Cost Accounting I

CH- ONE . 1-Identify cost categories and nature

Definition & Concepts of cost accounting and

cost
• Cost accounting is an accounting information
system that records, measures and reports
information about cost.
• Cost accounting is, thus, concerned with recording,
classifying and summarizing costs for determination
of costs of products or services, planning,
controlling and reducing costs and furnishing of
information to management for decision making.
• Cost accounting is defined as "a systematic set of
procedures for recording and reporting measurements of
cost of manufacturing goods and performing services in
the aggregate and in detail.
• Cost accounting is a bridge between financial and
management accounting
• It provides information to both management accounting
and financial accounting.
• Cost Accounting primarily deals with collection,
analysis of relevant cost data for interpretation and
presentation for various problems of management.
• Cost accounting is a management information system,
which analyses past, present, and future data to provide
the basis for managerial decision making .
 Cost Vs Expenses
• Costs- refer to economic resources scarified or given
up to acquire goods and services.
• Cost is incurred on benefits to be used in the future.
• When the benefits are used up, the cost becomes an
expense.
• Cost represents an asset.
 Unused portion of Cost is Asset
 Used portion of Cost is Expense
• Expense is a cost that has given a benefit and then
expired.
• Expenses are matched with revenue to determine the
operational result of a firm.
• The distinction between costs and expenses is
important for the preparation of financial statements
for service, merchandising and manufacturing firms.
• However, it has more importance for manufacturing
enterprises.
• This is because costs incurred in the manufacturing
process do not become expenses until the product is
sold and thus, items that are fully or partially
manufactured represent costs and should be
recognized as assets on the Balance sheet.
• Therefore, financial reporting in manufacturing firms
has some complication as compared to financial
reporting in the service and merchandising
businesses.
 Cost Terms

Cost and Cost Objects

• Cost: - is a monetary measure of economic resources
scarified to achieve a specific objective or purpose.
– Cost measurement is related to a particular purpose or
activity (measure the use of labor hr, machine hr, material
etc.)
• Cost Object: - is defined as any activity for which
separate measurement of cost is desired.
• It is a particular product during a specific period of
time.
• An Expense:- is a cost that has given a benefit and
then expired.
 Cost Accumulation, Cost Assignment,
Cost Tracing & Cost Allocation
• Cost Accumulation: - is the collection of data in
some organized way through an accounting system.
• Cost Assignment :- is a general term that
encompasses both
 Tracing accumulated costs to a cost object
 Allocating accumulated costs to a cost object
• Managers assign costs to a cost objects for many
purposes;
 Facilitate decision about departmental efficiency
 Help in pricing decisions and in analyzing how
profitable different products are;
 Cost Tracing Vs Cost Allocation
• Cost Tracing: - is the assignment of direct costs
to the chosen cost object.
• Direct costs of a cost object are costs that are
related to the particular cost object and can be
traced to that cost object in an economically
feasible (cost-effective) way.
• Cost Allocation:- is the assignment of indirect
costs to that chosen cost object
• Indirect costs of a cost object are related to the
particular cost object but cannot be traced to that
cost object in an economically feasible (cost-
effective) way.
 Classification of cost

• There are different costs for different purposes.

• Cost classifications are needed for the development
of cost data that will aid management in achieving its
objectives.
• These classifications are based on the relationship of
costs.
1. Cost classification by elements of a product
This classification by provides management with
information necessary for income measurement and
product pricing.
These manufacturing cost elements are cost of material,
costs of labor, and factory overhead costs.
 A. Material cost
• The cost of material may be divided into direct and indirect
material cost.
I. Direct Materials:-these are composed of all raw materials that
can be identified with a particular finished product.
 These costs are easily traceable with the final product and
represent the major material cost of producing that product.
 E.g. to produce a wooden chair, the wood is direct material.
II. Indirect Material: - these are composed of all raw materials,
which are not directly identifiable with the final product under
economically feasible way (i.e. under cost effective way).
 E.g. In a furniture factory inputs such as glues and nails are
grouped as indirect materials.
 It is not only the physical appearance that is relevant to say direct
or indirect but also the significance of the material cost.
 If it is immaterial, it could be classified as indirect material.
 B. Labor Cost.
• Labor is the physical or mental skill exerted in the
production of a product.
• Labor costs are classified as direct and indirect labor.
I. Direct Labor:-refers to factory employee’s labor
directly involved in the conversion of raw materials
into finished product that can easily trace to the
product. E.g. the wage paid to machine operator is
direct labor cost.
II. Indirect Labor:-all labor involved in the production
process but cannot be directly identifiable with a
particular product under economically feasible
included in the factory overhead costs.
E.g. cleaning service, maintenance labor etc.
 C. Factory overhead Cost

• This refers to all manufacturing costs other than direct

material and direct labor costs.
• It is also known as manufacturing overhead cost,
indirect manufacturing costs, Factory Burden etc.
• The cost of a product is composed of direct material
cost, direct labor cost, and Factory overhead costs.
2. Cost classification by relationships to
production
• This classification is closely related to the cost
classification by cost elements of a product.
• In this classification system costs are grouped as prime
cost and conversion costs.
I. Prime Costs:- is the primary cost of the products
 These costs are cost of direct material and cost of direct
labor.
 These costs are directly related to the production process.
II. Conversion Costs: - are costs require transforming direct
materials into finished product.
 These costs related with conversion process.
 The costs included in this group are the cost of direct labor
and factory overheads.
Note: Prime cost=Direct material+ Direct Labor.
• Conversion cost= Direct labor+ Factory overheads.
• Total manufacturing cost=Direct material +
Direct labor + FOH.
 3. Cost classification in Relation to Volume

 Costs can be related to a particular volume of activity

 Costs in relation to volume are classified as variable & fixed
costs.
I. Variable Costs;-are those costs, which change in total directly
with the volume of activity.
II. Fixed Costs: - are those in which total fixed costs remains
constant over irrelevant range of output whereas the fixed cost
per unit varies with output changes.
 The cost per unit will decrease as the volume of activity
increases. Example: Rent paid on a monthly basis
 Beyond the relevant range the fixed costs vary in total. These
are usually referred to as discretionary fixed costs.
Note: It is not possible to classify all costs as purely variable and
purely fixed.
 There are costs, which have mixed behaviors. These costs are
 4. Cost classification Based on Responsibility centers

• In manufacturing organization there are two basic departments

such as production and service department.
I. Production department:-these are responsibility centers
where operations are performed to produce a product. These
costs include the three manufacturing costs (i.e. DM, DL, and
FOH).
• E.g. Assembly department, cutting departments, mixing
department, finishing, packing department etc
II. Service departments:-these are responsibility centers not
directly involved in production process.
 These departments will support the production departments to
function properly.
 The total costs of these departments are ultimately allocated to
production department for product costing purpose. E.g.
Maintenance, information processing department’s etc.
 5. Cost classification by Functional Areas .

• This analysis groups costs by the type of activity performed.

• It helps management in preparing budgets and financial
statements.
I. Manufacturing Cost: - these are all costs incurred to
produce finished goods. These are the sum of direct material
cost, direct labor, and Factory Overhead costs.
II. Selling and Distribution costs: - these are all costs incurred
in order to sell a product service.
 Costs included are cost of processing order, cost of getting customer,
cost of retaining customer, cost of transportation etc.
III. Administrative and General expenses:- these are costs
incurred to direct, control, and operate the enterprise
IV. Financing costs: - these are costs incurred in relation to
obtaining and operating funds for the company.
 It includes cost of borrowing (interest expense)
 6. Cost Classification by Period Charged to Revenue

• Cost may be classified on the basis of time period they are

charged against revenue.
• Some costs are recorded as assets and then expensed as
they are used or expired.
I. Product Cost: - these costs are initially inventoried and
when goods are sold, they are charged to cost of goods
sold.
 The CGS is matched against revenue of the period in
which goods are sold.
II. Period costs:-these costs are neither directly nor
indirectly related to the product and are not inventoriable.
 There is reported as expenses on income statement.
E.g. Selling & distribution expense, administrative, financing
expense exc.
 7. Cost Classification by economic consideration

This types of cost classification groups costs into two broad

categories.
I. Opportunity cost: - are defined as measurable value of
benefits that could be obtained by choosing an alternative
course of action.
 Opportunity costs do not represent cash outlays, and are not
part of formal accounting system.
 These costs measure the benefit forgone by not taking a
particular course of action.
II. Cash outlay costs: - are costs that require cash payments by
the organization.
 They include assets (unexpired costs) and expense(expired
costs)
• Note: This classification helps management in analyzing
investment alternatives
 Sunk cost

• Sunk cost;- are the costs of resources that have

already been incurred whose total will not be
affected by any decision made now or in the
future. They represent past or historical costs.
• Example Suppose you acquired an asset
for$50,000 three years ago which is now listed at
a book value of $20,000. The $20,000 book value
is a sunk cost which does not affect a future
decision.
 8. Cost Classification by ease of traceability to cost
object
I. Direct costs: - these costs are related to a particular cost object
and can be traced (assigned) to that cost object in a cost-
effective way.
II. Indirect costs:- these costs are related to a particular cost
object but can’t be traced to that cost object in a cost-effective
way. E.g. the cost of quality control personnel in food processing
factory.
9. Cost Classification by degree of Averaging
I. Average (unit) cost: - is computed by dividing total costs by
total unit of quantities. It must be interpreted with caution.
II. Total Cost: - is the total (aggregate) cost of producing a product
or giving a service. It is unit cost multiplied by the total number
of unit produced. The total costs will be the sum of fixed and
variable costs
 10. Cost Classification by decision significance
• Based on the relevancy of costs to decision making we can
categorize costs into;-
I. Relevant Costs: - these costs are expected future costs that
differ among alternative courses of actions being considered.
It may be eliminated if some economic activity is changed.
II. Irrelevant costs: - are unaffected values by management
actions when confronted with choice. They are not relevant
and should not be considered in a decision making analysis.
11. Controllable and non- Controllable Costs
I. Controllable costs: - are those which may be directly
influenced by unit managers in a given time period. E.g. Time
period, material cost.
II. Non-controllable costs:- are those costs which are not
directly administered at a given level of management
authority.
 Identifying cost behaviors
• Cost behavior is the way costs respond to changes in volume
or activity—is a factor in almost every decision managers
make.
• Cost behavior: How costs respond to a change in activity
level within the relevant range
• Relevant range: Activity levels within which a given total
fixed cost or unit variable cost will be unchanged
Classification of cost behaviors
• Managers need to know how costs behave to make informed
decisions about products, to plan, and to evaluate performance.
• We classify the behavior of costs as being in one of three
basic categories:
1. Fixed,
2. Variable,
3. Semi variable
Figure 1.4:-Classification of cost behavior
1. Fixed Costs
• Fixed costs remain unchanged as volume changes within
the relevant range.
• Fixed costs per unit vary inversely to a change in
activity.
• Fixed costs are “fixed” in “total” as activity changes.
2. Variable Costs
• Costs that change in direct proportion with a change in the
volume within the relevant range
• Variable costs “vary” in “total” as activity changes.
• Variable cost per unit stays constant when activity changes
within the relevant range.
3. Semi variable Costs
• Costs that have both fixed and variable components. Also
known as mixed costs