Chapter-1: Overview of Cost and Management Accounting

1.1. Objectives of Cost & Management Accounting

Cost accounting and management accounting are regarded as specialized branches of accounting. Cost
accounting involves accounting and control of cost. It is concerned with the measurement of cost and
communication of cost-related information to the management for their effective decision making. Cost
accounting is useful for locating unprofitable activities and inefficiencies occurring in various forms of wastes. It
further facilitates the preparation of projected cost statement and assists in controlling actual cost of production. It
is also useful for price fixation. Thus, cost-related information becomes imperative for planning and controlling
the operations of an enterprise. Intelligently used cost information forms the basis of many strategic decisions.
Long-term competitive success of an enterprise depends on its proper cost management.

The main purposes of Cost Accounting are:

 To accumulate cost data for determining the product (or service) costs;
 To provide cost data to the management for the preparation of budgets and fixing standard costs;
 To assist the management in their decision making;
 To ascertain the cost of products, activities, functions, processes, etc.;
 To apply various cost control techniques;
 To improve efficiency in order to control and reduce costs.
Management accounting deals with the presentation of accounting and other information to the management for
managerial decision-making purposes. It provides financial data, cost data, and other qualitative information to
the management for their planning, decision making, and control purposes. Management accounting acts as a
decision support system for providing the right information to the management at the right time. It guides
management‟s actions and helps managers to run their organizations smoothly. In recent years, the management
accounting profession has gained immense importance due to increased competitiveness as a result of
globalization and advancement in technology.
The main purposes of Management Accounting are:
 To provide management with financial data, cost data and other qualitative information for planning and
decision making;
 To get an insight into the profitability, solvency, liquidity, etc., of the organization;
 To measure and interpret the results of operations with necessary comments and conclusion;
 To report on the effectiveness of the organization as regards utilization of resources;
 To meet the changing needs of management functions.
The Management Accountant
Management Accounting provides significant economic and financial data to the management and the
Management Accountant is the channel through which this information efficiently and effectively flows to
the management.
Management accountant or controller is the person who designs the management information system for the
organization, operates it by means of interlocked budgets, computes variances and exhorts others to institute
corrective measures. The Management Accountant has a very significant role to perform in the installation,
development and functioning of an efficient and effective management information system.

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 Apart from top management no one in the organization perhaps knows more about the various functions of
the organization than him. He is, therefore, sometimes described as the Chief Intelligence Officer of the top
management.

Functions of Management Accountant

It is the duty of the management accountant to keep all levels of management informed of their real position. He
has, therefore, varied functions to perform.
His important functions can be summarized as follows:
(i) Planning: He has to establish, coordinate and administer, as an integral part of management, an adequate
plan for the control of the operations. Such a plan would include profit planning, programmers of capital
investment and financing, sales forecasts, expenses budgets and cost standards.

(ii) Controlling: He has to compare actual performance with operating plans and standards and to report and
interpret the results of operations to all levels of management and the owners of the business. This is done
through the compilation of appropriate accounting and statistical records and reports.

(iii) Coordinating: He consults all segments of management responsible for policy or action. Such consultation
might concern any phase of the operation of the business having to do with attainment of objectives and the
effectiveness of the organizational structures and policies.

(iv) Other functions:

 Administers tax policies and procedures.
 Supervises and coordinates the preparation of reports to governmental agencies.
 Ensures physical protection for the assets of the business through adequate internal control and proper
insurance coverage.
1.2. Financial accounting, cost accounting and Management accounting
 Accounting systems are designed to provide information to decision-makers. Accounting language has two
primary “variations”, Financial Accounting and Management accounting. Cost accounting is a bridge
between financial and management accounting.
 Financial accounting reports the financial performance of the company mainly to external users. It reports
financial position and income according to IFRS. Data should be comparable across firms.
 Management accounting is the process of measuring, analysing, and reporting financial and nonfinancial
information that helps managers make decisions to fulfil the goals of an organization. Management
accounting provides information for internal users (managers) who direct and control its operations. The
reports are not governed by IFRS.
 Cost accounting is defined as “a technique or method for determining the cost of a product, service, project,
process, or things. It integrates with financial accounting by providing product costing information for
financial statements and with management accounting by providing some of the quantitative, cost-based
information managers need to perform their tasks.
 Cost accounting has long been used to help managers understand the costs of running a business. Modern
cost accounting originated during the industrial revolution, when the complexities of running a large scale
business lead to the development of systems for recording and tracking costs to help business owners and
managers make decisions.

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  Organizations that do not manufacture products may not require elaborate cost accounting systems.
However, even service companies need to understand how much their services cost so that they can
determine whether it cost-effective to be engaged in particular business activities.
Management Accounting and Financial Accounting
Financial accounting and management accounting are closely interrelated since management accounting is to a
large extent rearrangement of the data provided by financial accounting. Moreover, all accounting is financial in
the sense that all accounting systems are in monetary terms

Major Differences between Management and Financial Accounting

Areas of comparison Management Accounting Financial Accounting

Purpose of information Help managers make decisions to Communicate organization‟s

fulfill an organization‟s goals financial position to investors, banks,
regulators, and other outside parties

Primary users Managers of the organization External users such as investors,

(internal users) banks, regulators, and suppliers

Focus and emphasis Future-oriented (budget for 2011 Past-oriented (reports on 2010
prepared in 2010) performance prepared in 2011)

Rules of measurement Internal measures and reports do not Financial statements must be
and reporting have to follow IFRS but are based on prepared in accordance with IFRS+
cost-benefit analysis and be certified by external,
independent auditors

Time span and type of Varies from hourly information to 15 Annual and quarterly financial
reports to 20 years, with financial and reports, primarily on the company as
nonfinancial reports on products, a whole.
departments, territories, and
strategies

Types of accounting Not restricted to Double entry Double entry system

systems system; any useful system can be
used

Units of measurement Any useful monetary(historical & Historical (past) dollars/Birr

future) or physical measurement such
as machine hours, labor hours etc.

Behavioral implications Designed to influence the behavior of Primarily reports economic events
managers and other employees but also influences behavior because
manager‟s compensation is often
based on reported financial results

Cost Accounting and Management Accounting

Cost accounting is the process of accounting for costs. It embraces the accounting procedures relating to
recording of all income and expenditure and the preparation of periodical statements and reports with the object
of ascertaining and controlling costs. It is, thus, the formal mechanism by means of which the costs of products

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or services are ascertained and controlled. On the other hand, management accounting involves collecting,
analyzing, interpreting and presenting all accounting information, which is useful to the management. It is
closely associated with management control, which comprises planning, executing, measuring and evaluating
the performance of an organization. Thus, management accounting draws heavily on cost data and other
information derived from cost accounting.

Today cost accounting is generally indistinguishable from the so-called management accounting or internal
accounting because it serves multiple purposes. However, management accounting can be distinguished from
cost accounting in one important respect. Management accounting has a wider scope as compared to cost
accounting. Cost accounting deals primarily with cost data while management accounting involves the
considerations of both cost and revenue. Management accounting is an all-inclusive accounting information
system, which covers financial accounting, cost accounting, and all aspects of financial management. But it is
not a substitute for other accounting functions. It involves a continuous process of reporting cost, financial and
other relevant data in an analytical and informative way to management. We should not be very much
concerned with boundaries of cost accounting and management accounting since they are complementary in
nature. In the absence of a suitable system of cost accounting, management accountant will not be in a position
to have detailed cost information and his function is bound to lose significance. On the other hand, the
management accountant cannot effectively use the cost data unless it has been reported to him in a meaningful
and informative form.

1.3. Cost terms and classification

Cost Terms
Cost is the monetary measure of economic resources (tangible or service) given up/sacrificed to attain a specific
objective/purpose such as acquiring a good or service.

One guiding principle is that the term cost is a relative term, dependent both on the “cost object” chosen and the
purpose for which cost is being calculated and reported.
“Cost” is often actually “estimated cost” due to difficulties involved in cost tracing and allocation, relevant
range issues, which cost method is used, and the cost-benefit approach to measuring costs.
Cost Object: To guide their decisions, mangers often want to know how much a particular thing costs. This
“thing” is called a cost object, anything for which a measurement of costs is desired. Example: - products,
services, projects, a division, branch, a brand category, a department, a program, customer etc.
Cost Driver: (also called a cost generator or cost determinant) is any factor that affects total costs. That is, a
change in the level of the cost driver will cause a change in the level of the total cost of a related cost object.
Costs that do not vary in the short run and have no identifiable cost driver in the short run may in fact have a
cost driver in the long run.
E.g. Number of products serviced, Hours spent servicing products, Labor hours on a project etc.
Cost Accumulation, Assignment and Tracing /Allocation
A costing system typically accounts for costs in two basic stages:
1. It accumulates costs by some „natural‟ (often self-descriptive) classification such as materials, labor, fuel,
advertising or shipping.
2. It assigns these costs to cost objects.
Cost Accumulation is the collection of cost data in some organized way through an accounting system.

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Cost Assignment is a general term that encompasses both (1) tracing accumulated costs to a cost object, and (2)
allocating accumulated costs to a cost object. Costs that are traced to a cost object are direct costs, and costs
that are allocated to a cost object are indirect costs. Many accounting systems accumulate actual costs, which
are the costs incurred (historical costs), as distinguished from budgeted or forecasted costs. In some
organizations, stage 1 (cost accumulation) and stage 2 (cost assignment) occur simultaneously.
Alternatively, stage 1 (cost accumulation) could occur first, followed by stage 2 (cost assignment).
Cost Tracing and Cost Allocation
A major question concerning costs is whether they have a direct or an indirect relationship to a particular cost
object.
Direct costs of a cost object are costs that are related to the particular cost object and that can be traced to it in
an economically feasible (cost-effective) way.
Indirect costs of a cost object are costs that are related cost objects but cannot be traced in an economically
feasible (cost-effective) way. Indirect costs are allocated to the cost object using a cost allocation method.
Managers prefer to make decisions on the basis of direct costs rather than indirect costs. Why? Because they
know that direct costs are more accurate than indirect costs.
Cost tracing is the assigning of direct costs to the chosen cost object.
Cost allocation is the assigning of indirect costs to the chosen cost object.
Cost assignment encompasses both cost tracing and cost allocation.
Relationship of direct and indirect costs to a cost object

Cost tracing Direct costs

Cost assignment Cost
Cost allocation Indirect costs Object

Classification of costs
Costs vary with purpose and the same cost data cannot serve all purposes equally well. The word cost is
used in such a wide variety of ways that is advisable to use it with an adjective or phrase, which will convey
the meaning intended.
 Now consider some ways of classifying costs:
 Based on assignment to cost object (direct vs. Indirect)
 Based on business function (R&D, Design, Production (Manufacturing), Marketing, distribution,
Customer service). For purposes of contracting with government agencies design & R&D costs are
treated as product costs.
 Based on behavior in relation to cost driver (variable vs. Fixed)
 Based on aggregation (total vs. unit)
 Based on whether or not the specified subunit can control or significantly influence the cost ( controllable
cost, uncontrollable cost)
 Based on decision making purposes ( opportunity costs, sunk cost, incremental cost, marginal cost)
 Based on financial statement presentation (Capitalized, non-capitalized, inventor able, non-inventor able:
product vs. Period)

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 Based on assignment: Direct Costs & Indirect Costs
Direct Costs- Direct costs are costs related to a cost object and can be conveniently and economically traced
(tracked) to that cost object (product, department, etc). It is a cost used by a single cost object and would be
eliminated if the cost object is eliminated. Many costs may be able to be traced to the cost object, but it is not
always practical to do so from a cost-benefit perspective.
 It includes the cost of materials and labour specifically used in manufacturing a product or providing a
service. Examples are:
 The cost of the cans or bottles of Pepsi-colas
 The cost of the metal frame and the lumber to make a chair
 The cost of cloth and buttons used in manufacturing clothing‟s
 A supervisor’s salary is a direct cost to the production department he or she is in charge of or managing.
 Specific labour costs that can be identified with the work involved in manufacturing a product or providing
a service and other expenses that can be specifically identified with a product or service.

Indirect Cost- Indirect costs related (directly or indirectly) to cost objects but cannot be conveniently or
economically traced to them. Instead of being traced, these costs are allocated to a cost object in a rational and
systematic manner. The term cost allocation is used to describe the assignment of indirect costs to a particular
cost object.
 Indirect costs are also known as common costs – costs shared by more than one cost object.
 For example, the salaries of supervisors who oversee production of many different soft drink products
bottled at a Pepsi plant is an indirect cost of Pepsi-colas. Supervision costs are related to the cost object
(Pepsi cola) because supervision is necessary for managing the production and sale of Pepsi-colas.
Supervision costs are indirect cost because supervisions also oversee the production of other products such
as 7-up. Unlike the cost of cans or bottles, it is difficult to trace supervision costs to the Pepsi cola line.
 Other examples include factory accountant‟s salary, electricity, rent, property taxes, janitors, factory
supplies are examples.
Factors affecting Direct/Indirect cost classification
1. The materiality (relative importance) of the cost: The larger the amount of a cost, the more likely that it is
economically feasible to trace that cost to a particular cost objects. But if it is small, it should be classified as
indirect cost as it would not be economically feasible (cost/benefit).
2. Information gathering technology: Improvement in technology have enabled to treat more and more cost
as direct costs, which were previously treated as indirect costs. E.g. many components parts display a bar code
that can be scanned at every point in the production process.
3. Design of operation: Classifying a cost as direct is easier if a company‟s facility (or some part of it) is used
exclusively for a specific cost object, such as a specific product or a particular customer. E.g. Depreciation on
special-purpose equipment
Based on their relation with production
Prime & Conversion Costs
Prime Costs: Prime costs are all direct manufacturing costs. Under the three-part classification of
manufacturing costs, prime costs are equal to direct material costs plus direct manufacturing labour costs. In
cases where other direct manufacturing cost categories are used, they too are prime costs.

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 For example, power costs could be classified as a direct cost if the power is metered to specific areas of a
plant that are dedicated to manufacturing separate products.
 It reflects the primary sources of costs for units in production (i.e. in many cases they constitute the major
portion of mfg costs)
Conversion Costs
 Conversion costs are all manufacturing costs other than direct material costs; they are incurred to convert
direct materials into finished goods. Under the three-part classification of manufacturing costs, conversion
costs are equal to direct manufacturing labour costs plus indirect manufacturing costs.
Based on Behavior: Variable & Fixed Costs
 Cost behavior refers to the way different types of production costs change when there is a change in level
of production.
 The major types of costs, in terms of cost behavior, are: 1) variable costs, and 2) fixed costs, 3) semi-
variable costs and 4) semi-fixed costs.
 This separation is helpful for budget preparation and control and evaluation of operation.
Variable Costs
 Changes in total in proportion to changes in the related level of activity or volume.
 The major activity that affects manufacturing costs is production volume. Production volume is frequently
measured in terms of units produced; direct labour hours used, machine hours used, materials costs or some
other production volume related measure. Total variable costs vary with total proportionately for any
change in the level of these factors. These would include DM, DL and in some instances indirect materials
(power and fuel, lubricants).
 The wood materials used to make a desk are an example. The total amount of wood needed would be
directly proportional to the number of desks made, but the amount of wood needed for each desk would be
the same. For example, if the wood for one desk cost $10, then the total cost for 5 desks would be $50
($10*5).
 Variable costs remain constant on a per unit basis. The implication of this for management in planning and
controlling of variable cost is that the company should expand its productive activity as long as the selling
price per unit exceeds the variable cost per unit.
Fixed Costs
 Remain unchanged in total regardless of changes in the related level of activity or volume. These are „stand-
by cost‟ costs because they will be incurred even when no production activity take place.
 Fixed costs tend to be capacity related costs such as the salary of the plant manager, depreciation of
machinery and equipment (except for units of production method), a supervisor‟s salary, property taxes, rent
of building (mfg and warehouse). Thus they arise in relation to the passage of time. Thus fixed cost per unit
will change inversely with the level of production. An increase in production will cause the average fixed
cost per unit t decrease and vice-versa.
For example, if rent expense (a FC) is $1,000 per month and we produce 200 units, the cost per unit, for rent, is
$5 ($1,000/200= 5). But if we produce 500 units, then the cost per unit would be $2 ($1,000/500= 2).
The implication of this for management in planning and controlling of fixed costs is that, with all other things
held constant, such as selling price per unit and variable cost per unit, productive activity should be expanded
as far as possible, which will reduce the fixed cost per unit to its lowest amount. This is the very essence of the
important concept of fully utilizing productive capacity.

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 Note that costs are variable or fixed with respect to a specific cost object. Consider annual registration and
license costs for a fleet of planes owned by an airline company. Registration and license costs would be a
variable cost with respect to the number of planes owned. But these costs are fixed with respect to the miles
flown by that plane during a year.
 Costs are variable or fixed for a given time period. It is important to understand that the notion of fixed and
variable costs is a short run concept. All costs tend to be variable in the long run.
Short run is the time period where a decision maker cannot adjust capacity. Long run is the opposite of the
above where capacity can be increased or decreased.
Semi-Variable (Mixed) Costs
These are costs that reflect both a fixed and a variable component. The fixed part usually represents a minimum
fee for making a particular item or service available (paid whatever quantity is consumed). The variable portion
is the cost charges for actually using the service (which will therefore vary with the level of activity).
E.g. – Telephone charges contain a fixed charge for being allowed to receive or make a phone call plus
additional amount for each phone call made (e.g. 10 cents per minute).
- The electricity bill contains a fixed or standing charge (paid whatever quantity of electricity is consumed) and
the variable aspect which depends on usage.
 On a per-unit basis, a mixed cost does not fluctuate in direct proportion to change in activity nor does it
remain constant with change in activity.
Semi-Fixed Cost (stepped cost)
 This is a cost that is fixed over relatively short activity ranges, but which increases dramatically (abruptly)
as the level of activity moves from one range to another. This is because these costs are acquired in
indivisible portion.
 They do not change continuously as the level of activity changes, but do increase in steps as activity
increases beyond various levels. As a result they are sometimes referred to as step cost and step functions.
 A good example is a supervisor‟s salary. For a particular range of outputs, a business may need to employ
only one production supervisor on a fixed salary which normally represents a fixed cost). However, to
increase production beyond this range will require the employment of a second supervisor. The fixed cost of
supervisory salaries increases suddenly and then continues at the new level until output is such that a third
supervisor needs to be employed. Supervisory costs might also be driven by the number of production
shifts.
 Variable costs are usually taken as varying linearly with the level of activity (that is, a graph of cost against
activity level is an upward-sloping straight line, and this implies that the variable cost per unit of output is
constant at all levels of output.
 However, in practice variable costs might not be linearly related for example, unit variable costs might
gradually decrease relative to the level of output (as would be the case where there are economies of scale
available production), gradually increase (if there are diseconomies of scale) or exhibit a more complex
relationship. But for many purposes we can assume that (at least over the range of output that interests us)
total cost may be divided into a fixed element, which does not vary over the range of output, and a variable
element, related linearly to output. Economies of scale=it shows the decrease in cost of each product that
happens as the total number of products produced increases.

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 Do not mistakenly equate variable costs with direct costs and fixed costs with indirect costs (overheads).
Often variable costs are direct (e.g. direct material costs) and fixed costs are indirect (e.g. rent), but this is
not always the case. Importantly, what is classified as direct and indirect depends on the cost object
 Understanding the types of behaviors exhibited by costs is necessary to make valid estimates of cost at
various activity levels.
Cost Drivers & Relevant Range
Cost Driver: Understanding cost behavior requires an understanding of “cost drivers”. A cost driver is a
variable, such as the level of activity or volume, that causes costs to increase or decrease over a given time
period. It is an activity that causes a cost to be incurred. In other words, a cause-and-effect relationship exists
between a change in the level of activity or volume and a change in the level of total costs. Cost accountants
often attempt to select a „suitable‟ drive in the light of the cost being apportioned. The cost driver of variable
costs is the level of activity or volume whose change causes these costs to change proportionately.

E.g. if labour cost changes with the number of hours worked, the number of hrs is the cost driver, number of
Parts /material used is a cost driver for costs of materials, similarly miles driven is a cost driver of distribution
cost
 Fixed costs have no cost driver in the short run but may have a cost driver in the long run.
E.g. the equipment and staff costs of product testing typically are fixed in the short run with respect to changes
in the volume of production. In the long run, however, the company increases or decreases these costs to the
levels needed to support future production levels.

The cost driver is used as cost-allocation base, a factor that is a common denominator for systematically linking
an indirect cost or group of indirect costs to a cost object. However simply because the cost and the cost driver
change together doesn‟t prove that the cost driver caused the change in the other item. In most situations the
cause – effect relationship is less clear because costs are commonly caused by multiple factors. For example,
factors including production volume, material quality, worker skill levels, and levels of automation.
Traditionally, a single cost driver has been used to predict types of costs. Accountants and mangers, however,
are realizing that single cost driver do not necessarily provide the most reasonable forecasts. This realization has
caused a movement towards ABC costing.
Relevant Range
 Although fixed costs are unchanging regardless of changes in the cost driver, this rule of thumb holds true
only within reasonable limits.
 The relevant range is the range of the cost driver over which the basic cost behavior assumptions will be
valid (i.e. the relationship between costs and cost drivers). For volumes outside these ranges, costs will
behave differently and will alter the assumed relationship.
 Take fixed costs; for example, rent costs, supervisory salary, insurance, property tax. Rent costs, will rise if
increased production requires a larger or additional building or decrease if you move to smaller buildings.
For a particular range of outputs, a business may need to employ only one production supervisor on a fixed
salary (which normally represents a fixed costs). However, to increase production beyond this range will
require the employment of a second supervisor resulting change in fixed cost.
 Even within the relevant range, a fixed cost remains fixed only over a given period of time, usually the
budget period. So fixed costs may change from one year to the next. E.g. insurance, property taxes, rental
levels. But these items are unlikely to change within a given years.

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 Based on aggregation: Total cost and Unit Cost
In economics and cost accounting, total cost (TC) describes the total economic cost of production and is
made up of variable costs plus fixed costs.
The rate at which total cost changes as the amount produced changes is called marginal cost. This is also known
as the marginal unit cost.
Marginal cost = the additional cost of producing one more unit of a product or thing.
Unit (Average) Costs
 A unit cost is the total expenditure incurred by a company to produce, store and sell one unit of a particular
product or service. Unit costs include all fixed costs, or overhead costs, and all variable costs, or direct
material costs and direct labor costs, involved in production.
UC = TC/TQ = UVC+FC/TQ
Example: ABC Bicycles assembles bikes at a variable cost of $52 each. Assume that ABC Bicycles incurred $
94,500 in a given year for the leasing of its plant. What is the unit cost (leasing & assembling) when ABC
Bicycles assembles 1,000 bicycles?
 Total fixed cost ($ 94,500) + Total variable costs ($52,000) = $ 146,500
 146,500/1,000 = $146.50
Based on decision making purposes
Differential Costs: (also known as incremental cost) is the difference in cost of two alternatives. For example,
if the cost of alternative A is $10,000 per year and the cost of alternative B is $8,000 per year. The difference of
$2,000 would be differential cost. The differential cost can be a fixed cost or variable cost.
Opportunity cost:
Unlike other types of cost, opportunity cost does not require the payment of cash or its equivalent. It is a
potential benefit or income that is given up as a result of selecting an alternative over another. For example, you
have a job in a company that pays you $25,000 per year. For a better future, you want to get a Master‟s degree
but cannot continue your job while studying. If you decide to give up your job and return to school to earn a
Master‟s degree, you would not receive $25,000. Your opportunity cost would be $25,000. Almost every
alternative has an opportunity cost. Opportunity costs are not recorded in the books. It is important in decision
making and comparing alternatives.

Sunk cost: The costs that have already been incurred and cannot be changed by any decision are known as
sunk costs. For example, a company purchased a machine several years ago. Due to change in fashion in
several years, the products produced by the machine cannot be sold to customers. The price originally paid to
purchase the machine cannot be recovered by any action and is therefore a sunk cost. This cost is not useful for
decision making as all past costs are irrelevant.
Based on controllability
Controllable & uncontrollable Cost
 As with direct and indirect costs, whether a cost is controllable or non-controllable depends on the point of
reference. All costs are controllable at some level or another in a company.
 Controllable cost (avoidable) is any cost that is influenced by a manger‟s decisions and actions. The manger
has the power to authorize the cost. E.g. entertainment expense for a sales manager if he has the power to
authorize it. Entertainment is performances or activities that people enjoy, or the pleasure gained from them.

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 Uncontrollable cost (unavoidable) is any cost that cannot be affected by the decision of a manger within a
given time span. For example, depreciation of warehouse facilities would not be controllable the sales
manager. The higher the management level, the higher the number of controllable costs and the vice-versa.
Costs that are controllable over the long run may not be controllable over the short run. For example, once an
adverting contract is signed, management has no power to change the amount of spending. But when the
contract expires, advertising cost can be renegotiated, and thus become controllable.
Based on financial statement presentation
Inventorable and Period Costs: Based on the period charged against revenue all costs incurred by the firm
during a given year can be classified into: inventor able costs and period costs. This classification aids
management in measuring income, in preparing financial statements, and in matching expenses to revenues in
the proper period.
Inventor able (capitalized, product) costs
 Inventor able costs are all costs of a product that are regarded as an asset when they are incurred and then
become cost of goods sold when the product sold.
 For manufacturing sector companies, all manufacturing costs are inventor able costs. Thus goods
manufactured this year but not sold until next year are deducted from next year‟s revenue.
 For merchandising sector companies, inventor able costs are the acquisition costs of merchandise which are
resold in their same form.
 For service sector companies, the absence of inventories means there are no inventor able costs except
inventory of supplies and WIP. The firm does engage in productive activity, but the service it produces is
consumed as it is produced.
Types of Inventories
1. Manufacturing – sector companies purchase materials and components and convert them into various
finished goods. These companies typically have three types of inventory:
a. Raw materials inventory- raw materials in stock and awaiting use in the manufacturing process. They can
be materials, supplies and/or component parts received from other sources that are in the same condition as
when received.
b. WIP inventory- Goods partially worked on but not yet fully completed. This would include some DM, DL
and FOH but not all that is necessary to complete the products.
c. Finished goods inventory - Goods fully completed but not yet sold
2. Merchandise – sector companies purchase and then sell tangible products without changing their basic
form. These companies have one type of inventory: merchandise inventory.
3. Service - sector companies provide services (intangible products) – for example, legal advice, checking
accounts, or audits – to their customers. But they may have inventory of supplies but no finished goods
inventory. These companies do not have an inventory of items for sale. For companies with inventories,
generally accepted accounting principles distinguish inventor able costs from period costs.
Non- inventor able (non capitalized, Period) Costs
Period costs are charged to expense in the accounting period in which, they are incurred. They are costs neither
directly nor indirectly related to the product.
 Are non-inventor able costs and are reported in the income statement.
 For manufacturing-sector companies, period costs include all non-manufacturing costs (research and
development, general & administrative expense, selling expense, interest expense, income taxes expense..

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 For merchandising companies, period costs include all costs not related to the cost of goods purchased for
resale (general and administrative expense, selling exp., interest exp., income taxes expense, etc.).
 For service-sector companies, all of their costs are period costs (operating expenses).

Budgeted, standard and actual costs

Actual costs: Costs based on actual transactions and operations during the period just ended, or going back to
earlier periods. Financial statement accounting is mainly based on a business‟s actual transactions and
operations; the basic approach to determining annual profit is to record the financial effects of actual
transactions and allocate the historical costs to the periods benefited by the costs.
Budgeted costs: Future costs, for transactions and operations expected to take place over the coming period,
based on forecasts and established goals. Fixed costs are budgeted differently than variable costs. For example,
if sales volume is forecast to increase by 10 percent, variable costs will definitely increase accordingly, but
fixed costs may or may not need to be increased to accommodate the volume increase.
Standard costs: A standard cost is described as a predetermined cost, an estimated future cost, an expected
cost, a budgeted unit cost. Costs, primarily in the area of manufacturing, that are carefully engineered based on
detailed analysis of operations and forecast costs for each component or step in an operation. Developing
standard costs for variable production costs is relatively straightforward because most are direct costs. In
contrast, most fixed costs are indirect, and standard costs for fixed costs are necessarily based on more arbitrary
methods.
The term standard cost refers to a specific cost per unit. Budgeted cost refers to costs in total given a certain
level of activity.
1.4. The concepts of cost units, cost centers and profit centers
Cost unit is a quantitative unit of product (or service) in relation to which costs are ascertained (or expressed).
A cost unit differs from industry to industry. The unit selected should be one which is the most natural to the
business and is acceptable to all concerned. Examples: (i) Cost per kg. of sugar; (ii) Cost per 1,000 bricks; (iii)
Cost per ton of cement, etc.
Cost Center is the smallest segment of activity (or area of responsibility) for which costs are ascertained. It is
an organizational subunit, such as a department or division, whose manager is held accountable for the costs
incurred in the subunit. Cost Center may be a location or person or item of equipment or group of all these in
respect of which cost may be ascertained and used for the purpose of Cost Control. So, a Cost Centre may be a
warehouse or an individual or a machine in the factory. For a cost center, the person in its charge is responsible
for the control of its costs.

A profit center is a business unit or department within an organization that generates revenues and profits
or losses. It is an organizational subunit whose manager is held accountable for profit. Since profit is equal
to revenue minus expenses, profit-center managers are held accountable for both the revenue and expenses
attributed to their subunits. Management typically uses profit center results to decide whether to allocate
additional funding to them, and also whether to shut down low-performing units.

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