Chapter 1 – Introduction to Cost Accounting

Learning Objectives

After completing this module, you should be able to know the following:

1. What is the difference between financial accounting, managerial accounting and cost
accounting?
2. What are the product-costing systems”
3. What are the uses of cost accounting information?

Comparison of Financial, Managerial and Cost Accounting

Accounting is always referred to as the language of business. As defined by the Accounting

Standards Council, accounting is a service activity. Its function is to provide quantitative
information, primarily financial in nature, about economic entities, that is intended to be useful
in making economic decision.
In other words, accounting supplies financial information to users - both internal and external
users so they can make informed judgment and sound decisions.
Internal users are those working within the company and use financial information primarily
on planning, controlling and making decision for the betterment of the company’s operations.
They are the company’s management itself- Senior/top-level management, middle level
management and low-level management.
External users are those outside of an organization and does not directly run its operations but
uses financial information of the company to make decisions particularly if decisions involve
investing or granting credit to the company.
Financial Accounting
It is an area of accounting which is primarily concerned in recording business transactions and
finally prepares financial statements. Thus, this is usually intended for external use.
Financial accounting adheres strict compliance to Generally Accepted Accounting Principles
(GAAP), the framework of accounting standards, rules and procedures.

Managerial Accounting
Managerial or management accounting is used to gather both the financial and nonfinancial
information needed by internal users. It commonly addresses individual or divisional concerns
rather than the organization as a whole.
This area of accounting measures, analyzes, and reports financial and nonfinancial information
that help managers make decisions to fulfill the goals of an organization.
Managers use management accounting information to choose and implement strategies.
 FINANCIAL ACCOUNTING MANAGERIAL ACCOUNTING
Primary Users External Internal
Purpose of Information Conveys financial information to Helps managers to make
investors, banks, government decisions to fulfill an
regulatory agencies and other organization’s objectives
outside parties
Scope of Information Entire (whole) organization Divisions/Departments/Segments
Emphasis of information Past-oriented Future-Oriented
Characteristics of Must be: May be:
information - Historical data - Current data
- Quantitative - Forecasted data
- Monetary - Quantitative or
- Verifiable Qualitative
- Monetary or
nonmonetary
- Timely
Overriding criteria Generally Accepted Accounting Does not conform with GAAP as
Principles (GAAP) long as it is relevant to
management decision making
and complies with standards set
by the management
Recordkeeping Formal Combination of formal and
informal
Independent examination Financial reports must be audited Does not need to be audited by
and verification process by an independent Certified Public an independent CPA
Accountants (CPA)

Cost Accounting
It is an intersection between financial and managerial accounting. It captures company's costs
of production by assessing the costs incurred to each step of production.
Cost accounting information is needed and used by both financial and managerial accounting.

External parties and management uses product cost information for investment decision and,
planning and controlling.

Product-Costing Systems
1. Job-order costing
2. Process costing

Job-order costing
A system for allocating costs to groups of dissimilar products of which is in accordance with
customer specifications.
It is being used by companies making one-of-a-kind or special-order products. In this system,
costs are assigned to specific job orders or batches of productions like furniture-makers, makers
of custom-made lanyards, t-shirt printing businesses, and custom-made cars makers.

Process Costing
A system for allocating costs to groups of similar products which go through continuous
production even without a direct demand from customers.
It is being used by companies that make a large number of similar products and maintains a
continuous production flow like companies who produces cosmetic products, automobile
companies, appliances manufacturers, cellphone/mobile manufacturers, food and beverage
companies.

Uses of Cost Accounting Data

1. It is being used to determining product costs to help management in making the
following decisions:
• What would be the selling price of a product
• What would be the best selling price to meet competition in the
market
• Given the costs data, what would be the profitability of the
company
2. It also helps management in planning and controlling operations particularly
those decisions involving costs of materials, labor and other factors needed in
the production

COST CONCEPTS AND COST BEHAVIORS

Cost Classification and Categories

Cost Classification Types of Cost Included Description

As to relationship with Direct Cost Directly traceable to the cost object
cost object
Indirect Cost Cannot be directly traced to the
cost object and needs to be
allocated
As to behavior to Variable costs Fluctuates in terms of total costs
changes in activity
Fixed Costs Remains Constant in total Costs

Mixed Costs Partly variable, partly fixed

Step Costs Increases at certain activity levels

As to presentation on Product costs Either in the balance or income

the financial statements statement since it depends whether
goods are sold or not
 If goods are not yet sold, these are
presented in the balance sheet
section of as part of Inventoriable
costs

When goods are sold, it will form

part of the cost of goods sold
section which is an item in the
income statement

Period Costs These are treated as outright

expenses, thus, it is presented in the
income statement

1. As to relationship with cost object

Cost Object
Ø These are items for which management accumulates costs
Ø Generally, these are products or departments for which costs are accumulated

Common Cost objects are:

- Product operations
- Departments where products go through
- Service lines
- Product or finished goods

Example:

In a furniture making company, manufacturing a furniture involves the following process,

These processes are the product operations, thus, can be construed as the cost object since
during the course of each process, costs are being incurred. Moreover, its finish product, let’s
say a complete set of dining, is also a cost object.
Direct Cost
- can be traced directly to a cost object
- do not have to be allocated to a product
Example: woods used in a furniture set, salary of production worker directly
involved in producing the product

Indirect Cost
- cannot be traced directly to a cost object
- needs allocation to a product
- Example: salaries of factory supervisors, glue and liters of paint used in making a
 furniture set

2. As to behavior to changes in activity

- Behavior of costs relative to a change in a related activity measure.
- Common activity measures are:
o Production volume
o Sales volume
o Machine hours used
o Labor hours used
o Pounds of materials used
o Number of purchase orders processed
o Number of set-ups

- Costs behavior varies depending on the assumed range of activity. This can be observed
at the company's normal operating range and is referred to as the relevant range. Within
the relevant range, the two main cost behaviors are variable and fixed.

Type of Cost Behavior in terms of Behavior in terms of TOTAL

UNIT COST COST
Variable Cost Constant Varies directly to changes in
Within relevant range activity

If Level increases or decreases, If level of activity increases,

variable cost per unit does not total variable costs increases
change
Thus, if level of activity
decreases, total variable
costs decreases
Fixed Cost Varies inversely to changes in Constant
activity Within the relevant range

If level of activity increases, If level if activity increases or

fixed cost per unit decreases decreases, total fixed costs
remain constant
Thus, if level if activity decreases
fixed cost per unit increases
Mixed Cost Combination of both variable and fixed costs

Step Cost Shift upward or downward when activity changes by a certain

interval or step. It can be variable or fixed. Step Variable costs
have small steps. Step fixed costs have large steps
- Other Classification of Costs:
o Sunk costs - these are costs that has already been incurred and cannot be
changed by any decision made now or in the future
o Opportunity costs - the potential benefit that is given up when one alternative is
selected over another
o Standard costs - predetermined costs
3. As to presentation on the financial statements
- When a product is the cost object, all costs can be classified as either product or period.
o Product Costs
§ Also known as Inventoriable costs
§ Costs that are related to making the products
§ Can be both part of balance sheet and income statement
§ Before the products are sold, these costs are recorded in inventory
accounts thus, it is presented in the balance sheet
 •
Raw materials (RM) inventory - costs of materials not issued yet
in production
• Work-in-process (WIP) inventory - costs of goods put into
production and not yet completed
• Finished goods inventory - costs of goods that are completed and
ready for sale
§ When finished goods are sold, its associated costs will form part of the
cost of goods sold account. Cost of goods sold is an expense account on
the income statement and represents the costs of producing goods sold
during the period. So, to reiterate:
• cost of unsold goods - part of balance sheet
• cost of goods sold - part of income statement
o Period Costs
§ Part of income statements as these costs are being treated as outright
expenses when incurred
§ These are costs that are related to business functions other than
production, such as general administrative, selling and distribution
expenses.
Separating Mixed Costs

Within the relevant range, the formula to express the combination of fixed and variable
costs is as follows:

Y= a + bx

Where:
y = Total cost (dependent variable)
a = Fixed cost
b = Variable cost per unit
x = Activity level (independent variable)

Methods of separating mixed costs:

(1) High-Low Method
(2) Least Square Regression

High Low Method

This method is the simplest way of segregating the fixed component and variable
component of costs by determining only two points of the activity level - highest and
lowest levels - within the relevant range. Shown below are the step by step procedures
of separating mixed costs:

Step 1:
On a given information of costs incurred and its related activity levels, select
the highest and lowest levels as well as its associated costs. However, in cases
where there are costs abnormalities like interference in connection of electricity
 and leak in water pipes, or operations occurring outside the relevant range like
special and rush orders from customers, it would be observed that costs are
distorted. This cost behavior are called outliers and should not be considered
in separating mixed cost.

In the above table, it can be observed that the highest machine hours used as well as the highest
electricity cost occurred on April. Whereas, the lowest activity level and its associated cost
occurred on July.

Step 2: Compute the variable cost per unit.

 In the formula, y=a+bx, substitute the calculated fixed and variable cost per unit to estimate
the total cost to be incurred at any given levels of activities within the relevant range.
So, for this activity, where machine hours serve as the activity base, estimate of total cost can
be expressed as:
y = P1,200 + P0.30x,
where x = machine hours

Square Regression Method

This method uses statistical technique in estimating total costs at any given activity level
which evaluates the relationship between independent and dependent variables.

Least-squares regression denotes that the regression line - the line that goes through the
averages of independent and dependent variables in a given set of observations - can be
attained by minimizing the sum of squares of the distances between the straight line and all
the points on the graph.

Thus, the ideal fitting of a regression line can be found by determining the "a" and “fa" values
using the actual activity and actual costs incurred from the observations.

By using mathematical techniques, the formula, y=a+bx, can be derived as shown below in
order to determine the values of a and b.

Considering the same data as used in the High-Low Method, the following are the step by step
procedures in determining the values of the given formula under the Least Square Regression
Method: