CHAPTER ONE

1. Overview of Cost and Management Accounting

1.1 Objectives of Cost & Management Accounting

Accounting is the process of identifying, measuring, recording and communicating financial
information to interested users so that they can make the best possible decisions. Thus, cost
accounting is the process of identifying, measuring, recording and communicating cost
information which will be used for determination of cost of a products or services on the basis of
historical data. This was the emphasis of cost of accounting for many years, however in the
course of time, the determination of cost of product or service has become equally important
with cost control due to competitive nature of the market and because of technological
developments in all areas. Thus, now a day’s cost control and reduction has also come within the
scope of cost accounting.
Modern cost accounting is, thus, concerned with recording, classifying and reporting cost
information for:
 Determination of costs of products or services,
 Planning, controlling and reducing costs and
 Furnishing of information to management for decision making.
Cost accounting measures and reports financial and other information related to the acquisition
or consumption of an organization’s resources. Cost accounting provides information to both
management accounting and financial accounting.
Management accounting is the process of identification, measurement, accumulation, analysis,
preparation, interpretation, and communication of financial (and non-financial) information used
by management to plan, evaluate, and control the organization and to assure appropriate use and
accountability for its resources.
Management accounting information helps organization make better decisions. Such decisions
make all organizations become more cost effective and help manufacturing, retail and service
organizations becomes more profitable. The major objectives of managerial accounting activity
are:
 Providing managers with information for decision making and planning
 Assisting managers in directing and controlling operational activities
 Motivating managers and other employees toward the organizational goals
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 Measuring the performance of subunits, managers and other employees within the
organization.

1.2 Cost and management accounting in comparison with financial accounting

Cost accounting refers to the accounting procedures relating to recording of all incomes 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 cost of
products or services are ascertained and controlled.
Cost accounting: is primarily concerned with determination of cost of something, which may be
a product, service, a process or an operation. A cost accountant is primarily charged with the
responsibility of providing cost data for whatever purposes they may be required.
Financial accounting: is primarily concerned with the preparation of financial statement, which
summarizes the results of operation for selected period of time and show the financial position of
the corporation at a particular date.

1.3 Cost terms, concepts and classification

Costs: Accountants usually define cost as resource scarified or forgone to achieve a specific
objective. It refers to an out lay or expenditure of money to acquire goods and services in the
course of generating revenue.
Expense is an expired portion of cost i.e. as the asset is used in generating revenue; the amount
consumed becomes an expense. The cost of asset used should then be recognized as expense to
properly match revenue and expense in the process of determining the income of the
organization over a given period
Cost object: is anything for which a separate measurement of cost is desired. In manufacturing
company, the cost object is the unit of finished goods produced.
Cost accumulation: is the collection of cost data in some organized way by means of an
accounting system. For example, organizations that manufacture consumer goods accumulate the
costs incurred in producing the commodities.
Cost assignment is a general term that encompass both (1) tracing accumulated cost that have
direct relationship to the cost object and (2) allocating accumulated costs that have an indirect
relationship to a cost object.
Cost -tracing is used to describe the assignment of direct costs to the particular cost object and
can be traced to it in an economically feasible (cots effective) way
Cost allocation is used to describe the assignment of indirect costs to the particular cost object
but cannot be traced to it in an economically feasible (cots effective) way.
Cost driver/cost determinant: is any activity that causes costs to be incurred. A cost Driver is
characteristics of an activity or event that causes that activity or event to incur costs. The cost
driver of variable costs is the level of activity or volume whose change causes the (variable)
costs to change proportionately.
Cost management: is the set of actions that a manager takes to satisfy customers while
continuously reducing and controlling cost.

1.3.1 Cost classification

 Direct and indirect costs,

Direct costs are costs that are directly traceable to the product. Costs that can be identified
specifically with or traced to a given cost object in an economically feasible way. Example:
 Direct material cost
 Direct labor cost
Indirect cost, Costs that cannot be identified specifically with or traced to a given cost object in
an economically feasible way (manufacturing overhead or factory overhead): are costs which are
not directly traced to the product but allocated to it by using some criteria. Example:
 Cost of electricity
 Depreciation of equipment
 Indirect labor
 Fixed and variable costs
Fixed cost is a cost which remains constant within a given relevant range regardless of change in
output level, Variable cost: are costs that vary in total, in direct proportion to changes in the
level of activity or cost driver i.e. if activity increase by n%, total variable cost also increase by n
%, but the per unit cost remains constant.
E.g. direct material cost, direct labor cost, commission paid to sales personnel, wages paid to
employees will increase as level of output increases.
 Period and product costs
A. Product costs: are cost producing goods that are sold to customers. They are also called
manufacturing cost and are composed of Direct Material, Direct Labor & Factory overhead.
Direct Material Costs: - All manufactured products are made from basic direct materials. Direct
 Materials are the acquisition costs of materials that can be conveniently and economically
traced to specific unit of product. Acquisition cost of direct materials includes freight –in
charges, sales taxes and customs duties. Some examples of direct materials are iron ore for steel,
sheet steel for automobiles and sugar for candy.
Direct Labor Costs: are the costs of labor to complete production activities that can be
conveniently and economically traced to specific units of product. The wages of machine
operators and other workers involved in actually shaping the product are direct labor costs.
Manufacturing Overhead Costs: The third elements of product cost include all manufacturing
costs that cannot be classified as direct materials or direct labor costs. Manufacturing overhead
costs are production related costs that can’t be practically or conveniently traced directly to an
end product. This assortment of costs is also called factory overhead, or indirect manufacturing
costs. Three common components of manufacturing overhead costs are indirect material costs,
indirect labor costs and other manufacturing overhead costs.
Indirect material costs: are the costs of materials that cannot be conveniently or economically
traced to a unit of product e.g. cost of nails, reverts, lubricants and small tools.
Indirect labor costs: are labor costs for production related activities that cannot be conveniently
or economically traced to a unit of product. E.g. cost of labor for maintenance, inspection,
engineering design, supervision, materials handling and machine handling.
Other indirect manufacturing costs: Cost of building and machine maintenance, property
taxes, property insurance and depreciation on plant and equipment used in production.
These costs are treated as assets until the product is sold as raw material inventory, work in
process inventory and finished goods inventory and later expensed in the form of cost of goods
sold when the product is sold.
B. Period (non-manufacturing) costs: Period costs are all goods in the income statement other
than cost of goods sold. These costs are treated as expenses of the period in which they are
incurred because they are assumed not to benefit future periods. Expensing these costs
immediately best matches to revenues.
 Controllable and uncontrollable costs
A cost which is under the control of a given manager is controllable cost where as a cost which
is beyond the control of a given manager is uncontrollable. Controllability of a cost depends on
the level of management and time period. All costs are controllable by someone at some level in
the organization if the time period is longer enough.
 Avoidable and unavoidable costs
An avoidable cost is a cost that is not incurred if the activity is not performed. For
example, supply expenses are avoidable costs. You can simply decide to not buy the
supplies, and no expense will be incurred. These costs are often identified as variable
costs, which vary based on production. If there is no production, there is no cost.
An unavoidable cost, on the other hand, is a cost that is still incurred even if the
activity is not performed. For example, if a manufacturing plant shuts down, its
avoidable costs (i.e. variable costs), like materials or supplies, will be $0, but it still
needs to pay for idle equipment, property taxes, lease payments, etc. These costs are
often considered fixed costs. Fixed costs are expenses that do not depend on production.
Sunk costs: A sunk cost refers to a cost that has already occurred and has no potential
for recovery in the future. For example, your rent, marketing campaign expenses or
money spent on new equipment can be considered sunk costs. A sunk cost can also be
referred to as a past cost.

1.4 The concepts of cost units, cost centers and profit centers
Cost center refers to one of the convenient unit into which the whole factory
organization has been appropriately divided for costing purposes. Each such unit
consists of a department or a sub department or item of equipment or, machinery
or a person or a group of persons. Cost unit- a unit of product or service in
relation to which costs are ascertained. The forms of measurement used as cost units are
usually the units of physical measurements like number, weight, area, length, time etc.
Unit selected should be unambiguous, simple and commonly used. We may for instance
determine the cost per machine hour.
A profit center is a section of a company treated as a separate business. Thus profits
or losses for a profit center are calculated separately.