Financial & Managerial Accounting

Lecture 9
Cost behaviors & Estimations
Course leader : Asst.Prof Tadele T
What is cost and Management Accounting?
is 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.
 Financial & Managerial Accounting
• Financial accounting provides
information for external decision
makers, such as outside investors and
lenders.
• Managerial accounting focuses on
information for internal decision
makers, such as the company’s
managers.
 Financial Accounting Vs. Managerial Accounting
Areas of Management
Financial Accounting
Comparison Accounting
1. Primary users Persons and organizations Various levels of internal
outside the business entity management

2.Purpose Communicate organization’s Help managers make

financial and operating decisions to fulfill an
information to investors, organizations goal
banks, regulators and other
outside parties

3. Types of Double entry system Not restricted to double

accounting systems entry system; any useful
system can be used
4. Restrictive guidelines Adherence to GAAP No formal guidelines or
restrictions, only criterion is
usefulness
5. Units of measurement Historical (past) Monetary unit Any useful monetary (historical
and future) or physical measure
such as machine hours, labor hours etc

6. Focal point for analysis Business entity as a whole Various segments of the business
entity.
7.Report Summarized report; concerned Detailed report; concerned about
primarily with the entity as a details of parts of the entity’s
whole products, departments, territories

7. Frequency of reporting Periodical on a regular basis Whenever needed; may not be on

a regular basis

8. Degree of objectivity Demands objectivity; historical in Deeply subjective for planning

nature purposes, but objective data are
used when relevant & future in
nature.
 Characteristics of cost & Management
Accounting
•It is a separate branch of accounting
which provides information for
management decision
•It is futuristic in its approach
•Collection of accounting data for analysis
and interpretation is made according to the
need of the management.
•It does not follow any prescribed
accounting format for reporting.
 Con’t….
• It only gives useful information for
decision making, it does not take part in
execution of decision. In other words, it
does not replace the management.
• The main focus of cost management is to
control, reduce and eliminate costs to
improve the quality of activities on value
chain for creating cost leadership to face
a worldwide competitive position.
Cost Concepts & Classifications
What is the d/ce between Price, Cost, Expense
and Loss?
 Price is the amount at which goods or services are sold
 Cost refers to an outlay or expenditure of money to
acquire Fixed assets, goods and services. All costs
initially represent an asset
 Expense is an expired cost in generating revenue
 Loss is cost incurred because of catastrophe or
unfavorable business condition
 Cost pool
• Cost pool is the account head in which
costs are accumulated for further
assignment to cost objects.
• Examples of cost pools include factory
rent, insurance, machine maintenance
cost, factory fuel, etc.
• EX. if a company uses just one allocation
base say direct labor hours or fixed
manufacturing overheads
 Cost object

• Cost object is an item for which a

business needs to separately estimate
cost.
• Examples of cost object include a
branch, a product line, a service line,
a customer, a department, a brand, a
project, etc.
 Cost driver

• Cost driver is any variable that

‘drives’ some cost.
• If increase or decrease in a variable
causes an increase or decrease is a
cost that variable is a cost driver for
that cost.
 What is Cost Accounting?
• Cost accounting is an accounting
information system that records, measures
and reports information about cost.
• Cost accounting deals with accumulating
cost of manufacturing a product and other
cost object to enable the determination of
profit.
• Cost accounting can be applied in any
organization but the detail concept will be
applied in manufacturing organizations.
 Classifications of Cost
Cost can be classified in different ways
from different points of view
1. Time period points of view
• Budgeted cost/future cost
• Historical/sunk cost
2. Management function points of view
• Manufacturing cost
• Selling and Marketing cost
• Administrative cost
• Research and development cost
3. From Cost Assignment points of view
• Direct cost
• Indirect cost
4. From GAAP Points of view
• Product cost/capitalized cost
• Periodic cost/non capitalized cost
5. Cost behavior point of view
• Fixed cost
• Mixed cost
• Variable cost
6. From decision making points of view
• Relevant cost
• Irrelevant cost
7. From controllability of cost points of view
• Controllable cost
• Uncontrollable cost
8. Other cost classifications
• Opportunity cost
• Incremental cost
• Joint cost

17
 Cost allocation

• Cost allocation (also called cost

assignment) is the process of finding cost
of different cost objects such as a project, a
department, a branch, a customer, etc.
• It involves identifying the cost object,
identifying and accumulating the costs
that are incurred and assigning them to
the cost object on some reasonable basis.
 Mechanism cost allocation
Typical cost allocation mechanism
involves:
Identifying the object to which the
costs have to be assigned,
Accumulating the costs in different
pools,
Identifying the most appropriate
basis/method for allocating the cost
 Con’t…
Include:
• Number of payments processed can be a
good cost driver for salaries of Accounts
Payable section of accounting department,
• Number of purchase orders can be a good
cost driver for cost of purchasing
department,
• Number of invoices sent can be a good cost
driver for cost of billing department,
• Number of units shipped can be a good cost
driver for cost of distribution department,
 Cost allocation base
• Cost allocation base is the variable
that is used for allocating/assigning
costs in different cost pools to
different cost objects.
• A good cost allocation base is
something which is an appropriate
cost driver for a particular cost
pool.
What is Manufacturing Overhead cost(MOH cost)?

MOH Cost Includes:

– Indirect materials, such as glue, nails, screws
– Indirect labor, such as supervisor’s salary and
Janitorial services.
– Taxes on manufacturing facilities.
– Utilities for the manufacturing process.
– Depreciation on manufacturing facilities
– Repair and maintenance cost
– Plant Insurance
– Plant Rent
23
 Total Versus Per-Unit Fixed Cost
Behavior
$ Total Fixed Costs
If total fixed costs look like
this . . .

Cost Driver

$/unit Per-Unit Fixed Costs . . . then fixed costs per

unit look like this.

Cost Driver
Slide # 24
 Stepwise fixed Cost Behavior
Some costs are fixed at one level for one range of
activity and fixed at another level for another range
of activity. These are known as stepwise linear fixed
costs and the range in which the cost is fixed is called
relevant range
Total Supervisor Salaries Cost in $1000s
Example: A production
120 supervisor makes $40,000
per year and the factory
can produce 100,000 units
80 annually for each 8-hour
shift it operates.

40

100 200 300

Number of units produced, in 1000s
 Total Versus Per-unit Variable Cost Behavior
$ Total Variable Costs
If total variable costs look
like this . . .
slope = $m/unit

Cost Driver

$/unit Per-Unit Variable Costs . . . then variable costs per

unit look like this.

Cost Driver
The Total ( Mixed) Cost Function
When costs are linear, the cost function is:
TC = F + V x Q, where
F = total fixed cost, V = variable cost per unit of the cost
driver, and Q = the quantity of the cost driver.

$ The intercept is the total fixed cost.

Total Costs
The slope is the variable cost per
unit of the cost driver.

slope = $V/unit of cost driver

F A cost that includes a fixed cost
element and a variable cost
element is known as a mixed cost.
Cost Driver

Slide # 27
 Non linear Cost Functions
A learning curve is best example of non linear cost
function
• it is the rate at which labor hours per unit decrease as
the volume of activity increases
• It is the relationship between cumulative average
hours per unit and the cumulative number of units
Aproduced.
learning curve can be represented mathematically as:
Y = α Xr, where
Y = cumulative average labor hours,
α = time required for the first unit,
X = cumulative number of units produced,
r = an index for learning = ln(% learning)/ln(2), and
ln is the natural logarithmic function.
Slide # 28
 Illustration
Deanna’s Designer Desks just designed a new solid wood
desk for executives. The first desk took her workforce 55
labor hours to make, but she estimates that each desk will
require 75% of the time of the prior desk (i.e. “% learning” =
75%). Compute the cumulative average time to make 7 desks,
and draw a learning curve.
First compute r: r = ln(75%)/ln(2) = -0.2877/0.693 = -0.4152
Then compute the cumulative
average time for 7 desks: 60 Cumulative Average Hours Per Desk
50
Y = 55 x 7(-0.4152) = 25.42 hrs 40
30 Hrs
In order to draw a learning curve, 20 per
Desk
you must compute the value of Y 10
for all X values from 1 to 7. . . . Cumulative Number of Desks
0
1 2 3 4 5 6 7

Slide # 29
 Manufacturing cost
Types of inventories in manufacturing Companies
– Raw materail inventory
– Work in process inventory
– Finished goods inventory
The three main manufacturing cost are
1.Direct material cost
2.Direct labor cost
3.Manufacturing overhead cost
Financial Statement for a Manufacturing
Organization
In order to prepare financial statements for manaufacturing
organizations, we have to go through the following
schedules:

Schedule1: Cost of Direct Material Used

Beginning direct material inventory XX
Add: Purchase in the period XX
Direct material available for use XX
Less: Ending direct material inventory (XX)
Cost of direct material used XX
 Schedule 2: Cost of Goods Manufactured
Work in process at the beginning----------------------- XX
Add: Cost of direct material used -------------XX
Direct labor cost -------------------------- XX
Manufacturing over head cost -----------XX
Cost incurred in current period ----------------------- (XX)
Total cost incurred to date ------------------------------ XX
Less: Work in process ending ---------------------------XX
Cost of goods manufactured ----------------------------XX
Schedule 3: Cost of Goods Sold
Finished goods beginning --------------------- XX
Add: Cost of goods manufactured -----------XX
Cost of goods available for sale -------------- XX
Less: Finished goods ending ---------------- (XX)
Cost of Goods Sold ----------------------------- XX
Schedule 4: Income Statement
Revenues XX
Cost of goods sold XX
Gross profit XX
Operating expenses (XX)
Operating income XX