CHAPTER 1: THE FUNDAMENTALS OF COSTING

I. Cost accounting
1. Cost accountant

Have access to cost information

Answer historical questions regarding cost & * What was the cost of goods produced or
revenue information services provided last week?
• What was the cost of operating a
-> assess the profitability, determine selling department last month?
price, put a value on inventory • What revenues were earned last year?

Provide information for forecasts or estimates • What are the future costs of goods and
for the future services likely to be?
• What information does management need in
order to make sensible
decisions about future profits and costs?
• What financial resources will be needed to
fund future growth or
activities?

2. Cost accounting & Management accounting

- Similarity: concerned with provision of information to help management with planning, control
and decision making
- Difference: cost accounting is a part of management accounting

3. Cost accounting systems

Provide information to help:
- Establish inventory valuations, profits or losses & balance sheet item
- Plan
- Control
- Decision making

4. Financial accounting vs Management accounting

Financial accounting Management accounting

Detail the performance of Aid management to record, plan and control

an organisation over a defined period the organisation's activities and to help the
decision-making process.

Must comply with law No legal requirement

The format of published financial accounts is The format of management accounts is

determined by law entirely at management discretion
 Often concentrate on the business as a whole Can focus on specific areas of an
organisation's activities

Most financial accounting information is of a The format of management accounts is

monetary nature entirely at management discretion

Present an essentially historical picture of Management accounts are both a historical

past operations. record and a future planning tool, linking to
budgets and forecasts.

II. Basic cost accounting concepts

Cost concepts Examples

Cost object: anything for which we are • a unit of product (e.g., a cake, a table)
trying to ascertain the cost. It could be a • a unit of service (e.g., a painting service of a
cost unit or a cost centre. table)
• a department or function (e.g., the packing
department)
• a project (e.g., the installation of a new camera
system)
• a new product or service

Cost unit: basic measure of product or Hospital -> patient/day; operation;...

service for which costs are determined
-> unit of quantity of product, service, or
time

Composite cost units: cost units being patient/ day cost; cost per tonne/ kilometers
made of of 2 parts
-> most used in service organizations
-> useful for monitoring & controlling
cost

* The concept of cost:

- A noun: amount of money incurred in producing a product
- A verb: the act of determining the amount of money incurred in operating a department
- Costs need to be classified in some way

* Direct & Indirect costs

Types of costs Examples

Direct cost: costs identified with a cost object Material used in production, worker paid for
making units, etc
 Indirect costs: costs that cannot be identified Salaries for production managers, rent of the
with a particular cost object building, etc.

III. Cost classification for inventory valuation & profit measurement

1. Cost elements
- Materials -> direct cost
- Labour -> direct cost
- Other expenses -> mixed: direct or indirect cost

2. Direct cost & Prime cost

- Definition: a cost that can be traced in full to the cost unit
- Types of direct cost:

Types Examples

Direct material costs: costs of material Components, packing materials

used in making & selling a unit of product/
service

Direct labour costs: costs of the workforce Wages paid to an employees sewing a
used to make a unit of product/ service button on a coat

Other direct expenses: expenses incurred Cost of hiring a special machine for a job
in full as a consequence of making a unit
of product/ service, running a department

- Prime cost = total direct cost = direct material cost + direct labour cost + direct expenses

3. Indirect cost & Overhead

* Indirect cost:
- Definition: a cost that is incurred which cannot be traced directly and in full to the cost
unit
- Eg: supervisors’ wages on a production line

* Overhead
 Concepts Examples

Production overhead: includes all indirect material used across several different
material costs, indirect wages and indirect products; supervisors’ wages, depreciation of
expenses incurred in the factory from receipt plan & buildings
of the order until its completion

Administration overhead: all indirect ‐ Depreciation of office equipment

material costs, wages and expenses incurred ‐ Office salaries, including the salaries of
in the direction, control and administration of secretaries and accountants
an undertaking ‐ Rent, rates, insurance, telephone, heat and
light cost of general
offices

Selling overhead: all indirect materials costs, ‐ Advertising cost

wages and expenses incurred in promoting ‐ Sales promotion
sales and retaining customers ‐ Printing of catalogues and price list
‐ Salaries and commissions of salesmen
‐ Sales department’s costs like staff, rent,
rates and insurance of showroom
‐ Cost of free samples to customers

Distribution overhead: all indirect material ‐ Packing cost

costs, wages and expenses incurred in ‐ Wages of packing staff, drivers, dispatch
making the packed product ready for clerks
despatch and delivering it to the customer ‐ Rent and rates, insurance and depreciation
of finished goods
warehouse
‐ Cost of delivery of finished goods

4. Product cost & Period cost

- Product cost:
+ costs of making or buying an item of inventory
+ Presented on Balance Sheet, Income Statement
- Period cost:
+ costs deducted as expenses during a particular period
+ Presented on Income Statement

IV. Cost classification for planning & decision making

1. Cost behavior patterns
- Definition: the way that costs vary in relation to the level of activity
- The level of activity can be measured in different ways depending on the circumstance
Eg: volume of production in a period, number of item sold, number of machine hours

2. Fixed costs & Variable costs

 Contents Fixed costs Variable costs Semi-variable costs

Definition Cost is not affected by Cost that changes as the Cost that partly affected by
changes in the level of level of activity increases or changes in the level of
activity decrease activity

Graph

Example - The rental cost of - Sales commissions varies Cost of running car:
business premises with the level of sale - FC: roadway fees
- Straight-line depreciation - Direct material costs when - VC: gas bill
more units of a product are
manufactured

3. Cost behaviour & Total Costs & Unit costs

4. The relevant range: the range of activity levels within which assumed cost behaviour
patterns occur

V. Cost classification for control

1. Responsibility accounting
- Definition: a system of accounting that segregates revenue and costs into areas of
personal responsibility
- Responsibility centre: a department or function whose performance is the direct
responsibility of a specific manager.

2. Controllable & Uncontrollable costs

Controllable cost: costs that can be Examples: Materials used for production,
influenced by managers wages paid to production
 workers, etc. can be controlled by production
managers.

Uncontrollable costs: costs that cannot be Increase expenditure due to inflation

affected by managers or some specific
managers within a given time span.

-> a cost that is not controllable by a junior manager might be controllable by a senior manager
Ex: senior manager hires extra full-time staff to reduce the requirements for overtime for junior
manager

-> a cost that is not controllable by a manager in one department may be controlled by a
manager in another department
Ex: an increase in material costs may be caused by buying at higher price than expected -
controlled by the purchasing department

VI. Ethics
- Professional accountant: an individual who is a member of an IFAC member body
- Ethical guidances -> ensure professional accountants in business prepare and report
information fairly, honestly and in accordance with relevant professional standards so
that the information will be understood in its context.
- Fundamental principle:
+ Integrity
+ Objectivity
+ Professional competence and due care
+ Confidentiality
+ Professional behavior
 CHAPTER 2: CALCULATING UNIT COSTS (PART 1)
I. Identifying direct & indirect costs for cost units
1.1. Direct cost
Direct material cost Direct wages or direct Direct expenses
labor costs

Definition - All material becoming - All wages paid for labour - Any expenses are
part of the cost unit (either basic hours or as incurred on a specific
(unless having negligible overtime) that can be cost unit other than
costs) identified with the cost unit direct material cost &
- Are charged to the cost - Are charged to the cost direct wages
unit as part of the prime unit as part of the prime - Are charged to the
cost cost product as part of the
prime cost

Example - Component parts - Workers alter the - Cost of special

- Primary packing condition, conformation/ designs, drawings or
materials, eg: cartons & composition of the product layouts
boxes - Inspectors, analysts, - The hire of tools or
testers specifically equipment for a
required particular job

Note - Not overtime premium

- Only specifically required
inspectors, not overseeing

1.2. Indirect costs

- Costs that cannot be traced in full to a specific cost unit
- Example: Rent, buildings insurance, depreciation of the garage equipment

1.3. Further points

- Direct costs are not necessarily bigger in size than indirect cost
- Indirect cost are not less important than direct cost
- Confusion between fixed - variable costs & direct - indirect costs:
+ Direct cost is often also a variable cost, eg: costs of raw materials that goes in
making a unit of product
+ Direct cost is a fixed cost, eg: the direct cost of the labor employed to do a
certain type of work
+ Indirect cost is a variable cost, eg: the cost of heating may rise as more hours are
worked

II. Inventory valuation

2.1. Valuing inventory in financial accounts
- In accounting: valued at the lower of cost and net realizable value
- In practice: valued at cost in the stores records throughout the course of an accounting
period
2.2. Charging units of inventory to cost of production or cost of sales
 Definition Advantages Disadvantages

FIFO (First in, Materials are issued at - Represents what is - Can be cumbersome to
First out) the cost of the earliest physically happening: operate (need to identify
delivery remaining in oldest inv is likely to be each batch of material
inventory used first separately)
- Easy to understand & - Manager may find
explain to manager difficult to compare costs
& make decisions (when
charging with varying
prices for the same
materials)
- Inv valuation can be - High inflation -> inv
near to a valuation issue prices will lag
based on replacement behind current market
cost value

LIFO (last in, Most recent deliveries - Inv are issued at a - Can be cumbersome to
first out) are issued before price close to current operate (results in
earlier ones & issues market value several batches being
are priced accordingly only part-used in the inv
records before another
batch is received)
- Managers are - Opposite of what is
continually aware of physically happening ->
recent costs when difficult to explain to
making decisions managers
- Difficult to make
decision due to the
variations in prices

Cumulative A new weighted - Fluctuations in prices - Resulting issue price is

weighted average price is are smoothed out -> rarely an actual price that
average calculated whenever a easier to use data for has been paid -> several
pricing new delivery of decision-making decimal places
materials is received - Easier to administer - Prices tend to lag a little
into the store (no need to identify behind current market
each batch separately) values (gradual inflation)

Periodic A single average is

weighted calculated at the end of
average the period based on all
pricing purchases for the
period

2.3. Inventory valuation & profitability

- Different methods of inv valuation will provide different profit figures
- The profit differences between methods are only temporary
CHAPTER 3: CALCULATING UNIT COSTS (PART 2)
I. Absorption costing
1.1. Calculating the absorption cost of a cost unit

Stages of determining the share of overhead:

- Overhead allocation
- Overhead apportionment
- Overhead absorption

1.2. Overhead allocation

- Allocation is the process by which whole cost items are charged direct to a cost centre
- Cost centre acts a collecting place for those costs before being analysed further
- Types of cost centres:
+ Production department -> charged production overheads
+ Production service department -> charged production overheads
+ Administrative department -> charged administration overheads
+ Selling/ Distribution department -> charged sales & distribution overheads
+ Overhead cost centre -> charged items of expense which are shared by a
number of departments, eg: electricity, rent, canteen,...
Eg: cost of warehouse security guard -> charged to the warehouse cost centre

1.3. Overhead apportionment

1.3.1. First stage: apportioning general overheads
- Identify all overhead costs as production, production service, administration, selling &
distribution department overheads
- The costs for heat, light, rent,... must be shared out between the other cost centres
- Overhead costs should be shared out on a fair basis:

- Overhead costs are apportioned formula:

1.3.2. Second stage: service cost centre cost apportionment
- Concerns the treatment of service cost centres
- The factory is divided into several production departments & service departments, but only the
production departments are directly involved in the manufacture of the units
- Apportion the costs of service cost centres to the production cost centres

- If there are several service cost centres:

+ First apportionment is for the service cost centre with the largest costs
+ The cost of the second service cost centre

1.4. Overhead absorption

Absorb allocated/ apportioned overheads into the cost of production/ sales:
- Production overheads: added to prime cost, being included in the value of inventories of
finished goods
- Administration, selling & distribution overheads: non-production overheads is the the
total cost of sales, not being included in the value of closing inventory

1.4.1. Predetermined absorption rate

1.4.2. Calculating predetermined overhead absorption rates
1.4.3. Selecting the appropriate absorption base

1.5. Blanket absorption rates & department absorption rates

1.6. Over & Under absorption of overheads