chapter 1 Rationales for Costing

Chapter Content
1 Management
Managementandand 4 Understanding
Understanding
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costs

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2
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 Management and Cost Accounting

Accountancy involves the measurement, analysis and reporting of

financial and non-financial information to help managers, shareholders
and other interested partied to make decisions about the organization

1 Management accounting
Is the application of the principles of accounting and financial
management to create, protect, preserve and increase value for
stakeholders for profit and not for profit organizations

Cost accounting
It is a sub-set of management accounting. Cost accounting focuses on the
calculation of the cost. It is the gathering of cost information and its
attachment to cost objects or service, the establishments of budgets,
standard cost and actual cost of operation.
 Management Accounting vs.
Financial accounting

1 Management Accounting Financial Accounting

1) internal focus 1) external focus

2) no legal requirement 2) required by law

3) no set formats or rules 3) governed by rules and regulations

4) main purposes are planning, 4) purpose is the production of statutory

controlling and decision making accounts
 Management Accounting
 Planning is formulating short  Control is the process of
term and long-term plans and monitoring, measuring,
actions to achieve a particular PLANNING evaluating and correcting
end. actual results to ensure that a
 A budget is the financial
business enterprise’s goals and
planning showing how plans are achieved.
A
resources are to be acquired
and used over a specified time
interval. B
C Management
accounting CONTROL

DECISION
MAKING
Decision-making is a process of choosing
among competing alterna­tives. Decision-
making is inherent in each management
function.
 Purpose of Management Accounting

1) Purpose of management accounting is to help managers

make decisions.
2) Management accounting helps organizations improve
their ability to control costs and plan for the future
through financial forecasts.
3) It also focuses on providing reports to ensure
comprehensive management oversight.
4) Main purposes are planning, controlling and decision
making
 3 Role of Management Accountant

The management accountant plays a vital role in the decision-

making process of the organization. He is variously known as
Controller of Finance, Financial Controller, Financial Advisor or
Chief Accounts Officer, etc.
1) Strategic planning
With the increasing complexity, volatility, uncertainty, and
pace of change and competition in today’s global
marketplace, the need for strategic analysis and execution
has never been greater. Management accountants are in a
unique position to participate in and lead the strategic
analysis process.
 3 Role of Management Accountant

2) Acquisition of finance
Management accountant has a major role to play in
raising of funds and their application. He has to decide
about maintaining a proper mix between debt and
equity. Raising of funds through debt is cheaper because
of tax benefits.
Management accountant has, therefore, to maintain an
optimum capital structure and give due consideration to
various cost of capital theories, leverage and possibility of
trading on equity.
 3 Role of Management Accountant

3) Improving business systems

a) Devising new systems, business processes, and analyses that save
the company money and help it run more efficiently
b) These main purposes of management accounting (planning,
controlling and decision making can only be guaranteed by the
proper analysis from management accounting information system
c) Accounting information is a substance for management planning,
control and effective business decision making as the result
d) The routine reports as well as reports for long-term decision-making
are forwarded to managerial personnel at all levels to take corrective
action at the right time.
e) The management accountant also uses these reports for taking
important decisions
 3 Role of Management Accountant

4) Performance measurement
a) An important role of the management accountant is to
provide decision making information for performance
measurement and helping to develop or refine
performance measurement systems.
b) The process of developing measurable indicators that
can be systematically tracked to assess progress made
in achieving predetermined goals and using such
indicators to assess progress in achieving these goals
 3 Role of Management Accountant

5) Risk management
6) Risk is the “effect of uncertainty on objectives” and an
effect is a positive or negative deviation from what is
expected (ISO 31000).
7) designed to identify potential events that may affect
the entity, and manage risks to be within its risk
appetite, to provide reasonable assurance regarding
the achievement of the entity’s objectives”.
 3 Role of Management Accountant

5) Interpreting financial information

a) Managerial accountants perform cash flow analysis in
order to determine the cash impact of business
decisions. Most companies record their financial
information on the accrual basis of accounting.
b) Essentially, management accountants provide key
insights that help a company's management team
make many of their decisions. They also support
decision making within a company by providing a
wealth of financial and statistical information, often
assisted by powerful accounting software
Functions of Management Accounting Information
 Characteristics of Information

1) Accurate (Must not contain any errors)

2) Cost beneficial (economical both in terms of time and cost)
3) Complete (must contain all important, related data)
4) Reliable (dependable, generated using correct data)
5) Understandable (simple and usable)
6) Easy to Use (formatted, should be available in desired
format)
7) Relevant (can be used by organization)
8) Verifiable (means to cross check)
9) Authoritative
10) Timely (available when needed)
11) Secure (access allowed to authorized individuals only)
 Cost identification and classification

Basic terminology

Cost Cost unit/

Cost
object composite
centre
cost unit
 Cost identification and classification

Cost Object Definition

describe something to which costs are assigned. Common examples of cost objects
are: product lines, geographic territories, customers, departments or anything else
for which management would like to quantify cost.

Types of Cost Objects

1) Output: The most common cost objects are a company's products and services. Assigning
a cost enables profitability analysis and price setting.
2) Operational: A cost object can be an area or function within a company, such as a
department, tooling operation, production line, or process. For instance, you could track
the cost of introducing a new product, or service call, or of refurbishing a returned product.
3) Business Relationship: A cost object can be external to the company, such as a supplier or
a customer, to determine the cost of dealing with that entity. Another variation on the
concept is the cost of renewing permits or licenses.
 Cost identification and classification

Cost Center:
a) A cost center is a function within an organization that does not
directly add to profit but still costs money to operate, such as the
accounting, HR, or IT departments.
b) The main use of a cost center is to track actual expenses for
comparison to budget.
c) A cost center indirectly contributes to a company’s profit via
operational excellence, customer service, and enhanced product
value.
d) The manager for a cost center is only responsible for keeping costs in
line with budget and does not bear any responsibility regarding
revenue or investment decisions.
 Cost identification and classification

Cost Unit:
Parameter of Cost Centre Cost Unit
Comparison
Meaning It is the term used to refer to the cost incurring It is the term used to identify the
subdivision that is not actively contributing to the specific product/service that is the
revenue generation of the organization. cause of the costs.
Scope It has a broader scope. It has a narrow scope.
Cost Cost units absorb the costs collected. It is the unit to measure the cost.
Purpose It helps to classify costs. It acts as a standard medium of
comparison.
Precedence It comes first in the process of cost analysis. It is preceded by the cost center.
Number There can be several cost centers. There are different cost units for
each product/service.
 Classification of costs

B Element

C nature
costs A function

D behaviour
 Classification of costs by FUNCTION A
1) Production or Manufacturing Costs
All the costs relating to the production of goods or services, whether
direct or indirect, variable or fixed, are included in the production
cost.

2) Non-production costs
a) Administration Costs
b) Marketing or Selling Costs
c) Distribution Costs
d) Research and Development Costs
e) Customer Service
Classification of costs by ELEMENTB
1) Materials:
“The material cost is the cost of commodities supplied to an undertaking
a) Direct materials cost
The cost of materials entering into and becoming constituent elements
of a product or saleable service”. Thus, materials which can be
identified with units of output or service are known as direct materials
b) Indirect Materials
 materials cost which cannot be identified with a specific product,
job, process is known as indirect material cost.
 Small tools, stationery used in works, advertising posters, and
materials used in maintenance of plant and machinery are a few
examples of indirect materials.
Classification of costs by ELEMENTB
2) Labor:
 Labor is the remuneration paid for physical or mental effort
expended in production and distribution.
 The labor cost is the cost of remuneration (wages, salaries,
commissions, bonus, etc.) of the employees of an undertaking
a) Direct Labor Cost:
also called ‘Direct-wages’. Direct labor cost is the cost of labor
directly engaged in production operations. (e.g., workmen engaged
in assembling parts, carpenters engaged in furniture making, etc.)
b) Indirect Labor Cost:
the remuneration paid for labor engaged to help the production
operations. The labor costs of idle time, overtime, holidays, etc., are
also taken as indirect costs.
Classification of costs by ELEMENTB
3) Expenses:
The cost of service provided to an undertaking and the notional cost
of the use of owned assets
a) Direct Expenses:
These are the expenses which can be directly identified with a
unit of output, job, process or operation. They are specifically
incurred for a job, or unit or process and in no way they are
connected with other jobs or processes. The direct expenses are
also known as chargeable expenses.
b) Indirect Expenses:
Indirect expenses are expenses other than indirect material and
indirect labor, which cannot be directly identified with units of
output, job, process or operation
Classification of costs by ELEMENTB
4) Factory Overhead:
 This is the aggregate of indirect material, indirect wages and
indirect expenses incurred in the factory. Examples of indirect
factory expenses are rent, power, depreciation lighting and
heating incurred in the factory.
 The aggregate of all the indirect costs i.e., Indirect Material,
Indirect labor and Indirect expenses is variously termed as ‘On
cost’ or ‘overhead’ or ‘Burden’. Over heads or on cost or indirect
cost cannot be identified with specific products or jobs. So it is
apportioned to the output on some reasonable basis.
Classification of costs by ELEMENTB
Direct Cost or Prime Cost:
The aggregate of all the direct costs i.e., Direct Materials, Direct Labor or wages
and Direct expenses is termed as- ‘Prime Cost’ or ‘Direct cost’. Thus prime cost
or direct cost is the sum of all the elements of costs which can be specifically
identified with particular products or jobs and allocated to such output.

The following items are excluded from computation of total cost:

a) Capital Costs and Capital Losses- Purchase of fixed assets, plant and
machinery, building, etc. Loss on sale of fixed assets, abnormal losses,
preliminary expenses, patents written off, etc.
b) Transfer to reserves, income tax, dividend, bonus to shareholders, etc.
c) Financial items like, cash discount, interest on debentures, interest on
loans, interest on own capital, etc.
 Classification of costs by NATURE C
1) Direct Costs:
 Direct Costs are the costs which can be conveniently identified
with and allocated to a particular unit of final product.
 Such costs are treated as the cost of the unit produced. The
examples of direct costs are raw materials, labor and other direct
expenses which are exclusively incurred for a particular unit of
cost, i.e., job, product or process.
2) Indirect Costs:
 Indirect Costs are those costs which cannot be assigned to any
particular cost unit, i.e., job, product or process.
 Indirect costs are, usually, incurred for the business as a whole
and are, therefore, apportioned among the various cost units
(product, job or process) on some reasonable basis.
Classification of costs by BEHAVIOURD
1) Fixed Costs
 Fixed costs are those which do not change with the level of
activity within the relevant range.
 These costs will be incurred even if no units are produced. For
example rent expense, straight-line depreciation expense, etc.
2) Variable Costs
 Variable costs change in direct proportion to the level of
production.
 This means that total variable cost increase when more units
are produced and decreases when less units are produced.
 Average variable cost i.e. variable cost per unit is constant
Classification of costs by BEHAVIOURD
3) Mixed Costs
 Mixed costs or semi-variable costs have properties of both fixed
and variable costs due to the presence of both variable and fixed
components in them.
 An example of mixed cost is delivery cost which has a fixed
component of depreciation cost of trucks and a variable
component of fuel expense.
 Since mixed cost figures are not useful in their raw form,
therefore they are split into their fixed and variable components
by using cost behavior analysis techniques such as High-Low
Method, Scatter Graph Method and Regression Analysis.
Classification of costs by BEHAVIOURD
4) Stepped Cost
 Stepped cost refers to the behavior of the total cost of an activity at
various levels of the activity. When a stepped cost is plotted on a graph
(with the total cost represented by the y-axis and the quantity of the
activity represented by the x-axis) the lines will appear as steps or stairs
rising from left to right.
 To illustrate a stepped cost, let's assume that you are developing a website
and find that the monthly cost of hosting the site is based on the number
of visits. For 0 to 999 visits per month, the cost is $20 per month. When
the visits are in the range of 1,000 to 2,999 the monthly cost jumps to $50.
If the visits are 3,000 to 9,999 the cost will be $200 per month. For
monthly visits of 10,000 to 24,999 the cost is $300, and so on. As the data
indicates, the total monthly cost is constant or fixed only for a given
range of activity (number of visits). When the number of visits exceeds the
upper limit of a range, the monthly cost jumps to a higher level and
remains fixed until the visits exceed the new upper limit.
Classification of costs by BEHAVIOUR
D

Category Fixed Costs Variable Costs Mixed Costs

Total cost Constant Changes Change with output
proportionately with but not
output proportionately
Cost per unit Decreases with Constant Decreases with
increase in output increase in output but
less than the decrease
in fixed cost per unit
Examples Plant depreciation, Fuel expense, wages, Telecommunication
property taxes raw materials costs, senior
management salaries,
transportation cost