal cost center is a cost center that consists of a person or group of persons (e.g., departmental foreman,
salesman, supervisor, and factory manager).
An impersonal cost center refers to a cost center that consists of a location, item of equipment, or a group of
these (e.g., machines, departments, and vehicles).
Factors for Selecting a Suitable and Effective Cost Center
The selection of a suitable cost center depends on several factors, including:
• Layout and organization of a factory
• Availability of cost data and information
• Management policy regarding the selection of cost centers
Classification of Cost Centers
Cost centers can be classified under the following three broad areas:
• Productive, Unproductive, and Mixed Cost Centers
Factories might choose productive cost centers whereas an administrative wing might choose an unproductive
cost center. Similarly, a tool department may choose a mixed cost center.
• Personal and Impersonal Cost Centers
When a plant or machine is taken as a unit, it is an impersonal cost center; when a person or group of persons is
taken as a unit, the personal cost center is implied.
According to the Institute of Cost and Management Accountants, "Impersonal cost center consists of a location
of item of equipment whereas personal cost center consists of a person or a group of persons."
• Operation and Process Cost Centers
According to the Institute of Cost and Management Accountants, the "operation cost center is a center which
consists of those machines and/or persons which carry out the same operations."
By contrast, the "process cost center is a cost center which consists of a continuous sequence of operations."
What is Profit Centre?
A profit centre is a type of responsibility centre wherein the manager of the centre or unit is responsible for both
cost and revenue for the asset assigned to the division. Here, we measure inputs in terms of expenses. Whereas

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we measure outputs in terms of revenues. In this way, the measurement of both the elements, i.e. cost (input)
and revenue (output) is in terms of money. And the difference between these two elements is the profit.
Profit Centre refers to that part of the firm for which collection of both cost and revenue takes place. These are
responsible for generating profit be it through controlling cost or increasing revenue. The managers of profit
centers focus on both the production and marketing of the product. It is the responsibility of the manager of the
profit centre to generate revenue and incur costs in a manner to maximize profit.
We measure the performance of a profit centre on the basis of whether the centre succeeded in achieving its
budgeted profit or not. We can also say that the company’s division that produces and markets products is the
profit centre. The manager of the division decides:
• Selling price
• Marketing programmes
• Production policies
With the help of the profit centre, it is easier to analyse how much each centre generates profit.
Example of Profit Centre
Kia can identify the highly profitable car models by making a comparison of the profit made by each model.
Similarly, a Supermarket chain like Big Bazaar or Wal-Mart can identify their highly profitable stores by
making a comparison of the profit made by each centre.
Important: As per Generally Accepted Accounting Principles (GAAP), we recognize revenue only when the
company makes sales to outside customers. But to measure the performance of a profit centre, revenue indicates
the monetary measurement of the output of a profit centre in a particular accounting period, regardless of the
fact that the firm has actually realized the revenue for that period.
Advantages of Profit Centre
• Broad-based measurement
• Relief to top management from day-to-day decision making
• Improvement in the quality of decisions
Disadvantages of Profit Centre
• Sub-units may compete with each other, leading to a lack of coordination
• Increase in friction among various divisions. Also arguments over transfer price that one profit centre is
going to charge from another may be there.

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