FUNDAMENTALS OF ACCOUNTING

Management, Cost and Financial accounting

Cost accounting is a system for recording data and producing information about costs for the
products produced by an organisation and/or the services it provides. It is also used to establish
costs for particular activities or responsibility centres.

• Cost accounting involves a careful evaluation of the resources used within the enterprise.

• The techniques employed in cost accounting are designed to provide financial information
about the performance of the enterprise and possibly the direction that future operations should
take.

• The terms ‘cost accounting’ and ‘management accounting’ are often used to mean the same
thing.

• Management accounting has cost accounting at its essential foundation.

Financial Accounting

Financial accounting involves recording the financial transactions of an organisation and

summarising them in periodic financial statements for external users who wish to analyse and
interpret the financial position of the organisation.

• The main duties of the financial accountant include: maintaining the bookkeeping system of the
nominal ledger, payables control account, receivables control account and so on and to prepare
financial statements as required by law and accounting standards.

• Information produced by the financial accounting system is usually insufficient for the needs of
management for decision making.

Difference Between Cost Accounting and Financial Accounting

Aspect Cost Accounting Financial Accounting

Focuses on recording, analyzing, Focuses on recording and summarizing
Definition and controlling costs related to financial transactions for external and
production and operations. internal stakeholders.
Helps management in cost control, Provides a true and fair financial
Purpose decision-making, and improving position and performance of the
efficiency. business.

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 Aspect Cost Accounting Financial Accounting
Internal users (management, External users (investors, creditors,
Users
employees). regulators) and internal users.
Reporting Continuous process with real-time Periodic (monthly, quarterly, or
Frequency cost tracking. annually).
Regulatory Not legally required, but essential Legally required and follows accounting
Requirement for internal decision-making. standards (e.g., IFRS, GAAP).
Analyzes costs of materials, labor, Focuses on the overall financial
Focus and overhead to optimize performance, including profit and loss,
operations. assets, and liabilities.
Time Future-oriented, used for planning Historical, based on past financial
Orientation and budgeting. transactions.
Uses techniques like standard Follows double-entry system and
Accounting
costing, marginal costing, and financial statements (income statement,
Method
activity-based costing. balance sheet, cash flow statement).
Helps in investment decisions, financial
Decision- Helps in pricing, cost-cutting, and
health assessment, and regulatory
Making efficiency improvement.
compliance.

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 COST BEHAVIOR

Cost refers to the monetary value of resources sacrificed or spent to acquire goods or services. It
includes expenses incurred in production, operations, or other business activities.

Classifying costs

Costs can be classified in a number of different ways.

• Element – classify costs as to whether they relate to material, labour or expenses. This is useful
for cost control.

• Nature – classify costs as to how they relate to production. Are they directly involved in the
production of the product/service or indirectly involved in production? This is useful for cost
accounting.

• Function – classify costs based on whether they are production costs or non-production costs.
This is useful for the financial accounts.

• Behaviour – classify costs based on how they change in relation to levels of output or activity.
This is useful for budgeting and decision making.

Classification by element

To classify by element you need to decide if a cost is a material cost, a labour cost or a cost relating
to something else – an expense.

• Materials – all costs of materials purchased for production or nonproduction activities. For
example, raw materials, components, cleaning materials, maintenance materials and stationery.

• Labour – all staff costs relating to employees on the payroll of the organisation.

• Expenses – all other costs which are not materials or labour. This includes all bought-in services,
for example, rent, telephone, subcontractors and costs such as the depreciation of equipment.

Classification by nature

Direct costs

Direct costs are costs which can be directly identified with a specific cost unit or cost centre.

There are three main types of direct cost – direct material, direct labour and direct expenses. The
direct costs associated with a shirt (cost unit) manufactured by a clothing company would be:

• direct materials – cloth for making shirts

• direct labour – the wages of the workers stitching the cloth to make the shirts

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• direct expenses – the royalties paid to a designer.

The total of direct costs is known as the prime cost.

Indirect costs

Indirect costs are costs which cannot be directly identified with a specific cost unit or cost centre.

The indirect costs associated with a shirt (cost unit) manufactured by a clothing company would
be:

• indirect materials – these include materials that cannot be traced to an individual item for
example cleaning fluids for cleaning the machinery

• indirect labour – the cost of a supervisor who supervises the shirt makers

• indirect expenses – the cost of renting the factory where the shirts are manufactured.

The total of indirect costs is known as overheads.

Classification by function

Production costs

Production costs are costs that relate to the manufacture of a product or provision of a service.
These costs are found in the cost of sales section of the statement of profit or loss.

Production costs, such as direct materials, direct labour, direct expenses and production
overheads, are included in the valuation of inventory.

Non-production costs

Non-production costs are costs that are not directly associated with the production of the
businesses output.

Non-production costs, such as administrative costs, selling costs and finance costs, are charged to
the statement of profit or loss as expenses for the period in which they are incurred. Non-
production costs are not included in the valuation of inventory.

Classification by behaviour

Costs may be classified according to the way that they behave in relation to changes in levels of
activity. Cost behaviour classifies costs as one of the following:

• variable cost

• fixed cost

• stepped fixed cost

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• semi-variable cost.

Variable costs

Variable costs are costs that vary in direct proportion with the level of activity. As activity levels
increase then total variable costs will also increase.

Fixed costs

A fixed cost is a cost which is incurred for an accounting period, and which, within certain activity
levels remains constant.

Semi-variable costs

Semi-variable costs contain both fixed and variable cost elements and are therefore partly
affected by changes in the level of activity.

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 The high low method used for separating a semi-variable cost
The total cost of a semi-variable cost is:

Total costs = Total fixed costs + (Variable cost per unit × Activity level)

To be able to predict costs at different activity levels it is necessary to separate the fixed cost
element from the variable cost element. The high low method can be used to approximate the
variable cost per unit and the total fixed cost.

The high low method

Step 1

Select the highest and lowest activity levels, and their associated costs.

Step 2

Calculate the variable cost (VC) per unit:

VC per unit = (Cost at high level of activity – cost at low level of activity)/(High level of activity –
low level of activity)

Step 3

Calculate the fixed cost by substitution, using either the high or low activity level:

Fixed cost = Total cost at activity level – (Variable cost per unit × Activity level)

Step 4

Use the total fixed cost and the variable cost per unit values from steps 2 and 3 to calculate the
estimated cost at different activity levels:

Total costs = Total fixed costs + (Variable cost per unit × Activity level)

Example

Output (units) Total cost ($)

200 7,000

300 8,000

400 9,000

Required:

(a) Calculate the variable cost per unit.

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(b) Calculate the total fixed cost.

(c) Estimate the total cost if output is 350 units.

(d) Estimate the total cost if output is 600 units.

Example 2

The total costs incurred at various output levels in a factory have been

measured as follows:

Output (units) Total cost ($)

26 6,566

30 6,510

33 6,800

44 6,985

48 7,380

50 7,310

Required:

Using the high low method, analyse the total cost into fixed and variable components.

Advantages and limitations of the high low method

The main advantage of the high low method is that it is easy to understand and easy to use.

The limitations of the high low method are as follows:

• it relies on historical cost data and assumes this data can reliably predict future costs

• it assumes that activity levels are the only factor affecting costs

• it uses only two values (highest and lowest) to predict future costs and these results may be
distorted because of random variations which may have occurred

• bulk discounts may be available for purchasing resources in large quantities.