Introduction to Cost Accounting - Topic 1

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INTRODUCTION TO COST

ACCOUNTINGACC116

ZAIRINAWATI BINTI AHMAD

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INTRODUCTION

1. Cost Accounting, Management and Financial Accounting

2. Cost, Cost Unit and Cost Centres3. Classification and Types of Costs

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AT THE END OF THIS CHAPTER, STUDENT MUST BE ABLE TO:

1. Differentiate between Cost Accounting and Financial Accounting.

2. Explain and differentiate between cost, cost unit and cost center.

3. Classify cost according to function, traceability and behavior.

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COST ACCOUNTING

CIMA defines cost accounting as “the establishment of budgets, standard costs and actual costs of operations, processes, activities or products; and the analysis of variances, profitability or the social use of funds”

Costing involves “the classifying, recording and appropriate allocation of expenditure for the determination of costs of products or services; the relation of these costs to sales value; and the ascertainment of profitability”.

COST + PROFIT = SALES

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OBJECTIVES OF COST ACCOUNTING

Cost accounting has the following main objectives to serve:

1. Determining selling price,2. Controlling cost3. Providing information for decision-making4. Ascertaining costing profit5. Facilitating preparation of financial and other

statements.6. Allocate costs between cost of goods sold and

inventories for internal and external profit reporting.

7. Provide information for planning, control and performance measurement.

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FINANCIAL ACCOUNTING

Financial accounting can be defined as “the process of identifying, measuring, and communicating economic information to permit informed judgments and decisions by users of information”.

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MANAGEMENT ACCOUNTING

Management accounting in the words of Robert S. Kaplan, is a system that collects, classifies, summaries, analyses and reports information that will assist managers in their decision making and control activities.

Management accounting is largely concerned with providing economic information to managers for achieving organisational goals.

Management accounts are prepared for internal managers of an organisation.

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FINANCIAL ACCOUNTING AND MANAGEMENT ACCOUNTING

Financial accounts are prepared for external users:1. Shareholders2. Customers3. Suppliers4. The Inland Revenue5. Employees

The data used to prepare financial accounts and management accounts are the same. The differences between the financial accounts and the management accounts arise because the data is analysed differently.

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DIFFERENCES BETWEEN FINANCIAL ACCOUNTING AND COST ACCOUNTING

Basis Financial Accounting Cost Accounting

Objective

It provides information about the financial performance and financial position of the business.

It provides information of ascertainment of cost to control cost and for decision making about the cost.

Nature It classifies records, presents and interprets transactions in terms of money.

It classifies, records, presents, and interprets in a significant manner the material, labour and overheads cost.

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DIFFERENCES BETWEEN FINANCIAL ACCOUNTING AND COST

ACCOUNTING

Basis Financial Accounting Cost Accounting

Recording of data

It records Historical data. It also records and presents the estimated/budgeted data. It makes use of both the historical costs and pre-determined costs..

Users of information

The users of financial accounting statements are shareholders, creditors, financial analysts and government and its agencies, etc.

The cost accounting information is used by internal management at different levels.

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DIFFERENCES BETWEEN FINANCIAL ACCOUNTING AND COST

ACCOUNTING

Basis Financial Accounting

Cost Accounting

Analysis of costs and profits

It shows the profit/ loss of the organisation.

It provides the details of cost and profit of each product, process, job, contracts, etc.

Time period

Financial Statements are prepared for a definite period, usually a year.

Its reports and statements are prepared as and when required.

Presentation of information

A set format is used for presenting financial information.

There are not any set formats for presenting cost information.

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DIFFERENCES BETWEEN FINANCIAL ACCOUNTING AND MANAGEMENT ACCOUNTING

Financial Accounting Management Accounts

Financial accounts detail the performance of an organisation over a defined period and the state of affairs at the end of the period.

Management accounts are used to aid management record, plan and control the organisation’s activities and to help the decision-making process.

Limited companies must, by law, prepare financial accounts.

There is no legal requirements to prepare management accounts.

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The format of published financial accounts is determined by law (mainly the Companies Acts), by Statements of Standard Accounting Practice and by Financial Reporting Standards. In principle the accounts of different organisations can therefore be easily compared.

The format of management accounts is entirely at management discretion; no strict rules govern the way they are prepared or presented. Each organisation can devise its own management accounting system and format of reports.

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Financial Accounting Management AccountsFinancial accounts concentrate on the business as a whole, aggregating revenues and costs from different operations, and are an end in themselves.

Management accounts can focus on specific areas of an organisation’s activities. Information may be produced to aid a decision rather than be an end product of a decision.

Most financial accounting information is of a monetary nature.

Management accounts incorporate non-monetary measures. Management may need to know, for example, tons of aluminium produced, monthly machine hours, or miles travelled by salesmen.

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Financial accounts present in an essentially historic picture of past operations.

Management accounts are both an historical record and a future planning tool.

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COST, COST UNIT AND COST CENTRES

CIMA Terminology defines cost as ‘resources sacrificed or forgone to achieve a specific objective’.

Cost is generally measured in monetary terms. Cost is the amount of expenditure (actual or

notional) incurred on or attributable to, a specified thing or activity.

The cost of an item can be divided into the following cost elements:

1. Materials2. Labour3. Expenses

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EACH ELEMENT CAN BE SPLIT INTO TWO, AS FOLLOWS:

MATERIALS = DIRECT MATERIALS

+ INDIRECT MATERIALS

+ + +

LABOUR = DIRECT LABOUR

+ INDIRECT LABOUR

+ + +

EXPENSES = DIRECT EXPENSES

+ INDIRECT EXPENSES

= = =

TOTAL COST = DIRECT COST

OVERHEAD

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COSTS

Important points:1. Costs are either variable or fixed,

depending upon whether they change when the volume of production changes.

2. Costs are either direct or indirect, depending upon how easily they can be traced to a specific unit of production.

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EXAMPLE OF UNIT COST CARDRM RM

Direct Materials:

Yellow plastic xx

Ink xx

Metal xx xx

Direct Labour:

Machine operators’ wages xx

Manual assembly staff wages xx xx

Direct Expenses:

Moulding machinery – operating costs

xx xx

Total direct cost or Prime cost XXX

Overheads – production xx

Manufacturing cost or Factory cost

XXX

Overheads – Administration, distribution and selling

xx

Total cost XXXX

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COST UNIT

Cost unit is a unit of product, service or a combination of them in relation to which costs are ascertained or expressed.

The selection of suitable cost unit depends upon several factors, such as, nature of business, process of information, requirements of costing system, etc. but usually relates to the natural unit of the product or service.

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EXAMPLES OF COST UNITS:

lndustry or product

Cost unit

Automobile NumberBiscuit KilogramBread Thousand loavesBricks Thousand bricksChemical Litre, gallon,

kilogramHospital Patient dayPower and electricity Kilowatt-hour

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COST CENTRES

Cost centre is defined as a location, person or item of equipment (or group of them) in respect of which costs may be ascertained and related to cost units for the purposes of cost control.

1. Impersonal cost centre consisting of a location or item of equipment (or group of these) such as machine shop, and

2. Personal cost centre consisting of a person or a group of persons such as factory manager, sales manager, etc.

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COST CENTRES

Cost centres are also classified in manufacturing concerns into production and service cost centres.

1. Production cost centres relate to those centres where production or manufacturingactivities take place.

2. Service cost centres are those, which are ancillary and render services to the production cost centres, so that manufacturing activities can take place.

In a biscuit manufacturing company, making, baking and packing are production cost centres while personnel, purchase, stores, canteen, accounts are service cost centres

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CLASSIFICATION OF COSTS

Cost classification refers to the process of grouping costs according to their common characteristics, such as nature of expense, function, variability, controllability and normality.

Thus, classification is essential for identifying costs with cost centres or cost units for the purpose of determination and control of cost :

1. By nature of expenses: Costs can be classified into material, labour and expenses.

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2. By function: production or manufacturing cost, administration cost, selling and distribution cost, research and development cost.

3. By variability: Costs are classified into fixed, variable and semi-fixed / semi-variable costs according to their tendency to vary with the volume of output.

4. By controllability: Costs can be classified under controllable cost and uncontrollable cost.

5. By normality : Costs can be divided into normal cost and abnormal cost.

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6. On the basis of time : Costs, may be classified into historical or actual cost and predetermined or future cost.

7. In relation to the product : Costs may be classified into direct and indirect costs.

8. Cost analysis for decision making: Here costs are classified under relevant costs (e.g. marginal cost, additional fixed cost, incremental cost, opportunity cost) and irrelevant costs (e.g. sunk cost, committed costs, etc.)

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TYPES OF COSTS

1. Direct cost is a cost that can be traced to full to saleable costs units (products or services) that are being costed.

2. Indirect cost or overhead is a cost that is incurred in the course of making a product or providing a service, but which cannot be traced directly and in full to the product or service.

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EXAMPLE: DIRECT COST VS INDIRECT COST

Example : Manufacture of desk.Wood would be the direct cost as it can be specifically and exclusively identified with a particular desk. In addition to it, salary of factory workers also can be identified as the direct cost for the manufacture of desk. However, the factory supervisor’s salary is not part of direct cost and will be classified as indirect cost.

Nails used to manufacture a particular desk can be identified specifically with the desk but the cost is likely to be insignificant as the expense of tracing such items does not justify the possible benefits from calculating more accurate product costs.

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DIRECT COSTS VS INDIRECT COSTS

Cost object Direct costs Indirect costsMaintenance department

Salary of the workers in that department

Product Operator’s salary Warehouse rentalSupervisor’s salary

Important note: The distinction between direct and indirect costs also depends on the cost object. A cost can be treated as direct for one cost object but indirect in respect of another.

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RELEVANT COSTS AND REVENUES

3. Relevant costs and revenues are those future costs and revenues that will be changed by a decision, whereas irrelevant costs and revenues are those that will not be affected by the decision.Example: If one has to decide whether to make a journey by car or public transport.Irrelevant cost – car tax and insurance costs since they will remain the same whatever alternative is chosen.Relevant cost – petrol costs for the decision making.

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SUNK COST

4. Sunk cost is a cost that has been incurred and cannot be reversed. Also referred to as "stranded cost."Example of the written down values of assets previously purchased are sunk costs. Machine purchased four years ago for RM100,000 with an expected useful life of five years and nil scrap then the written value will be RM20,000 if straight line depreciation is used. This written down value will have to be written off, no matter what possible alternative future action might be chosen. If the machine was scrapped, the RM20,000 would be written off; if the machine was used for productive purposed, the RM20,000 would still have to be written off.This cost cannot be changed by any future decision and therefore classified as sunk cost.

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OPPORTUNITY COST

5. Opportunity cost is a cost that measures the opportunity that is lost or sacrificed when the choice of action requires that an alternative course be given up.

Example: A company has an opportunity to obtain a contract for the production of a special component. This component will require 100 hours of processing on machine X. Machine X is working at full capacity on the production of product A, and the only way in which the contract can be fulfilled is by reducing the output of product A. This mean a loss of revenue of $200. The contract will also result in additional variable costs of $1000.

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OPPORTUNITY COST

If the company takes on the contract, it will sacrifice revenue of $200 from the lost output of product A. This represents an opportunity costs and should be included as part of the cost when negotiating for the contract. The contract price should at least cover the additional costs of $1000 plus $200 opportunity cost to ensure that the company will be better off in the short term by accepting the offer.

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INCREMENTAL COSTS AND REVENUES

6. Incremental costs and revenues are the difference between costs and revenues for the corresponding items under each alternative being considered.Example: The incremental costs of increasing output from 1000 to 1100 units per week are the additional costs of producing an extra 100 units per week.

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COST BEHAVIOR

1. Fixed costs tend to remain unaffected by the variation or change in the volume of output, such as supervisory salary, rent, taxes, etc.

2. Variable costs tend to vary directly with volume of output, such as direct material, direct labour and direct expense.

3. Semi-fixed/semi-variable cost is partly fixed and partly variable, such as telephone expense, electricity charges, etc.

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THANK YOU…

A journey of a thousand miles begins with a single step.

Introduction to Cost Accounting - Topic 1

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