TOPIC ONE: COST ACCOUNTING AND MANAGEMENT ACCOUNTING

Learning Outcome Content Suggested

Assessment Methods

Cost Accounting and Management Accounting

• Nature and purpose of cost accounting
• Classifications of costs and overheads Class Assignments
Demonstrate understanding
• Elements and division of costs Question & Answer
of the basic concept in
• Meaning of management accounting,
management and cost Demonstrations
scope, limitations and its applications
accounting
• Relationship between cost, financial and Group discussions
management accounting

Definition of and Scope of Cost Accounting

Cost scouting (commonly) termed „costing‟ may be defined as: „The establishment of budgets,
standard costs and actual costs of operations, activities or products; and the analysis of
variances, profitability, or the social use of funds’ The accounting system of any organization
is the foundation of the internal financial information system. Management needs a variety of
information to plan, to control and to make decisions. Information regarding the financial
aspects of performance is provided by the costing system. Examples of information provided
by a typical costing system and how it is used are given in the following table and the following
paragraphs:

Examples of costing information and uses

Information provided by costing Possible uses by management

system
1 Cost per unit of production or service or As a factor in pricing decisions,
for a process production planning and cost control
2 Cost of running a section, department of Organization planning, decisions on
factory alternative methods, wages cost control

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 3 Wages costs for unit of production or per Production planning, decisions on
period of production. alternative methods, wages cost control
4 Scrap/rectification costs Material cost control, production
planning
5 Cost beheviour with varying levels of Profit planning, make or buy decisions,
activity cost control

Cost accounting and control

An important part of the management task is to ensure that operations, departments, processes
and costs are under control and that the organization and its constituent parts are working
efficiently towards agreed objectives. Although there are numerous other control systems
within an organization, for examples production control, quality control, inventory control, the
costing system is the key financial control system and monitors and the results of all activities
and all other control systems. The detailed analysis and location of all expenditures, the
calculation of job and product costs, the analysis of losses and scrap, the monitoring of labour
and departmental efficiency and outputs of the costing system provide a sound basis of
information for financial control.

Cost accounting and financial accounting

• Financial accounting can e defined as: „The classification and recording of the
monetary transactions of an activity in accordance with established concepts,
principles, accounting standards and legal requirements and their presentation, by
means of profit and loss account, balance sheets and cash flow statements, during and
at the end of accounting period’
• Financial accounting originated to fulfil the stewardship function of businesses and this
is still an important feature. Most of the external financial aspects of the organization,
e.g., dealing with accounts payable and receivables, preparation of final accounts etc.,
are dealt with by the financial accounting system. Of course internal information is also
prepared, but in general it can be said that financial accounting presents a broader, more
overall view of the organization with primary emphasis upon classification according
to type of transaction rather than the cost and management accounting emphasis on the

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 function, activities, products and processes and on internal planning and control
information.

Difference between financial accounting and cost accounting

Financial accounting Cost accounting
1 Provides information to external users Provides information to internal users
2 Produces general purpose financial Produces special statements and reports
statements
3 Must confirm to generally accepted Must conform to information needs of
accounting principles management
4 Provides accounting data in monetary Provides accounting data in monetary and
terms non-monetary terms
5 Financial statements are prepared on Cost statements and reports are prepared
yearly or half yearly basis more frequently i.e. weekly and daily basis

Management Accounting
Management accounting is defined as: „The application of professional knowledge and skill in
the preparation and presentation of accounting information in such a way as to assist
management in the formulation of policies and in the planning and control of operations of the
undertaking’.

The provision of information required by management for such purposes such as:
a) Formulation of policies
b) Planning and controlling the activities of the enterprise
c) Decision taking on alternative courses of action
d) Disclosure to those external to the entity
e) Disclosure to employees
f) Safeguarding assets

Management accounting uses both financial and cost information to advise management in
planning and controlling the organization.
The objectives of the various facets of accounting have been given above and differences. And
the differences discussed. However, it must be realized that all form part of the financial

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information system of an organization and in many organizations the various facets are totally
integrated with no artificial divisions between them.

Purpose of Cost Accounting

The main purpose or advantages of cost accounting are

i) Cost ascertainment. The costs of producing different goods or services must be

ascertained accurately. These costs consist of material cost, labour costs and
overheads.
ii) Controlling. This is the process by which management makes sure that intended and
desired results are consistently and continuously achieved. This consists of;
establishing of standards, comparison of results against standards and correction of
deviations.
iii) Disclosure of waste. Costs incurred for the production of any commodity can be
determined in advance in view of the past experience. If actual costs are higher
than the expected or standard costs then this excessive cost can be analyzed. These
excessive costs may be due to wastage of raw materials or idle labour time.
iv) Decision making management is responsible for decisions regarding what
goods/services should be produced and in which quantity. Cost accounting
information provides information for making these decisions.
v) Cost control this is an important function of management. Material cost, labour cost
and overheads must be maintained at desirable levels. Cost accounting principles
are used to eliminate unnecessary costs.
vi) Evaluation of alternatives Management is frequently confronted with decisions
involving choice from different alternative courses of action e.g., whether to make
or buy a product, whether to continue or discontinue a product/service etc. Cost
accounting provides information as to how future costs and revenues will be
affected under each alternative thus assisting management in taking an appropriate
selection.
vii) Planning is the process of setting objectives and then determining the steps required
to attain them. It is the activity by which managers analyze present conditions to
determine ways of reaching the desired future. Planning requires appropriate
information and cost accountants makes analysis of costs of past operations. These

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 costs are adjusted to reflect changes in products, technology, volume, production
efficiency, input cost etc.
viii) Pricing of products and projects This involves determination of prices of new
products adjustment in prices of existing products as well as determination of bid
prices for contracts. The decision of setting prices is based on cost data collected.
ix) Measurement of efficiency Cost data are used to measure the efficiency of an
organization in utilization of resources employed in production process.
x) Inventory management costing assists in inventory management by keeping
accurate and complete records of materials from time they enter into premises till
the time they are used in production process.
xi) Evaluation of profitability Costing provides information for evaluating the
profitability of an activity, department or the entire organization.

Conditions for Effective Costing System

A costing system is designed in accordance to the requirements of the organization. The system
should simple, economical and practicable. The main conditions are:

i) There must be a proper system of store and stock control

ii) There must co-operation and co-ordination among the staff members of the
organization.
iii) The wages procedure must be proper and satisfactory. Labour costs should be
charged to respective jobs accurately.
iv) Standard printed forms must be used for recording the receipts of materials and
issues, recording labour hours worked and calculations and other activities of the
organization.
v) The overheads must be recorded accurately and these must be charged to respective
production departments
vi) The costing department must be established. The responsibilities and duties of cost
accountant should be clearly stated.
vii) The cost accounts and financial accounts should be maintained in a way that results
can be reconciled easily.

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Cost Classification

This may be defined as: „The amount of expenditure (actual or notional) incurred on, or
attributable to, a specified thing or activity.‟
At the simplest level, cost includes two components, quantity used and price, ie, Cost = quantity
used x price

Cost units
The cost unit to be used in any given situation is that which is most relevant to the purpose of
the cost ascertainment exercise. This means that in any one organization numerous cost units
may be used for particular parts of the organization or for differing purposes.

The main elements of costs are:

a) Raw material this usually form a high proportion of the total cost of production
b) Labour
c) Overheads

Classification of Costs
Classification is the process of grouping costs recording to their common characteristics.
Classification of cost is done in order to be concise of every cost incurred in the process of
manufacture so that such costs can be accurately recorded, monitored and controlled. They are
various ways of grouping cost:-

1. Function classification
A business has to perform a number of functions e.g. manufacture, administration, selling,
distribution and research. On this basis costs are classified into the following;

a) Manufacturing /production / factory cost This are costs related to the manufacturing
process e.g. material cost, labour, cost and factory cost such as rent, depreciation of
machinery, power and lighting etc.
b) Administrative costs include all expenditure incurred in formulating policies,
directing the organizations and controlling the operation of an undertaking such as
audit fee, office rent, salaries etc.

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 c) Selling cost are costs of seeking to create and stimulate demand and to serve orders
e.g. advertising, salaries and commission of salesmen etc.
d) Distribution expenses are cost incurred to avail the product to the final consumer.
E.g. packing cost, carriage outward, warehousing cost etc.
e) Research and development cost this is the cost of searching new and improved
products and methods. E.g. wages and salaries of research staff, payment to outside
research organizations etc.
2. Classification according to behaviour or variability
a) Fixed cost – This is a cost which does not vary with activities or output. It
remains constant within the relevant range as shown in Figure 2.1. A
relevant range is range within which relationship between cost and activity
hold

Fixed cost
e.g. rent management salaries insurances of building etc.
Cost
Activity
b) Variable cost is costs that vary in direct proportion to the volume of output.
When volume of output increases variable cost also increases and vice versa
as indicated in Figure 2.2.
variable cost

variable cost
e.g. material and labour cost
` cost

Activity

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 c) Semi variance cost These are costs that are partially fixed and partially
variable. A semi-variable cost has often a fixed element below which it will
not fall at any level of output. The variable element is a semi-variable cost
changes either at a constant rate or in lumps. E.g. electricity bill which has
a fixed element in it below which it cannot follow and a variable element
that changes based on the power consumptions as shown in Figures 2.3 and
2.4.

Changing in lumps semi variable cost

Cost

e.g. rent

Activity

3. Product cost and period cost

a) Product cost is costs necessary for production and can not be incurred in
case there is no production. They include; cost of direct materials, direct
labour and some of the factory overhead. They are called production costs
because they are included in the course of production.
b) Period costs are costs which are not necessary for production and they are
written as expenses in the period in which they are incurred. They are
incurred for a time period and are charged to the income statement for the
period e.g. rent salary of company executives, travel expenses etc.

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 4. Classification according to identifiability with the product
a) Direct costs are costs which are incurred for and may be conveniently
identified with a particular cost unit process or department such as direct
labour, direct materials etc.
b) Indirect costs are costs which can not be conveniently identified with a
particularly cost unit process or department. They are general cost incurred
for the benefit of a number of cost unit or cost centres such as salary paid to
a factory foreman.

5. Classification according to controllability

a) Controllable costs are costs that may be directly regulated by a given level
of managerial influence. E.g. variable costs are generally controllable by
department heads.
b) Uncontrollable costs are costs that cannot be influenced by the action of a
specified member of the enterprise e.g. fixed cost like rent are generally
uncontrollable.

6. Special cost for managerial decision making

a) Relevant costs are costs which changes from one decision to the next
and as such relevant cost will be affected by the decision being made
under different alternatives. In decision making management will be
concerned with those costs that differ from one decision to another.
b) Sunk or irrelevant cost These are cost which have been already been
incurred in the past and cannot be changed. They are relevant in decision
making.
c) Incremental cost / differential costs This is an increase or decrease in
cost as a result of an alternative course of an action.
d) Marginal or variable cost It is the cost of producing an extra unit of a
commodity.
e) Replacement cost This market value of replacing an existing asset.
f) Opportunity cost It is the sacrifice involved in accepting the alternative
under consideration.

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 7. Classification according to time
a) Historical costs are costs ascertained after they have been incurred. They
are the actual costs which are only available after completion of the
manufacturing process.
b) Predetermined costs They are future costs that are ascertained in
advance of production on the bases of all specified factors affecting cost.

Concepts of Cost accounting

a) Cost per unit this may be unit of a product service all time in relation to which cost may
be ascertained all expressed. There are the things that the business is set up to provide
which cost to ascertained. E.g. kilowatt in case of power consumption meals in case of
a hotel passages in case of transport.
b) Profit centre `this may be defined as subdivision within an organization operating on a
self contained bases. Usually it will be a cost and an income earning subdivision hence
producing profit measurable as a return on capital employed

Review Questions

1. Define cost accounting?

2. Give six examples of costing information and its uses
3. What is the relationship between costing, management accounting and financial
accounting?
4. Describe the main purposes of cost accounting
5. What is meant by the tem „classification of costs‟? Explain various types of cost
classifications.
6. Write short notes on
a) Cost unit
b) Cost centre
c) Profit centre
d) Cost beheviour

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References:

1. Finnerty, J.D. (2013). Project financing: asset-based financial engineering (3rd ed.). New
Jersey, USA: John Wiley & Sons Inc.
2. Gatti, S. (2013). Project finance in theory and practice: designing, structuring, and
financing private and public projects (2nd ed.). Oxford, England: Academic Press/Elsevier
Inc.
3. Meredith, J. R. and Mantel, S.J. (2012). Project Management: a managerial approach (8th
ed.). New Jersey, USA: John Wiley & Sons Ltd.
4. Prassana, C. (2009). Projects: Planning, Analysis, Selection, Financing, Implementation
and Review, (7th ed.). New Delhi, India: Tata McGraw-Hill Education Private Limited.
5. Van Horne C. J. & Wanchowcz J. M. (2009). Fundamentals of Financial Management
(13th ed.). Harlow, England: Financial Times Press/Pearson Education Ltd.
6. Yescombe, E.R. (2014). Principles of project finance (2nd ed.). Oxford, England: Academic
Press/Elsevier Inc.

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