chapter 1 Rationales for Costing

Chapter Content
1 Management
Managementandand 4 Understanding
Understanding
cost
costaccounting
accounting costs
costs

Rationale
Rationalefor
forcosting
costing

2
The
Thepurpose
purposeof
of The
Therole
roleof
ofthe
the
management
management management
management
accounting
accounting accountant
accountant
 Management and Cost Accounting
Management Accounting Financial Accounting 1
1
Accountancy involves the measurement, analysis and reporting of 1) internal focus 1) external focus
financial and non-financial information to help managers,
shareholders and other interested partied to make decisions about
the organization 2) no legal requirement 2) required by law

Management accounting 3) no set formats or rules 3) governed by rules and

regulations
Is the application of the principles of accounting and financial
management to create, protect, preserve and increase value for 4) main purposes are planning, 4) purpose is the production of
stakeholders for profit and not for profit organizations controlling and decision statutory accounts
making
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 Purpose of Management Accounting
budgets, standard cost and actual cost of operation.

Management Accounting 1) Purpose of management accounting is to

 Planning is formulating short term and long-term help managers make decisions.
 Control is the process of
plans and actions to achieve a particular end.
 A budget is the financial planning showing how PLANNING monitoring, measuring, 2) Management accounting helps organizations
resources are to be acquired and used over a evaluating and correcting actual improve their ability to control costs and
specified time interval. results to ensure that a business plan for the future through financial
enterprise’s goals and plans are forecasts.
A achieved.
3) It also focuses on providing reports to ensure
comprehensive management oversight.
C Management
B
4) Main purposes are planning, controlling and
accounting
CONTROL decision making

DECISION
MAKING
Decision-making is a process of choosing among
competing alterna­tives. Decision-making is inherent in
each management function.
 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 3) Improving business systems
2) Acquisition of finance
a) Devising new systems, business processes, and
With the increasing complexity, volatility, uncertainty, and Management accountant has a major role to analyses that save the company money and help
pace of change and competition in today’s global play in raising of funds and their application. He it run more efficiently
marketplace, the need for strategic analysis and execution has to decide about maintaining a proper mix b) These main purposes of management
has never been greater. Management accountants are in a between debt and equity. Raising of funds accounting (planning, controlling and decision
unique position to participate in and lead the strategic through debt is cheaper because of tax benefits. making can only be guaranteed by the proper
4) analysis process.
Performance measurement analysis from management accounting
Management accountant has, therefore, to
information system
a) An important role of the management maintain an optimum capital structure and give
accountant is to provide decision making due consideration to various cost of capital c) Accounting information is a substance for
information for performance measurement theories, leverage and possibility of trading on management planning, control and effective
and helping to develop or refine business decision making as the result
equity.
performance measurement systems. d) The routine reports as well as reports for long-
b) The process of developing measurable term decision-making are forwarded to
5) Risk management managerial personnel at all levels to take
indicators that can be systematically tracked
to assess progress made in achieving 6) Risk is the “effect of uncertainty on corrective action at the right time.
predetermined goals and using such objectives” and an effect is a positive e) The management accountant also uses these
indicators to assess progress in achieving or negative deviation from what is reports for taking important decisions
these goals Characteristics of Information
expected (ISO 31000). Functions of Management Accounting Information

7) designed to identify potential events

1) Accurate (Must not contain any errors) that may affect the entity, and
manage risks to be within its risk
2) Cost beneficial (economical both in terms of time and cost) appetite, to provide reasonable
5) assurance
Interpreting financial regarding the achievement
information
3) Complete (must contain all important, related data) of the entity’s objectives”.
a) Managerial accountants
4) Reliable (dependable, generated using correct data) perform cash flow analysis in
order to determine the cash
5) Understandable (simple and usable) impact of business decisions.
Most companies record their
6) Easy to Use (formatted, should be available in desired format) financial information on the
accrual basis of accounting.
7) Relevant (can be used by organization) b) Essentially, management
accountants provide key
8) Verifiable (means to cross check) insights that help a company's
management team make many
9) Authoritative of their decisions. They also
support decision making within
10) Timely (available when needed) a company by providing a
wealth of financial and
11) Secure (access allowed to authorized individuals only) statistical information, often
assisted by powerful
 Cost identification and classification

Cost object Cost centre

Cost Object Definition
describe something to which costs are assigned. Common examples of cost objects
Cost Center:
are: product lines, geographic territories, customers, departments or anything else a) A cost center is a function within an organization that
for which management would like to quantify cost. does not directly add to profit but still costs money to
operate, such as the accounting, HR, or IT departments.
Types of Cost Objects b) The main use of a cost center is to track actual
1) Output: The most common cost objects are a company's products and expenses for comparison to budget.
services. Assigning a cost enables profitability analysis and price setting. c) A cost center indirectly contributes to a company’s
2) Operational: A cost object can be an area or function within a company, profit via operational excellence, customer service, and
such as a department, tooling operation, production line, or process. For enhanced product value.
instance, you could track the cost of introducing a new product, or service
call, or of refurbishing a returned product. d) The manager for a cost center is only responsible for
3) Business Relationship: A cost object can be external to the company, such keeping costs in line with budget and does not bear any
as a supplier or a customer, to determine the cost of dealing with that responsibility regarding revenue or investment
entity. Another variation on the concept is the cost of renewing permits or Costdecisions.
unit/
licenses.
Cost Unit: composite 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
revenue generation of the organization. the 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 Classification of costs by ELEMENT
1) Materials:
Classification of costs by FUNCTION A “The material cost is the cost of commodities supplied to an
undertaking
1) Production or Manufacturing Costs a) Direct materials cost
All the costs relating to the production of goods or services, The cost of materials entering into and becoming
whether direct or indirect, variable or fixed, are included in the constituent elements of a product or saleable service”.
production cost. Thus, materials which can be identified with units of
output or service are known as direct materials
b) Indirect Materials
2) Non-production costs  materials cost which cannot be identified with a
a) Administration Costs specific product, job, process is known as indirect
material cost.
b) Marketing or Selling Costs  Small tools, stationery used in works, advertising
c) Distribution Costs posters, and materials used in maintenance of
plant and machinery are a few examples of
d) Research and Development Costs 2) Labor: indirect materials.
3) Expenses:
e) Customer Service  Labor is the remuneration paid for physical or
The cost of service provided to an undertaking and the
mental effort expended in production and
distribution. notional cost of the use of owned assets
 a) Direct Expenses:
The labor cost is the cost of remuneration (wages,
salaries, commissions, bonus, etc.) of the These are the expenses which can be
directly identified with a unit of output,
employees of an undertaking
Direct Cost or Prime Cost: job, process or operation. They are
B The aggregate of all the direct costs i.e., Direct Materials, Direct Labor or wages and
a) Direct Labor Cost:
also called ‘Direct-wages’. Direct labor cost is the
specifically incurred for a job, or unit or
process and in no way they are connected
with other jobs or processes. The direct
Direct expenses is termed as- ‘Prime Cost’ or ‘Direct cost’. Thus prime cost or direct cost cost of labor directly engaged in production expenses are also known as chargeable
operations. (e.g., workmen engaged in assembling expenses.
is the sum of all the elements of costs which can be specifically identified with particular parts, carpenters engaged in furniture making, b) Indirect Expenses:
products or jobs and allocated to such output. etc.)
Indirect expenses are expenses other than
b) Indirect Labor Cost: indirect material and indirect labor, which
cannot be directly identified with units of
the remuneration paid for labor engaged to help output, job, process or operation
The following items are excluded from computation of total cost: 4) the production operations. The labor costs of idle
Factory Overhead:
 time,
This isovertime, holidays,ofetc.,
the aggregate are also
indirect taken indirect
material, as wages and
a) Capital Costs and Capital Losses- Purchase of fixed assets, plant and machinery, indirect
indirect costs.
expenses incurred in the factory. Examples of indirect
building, etc. Loss on sale of fixed assets, abnormal losses, preliminary expenses, factory expenses are rent, power, depreciation lighting and heating
patents written off, etc. incurred in the factory.
 The aggregate of all the indirect costs i.e., Indirect Material, Indirect
b) Transfer to reserves, income tax, dividend, bonus to shareholders, etc. labor and Indirect expenses is variously termed as ‘On cost’ or
‘overhead’ or ‘Burden’. Over heads or on cost or indirect cost
c) Financial items like, cash discount, interest on debentures, interest on loans, cannot be identified with specific products or jobs. So it is
interest on own capital, etc. apportioned to the output on some reasonable basis.
 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.
4) Stepped Cost
 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 Stepped cost refers to the behavior of the total cost of an activity at
exclusively incurred for a particular unit of cost, i.e., various levels of the activity. When a stepped cost is plotted on a graph
job, product or process. (with the total cost represented by the y-axis and the quantity of the
2) Indirect Costs: activity represented by the x-axis) the lines will appear as steps or stairs
 Indirect Costs are those costs which cannot be rising from left to right.
assigned to any particular cost unit, i.e., job, product
or process.
 To illustrate a stepped cost, let's assume that you are developing a
 Indirect costs are, usually, incurred for the business as
a whole and are, therefore, apportioned among the website and find that the monthly cost of hosting the site is based on the
various cost units (product, job or process) on some number of visits. For 0 to 999 visits per month, the cost is $20 per month.
reasonable basis. When the visits are in the range of 1,000 to 2,999 the monthly cost jumps
Classification of costs by BEHAVIOUR D 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
1) Fixed Costs 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
 Fixed costs are those which do not change with the level of the upper limit of a range, the monthly cost jumps to a higher level and
activity within the relevant range. remains fixed until the visits exceed the new upper limit.
 These costs will be incurred even if no units are produced. For
example rent expense, straight-line depreciation expense, etc.
Category Fixed Costs Variable Costs Mixed Costs
2) Variable Costs
 Variable costs change in direct proportion to the level of Total cost Constant Changes Change with output
production. proportionately with but not proportionately
output
 This means that total variable cost increase when more units
are produced and decreases when less units are produced. Cost per unit Decreases with Constant Decreases with
3) increase in output increase in output but
Average variable cost i.e. variable cost per unit is constant
Mixed Costs less than the decrease
 Mixed costs or semi-variable costs have properties of both fixed and variable in fixed cost per unit
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 Examples Plant depreciation, Fuel expense, wages, Telecommunication
depreciation cost of trucks and a variable component of fuel expense. property taxes raw materials costs, senior
 Since mixed cost figures are not useful in their raw form, therefore they are management salaries,
split into their fixed and variable components by using cost behavior analysis transportation cost
techniques such as High-Low Method, Scatter Graph Method and Regression
Analysis.