MANAGEMENT ACCOUNTING

FUNDAMENTALS OF ACCOUNTS An account is a summarised record of relevant transactions at one place relating to a particular head. It records not only the amount of transactions but also their effect and direction. Debit and Credit are simply additions to or subtractions from an account.

Fundamentals of Accounts
The three rules of accounting are Debit the receiver and Credit the giver Debit what comes in and Credit what goes out Debit all expenses and Credit all gains and profits

Classification of Accounts
Personal Account Real Account Nominal Account

Classification of Accounts (Contd.)

Type
Personal Accounts Real Accounts

Rules for Debit

Debit the Receiver Debit what comes in

Rules for Credit

Credit the Giver Credit what goes out

Nominal Accounts

Debit all expenses and losses

Credit all incomes and gains

Classification of Accounts (Contd.)

Assets accounts Liabilities accounts Capital accounts Revenue accounts Expenses accounts Assets = liabilities + capital + profits losses Profits = revenue expenses Losses = expenses - revenue

Rules of Debit and Credit

Increase in assets are debits and decrease are credits Increase in liabilities are credits and decrease are debits Increase in capital are credits and decrease are debits Increase in expenses are debits and decrease are credits Increase in revenues are credits and decrease are debits

Financial Statements
Financial Statements are compilation of accounting information for the external users. They include Profit and Loss Account Balance Sheet Schedules and Notes forming part of the above

Financial Statements (Contd.)

Capital Expenditure is the amount spent by an enterprise on purchase of fixed assets that are used in the business to earn income and not intended for resale. Capital expenditure normally yields benefits over a period extending beyond the accounting period. Revenue expenditure is the amount spent on running of a business The benefit of the revenue expenditure is exhausted in the accounting period in which it is incurred.

Distinction between Capital and Revenue Expenditure

Purpose It is incurred for acquisition of fixed assets for use in business It is incurred for running of business

Capacity

It increases the earning It is incurred for capacity of the earning profits business Its benefit is extended to more than one year It is shown in the balance sheet Its benefit extends to only one accounting year It is part of trading or Profit or Loss account

Period

Depiction

Management Accounting
Definition Management accounting is the process of identification, measurement, accumulation, analysis, preparation, interpretation and communication of information that assists managers in specific decision making within the framework of fulfilling the organizational objectives.

Types of Decisions
The decisions, managers are concerned with, can be categorized as Planning decisions Control decisions

Planning Decisions
Planning Decisions are concerned with the establishment of goals for the organization and the choosing of plans to accomplish these goals Management accounting information is needed to take Planning decisions

Control Decisions
Control decisions result from implementing the plans and monitoring the actual results to see if goals are being achieved If goals are not being achieved, either corrective steps must be taken resulting in goal achievement or goals themselves have to be revised to attainable levels Cost accounting data are needed for taking Control decisions

Financial Accounting vs. Management Accounting

Financial Accounting covers the process of book keeping, finalization of accounts, preparation of financial statements, communication of accounting information to users and interpretation thereof Management Accounting is concerned with accounting information that is useful to management Financial Accounting emphasizes the preparation of reports of an organization for external users whereas Management Accounting emphasizes the preparation of reports for its internal users

Financial Accounting vs. Management Accounting

External users vs. Internal users Record of financial history vs. Emphasis on the future GAAP vs. Own rules Objectivity and verifiability vs. Flexibility Emphasis on accuracy vs.Acceptance of estimates Focus on company as a whole vs. Focus on segments of a company Bound by conventional accounting systems vs. Use of other disciplines such as Economics, Statistics, OR, OB, etc Governed by Regulatory Bodies vs. Freedom of choice

 Cost Accounting is mainly concerned with the techniques of product costing and deals with only cost and price data. It is limited to product costing procedures and related information processing. It helps management in planning and controlling costs relating to both production and distribution channels. Cost Accounting is a Line function Management Accounting is not confined to the area of product costing. The objective is to have a data pool which will include all information that management may need, both costing and financial. Management accounting is a Staff function

Cost Accounting vs. Management Accounting

Management Accounting Framework

Management Accounting Framework

Data accumulation is done through Financial Accounting and Cost Accounting systems. Financial records are maintained through financial accounting system and cost records are maintained through cost accounting systems
In Management Accounting system, data support is taken from financial accounting and cost accounting and also data accumulation is carried out from external sources. Accumulated data are reclassified as per the requirements of the management decision making process. Information is built up and then communicated to assist the decision making process

Contents of Management Accounting

Management process is a series of activities involved in planning, implementation and control. Each phase of management process requires decision making Management Accounting supports managerial decision making providing the required information Information generated in management accounting process includes- Financial Statement Analysis - Cash flow information - Cost information - Budgets and Standards

Statements of Financial Information

Balance Sheet Profit and Loss Account Statement of changes in financial position - Cash flow statement - Fund flow statement

Contents of Balance Sheet

The balance sheet provides information about the financial standing/position of a company at a particular point in time i.e. as March 31, 2006 It is a snapshot of the financial status of the company The financial position of the company is valid for only one day i.e. the reference day

Contents of Balance Sheet

The financial position as disclosed by the balance sheet refers to its resources and obligations and the interests of its owners in the business. The balance sheet contains information regarding assets, liabilities and shareholders equity The balance sheet can be present in either of the two forms: - the account form - the report form

Assets
Assets are the valuable resources owned by a business Assets need to satisfy three requirements: - the resources must be valuable i.e. it is cash or convertible into cash or it can provide future benefits to the operations of the firm - the resources must be owned in the legal sense. Mere possession or control would not constitute an asset - the resource must be acquired at a cost

Assets
The assets in the balance sheet are listed either in the order of liquidity i.e. promptness with which they are expected to be converted into cash or In the reverse order i.e. fixity or listing of the least liquid asset first, followed by others

Assets
All assets are grouped into categories i.e. assets with similar characteristics are put in one category The standard classification of assets divides them into- fixed assets / long term assets - current assets - investments - other assets

Fixed assets
These assets are fixed in the sense that they are acquired to be retained in the business on a long term basis to produce goods and services and not for resale They are long term resources and are held for more than one accounting year These assets are significant as the future earnings/profits of the company are determined by them

Categories of Fixed Assets

Tangible Intangible

Tangible Fixed Assets

These assets have a physical existence and generate goods and services Examples are land, buildings, plant, machinery, furniture, etc They are shown in the balance sheet at their cost to the firm at the time of their purchase The cost of these assets are allocated over their useful life The yearly allocation is called Depreciation

Tangible Fixed Assets (Contd.)

As a result of depreciation, the amount of tangible fixed assets shown in the balance sheet every year declines to the extent of depreciation charged that year By the end of the useful life of the asset, value becomes nil or the salvage value, if any Salvage value signifies the amount realizable by the sale of the asset at the end of its useful life

Intangible Fixed Assets

These assets do not generate goods and services directly They reflect the rights of the company Examples patents, copyrights, trademarks, goodwill, etc They confer certain exclusive rights on their owners Intangibles are also written off over a period of time

Current Assets
The second category of assets in the balance sheet are current assets In contrast to the fixed assets, current assets are short term in nature As short term assets, they refer to assets / resources which are either held in the form of cash or expected to be realized in cash within the accounting period or the normal operating cycle of the business
The term operating cycle means the time span during which the cash is converted into inventory, inventory into receivables/cash sales and receivables into cash

Current assets (Contd.)

Current assets are also known as liquid assets They include- cash - marketable securities - accounts receivables/debtors - bills receivables - inventory

Current Assets (Contd.)

Cash Most liquid form of current asset Cash in hand and at bank To meet obligations / acquire assets without any delay

Current Assets (Contd.)

Marketable Securities Short term investments which are readily marketable and can be converted into cash within a year Outlet to invest temporarily available surplus/idle funds Declared at cost or market value whichever is lower and the other amount is indicated in the financial statement

Current Assets (Contd.)

Accounts Receivable The amount the customers owe to the firm, arising out of the sale of goods on credit They are called the sundry debtors The unrecoverable portion is termed as bad debts and written off out of the P & L a/c

Current assets (Contd.)

Bills Receivable Amount owed by outsiders for which written acknowledgements of the obligations are available IOUs are drawn and exchanged Temporary credit can be arranged by discounting these IOUs

Current Assets (Contd.)

Inventory It includes The goods which are held for sale in the course of business (finished goods) The goods which are in the process of production (work in progress or semi finished goods) The goods which are to be consumed in the process of production (raw materials)

Investments
The third category of assets is investments They represent investment of funds in the securities of another company They are long term assets outside the business of the firm The purpose is to earn a return and/or to control another comapny

Other Assets
Included in this category are the Deferred Charges Example: Advertisement, Preliminary expenses, etc

Liabilities
Liabilities are defined as the claims of outsiders against the firm They represent the amount that the firm owes to outsiders other than the owners The assets are financed by different sources Depending on the periodicity of the funds, liabilities are classified into - Long term and short term sources

Long term Liabilities

Sources of funds included in this category are available for periods exceeding one year Such liabilities represent obligations of a firm payable after the accounting period Example: Debentures, Bonds, Mortgages, Secured loans from FIs and banks They have to be redeemed/repaid either as a lump sum on maturity or over a period of time in instalments

Current Liabilities or Short term Liabilities

These Liabilities are payable to outsiders in a short period, usually within the accounting period or the operating cycle of the firm Example: Accounts payable, Bills payable, Tax payable, Accrued expenses, Short term bank credit Accounts and Bills payable are considered as Trade Credit

Current Liabilities (Contd.)

Trade Credit The claims of outsiders who have sold goods to the firm on credit for a short period Usually these are unsecured Such liabilities extended without any written commitment are Accounts Payable or Sundry Creditors Such liabilities extended with formal agreements through IOUs are Bills payable

Current Liabilities (Contd.)

Short term Bank Credit Liabilities contracted through banks for a short period for the purpose of running the business Example: cash credit, overdraft, loans and advances

Current Liabilities (Contd.)

Tax Payable refers to the amount payable to the Government as taxes Accrued Expenses represents obligations which are payable and kept outstanding by the firm Example: outstanding wages, salaries, rent, commission, etc

Owners Equity or Capital

The next main component of the balance sheet is the owners equity It represents the residual claim of the owners on the assets of the company after settling all the external liabilities The owners of the company are called the shareholders Two types of shareholders equity and preference

Preference Capital
These shareholders are entitled to a stated amount of dividend and return of principal on maturity In this sense, they are akin to that of a lender But, he is entitled to the dividend only if the company has made profits In this sense, they are the owners

Equity Capital
They are the residual claimants of the profits After all the external liability holders and the preference shareholders have been paid, the balance amount, if any, belongs to the Equity shareholders Components: Paid up capital which is the initial investments made by this group and Retained earnings/Reserves and Surplus which is the undistributed part of the residual profits over the years which has been put back in business

Common Doubts
Why is share capital shown as a liability? Depreciation what is its nature? Accumulated losses treatment? Goodwill what is its nature? What is the significance of the auditors report?

Contents of Profit and Loss Account

Revenues : Turnover Other income Sale of fixed assets Expenses Profit / Loss

Revenues
Revenue is defined as the income that accrues to the firm by sale of goods and services or through investments Sales Revenue is the amount earned through sale of goods/services Gross sales is the total sales, while Net sales is gross sales minus the trade discounts

Revenue (Contd.)
Other income is earned through other sources of investments Examples: Interest, dividend, royalty, commission, fee, etc Sale of Fixed Assets are the revenues which come into the business when unused / unwanted assets are sold and money recovered by the company

Expenses
The cost of earning the revenues are the expenses Examples: variable expenses like cost of manufacture, cost of selling, fixed expenses like salaries, administrative expenses

Expenses (Contd.)
Cost of goods consumed This is the value of the inputs used to manufacture the final product It is calculated as Opening stock + Purchases - Closing Stock

Expenses (Contd.)
Manufacturing expenses These include all expenses related to plant and manufacturing operations like power and fuel, repairs and maintenance, stores consumed, water consumed, etc Excise Duty This is the amount paid to the Govt. as a tax, before the goods are dispatched from the factory

Expenses (Contd.)
Salaries and Wages These are the cost of labour and other staff and will also include all other employee benefits and amenities. The other benefits include Provident Fund, ESI contributions, medical benefits, LTC, bonus, gratuity, pension, other superannuation benefits, etc

Expenses (Contd.)
Administrative Expenses These include office expenses, secretarial costs, postage and telephones, directors remuneration and other administrative expenses Selling Expenses These include freight, advertising and sales promotion, commissions and discounts and other selling and distribution costs

Expenses (Contd.)
Interest The interest costs consist of interest on long term loans, debentures, bank loans for working capital, interest on public deposits and other loans Depreciation This represents a non cash expenditure as it is only an accounting provision. This amount is not paid to an outside party Other expenses This includes auditors remuneration, petty expenses, donations, etc

Profit / Loss
The difference between the revenue and expense is profit When expense exceeds the revenue, the company ends up with a loss. PBID: Profit before Interest and Depreciation PBT: Profit before Tax PAT: Profit after Tax

The Profit Appropriations

Profit after Tax (PAT) is available for appropriations for Debenture Redemption Reserve General Reserve Dividend on Preference Share Dividend on Equity Share

Profit or Loss carried over

After appropriating the taxes and dividends, the balance surplus is transferred to Reserves and Surplus in the Balance Sheet The net loss reduces the Reserves and Surplus in the Balance Sheet

Financial Ratio Analysis

Financial Analysts use the financial ratio analysis to gain critical insights about companies Several ratios are worked out using the financial data drawn from the P&L account and Balance Sheet These ratios are studied and compared to obtain analytical insights

Merits of Ratio Analysis

Financial ratios are helpful: To bankers for appraising the credit worthiness To the financial institutions for project appraisal To investors for taking investment and disinvestment decisions To financial analysts for making comparisons and recommending to the investing public

Merits of Ratio Analysis

To the credit rating agencies (like CRISIL, ICRA, etc) in their credit rating exercise To the Government agencies for reviewing a companys overall performance To the companys management for making intra-firm and inter-firm comparisons

Limitations of Ratio Analysis

No uniformity in definitions No norms Varying situations Limitations of published accounts Diversified companies Historical costs (replacement cost / market price) Window dressing

Financial Ratio Analysis

Ratios on ROI Activity ratios Liquidity ratios Profitability ratios Leverage ratios Coverage ratios Equity investors ratio

Ratios on ROI
Return on assets = PAT ---------------- * 100 Total assets Return on total capital employed = PBT + Interest -------------------------- * 100 Total capital employed (Total cap.employed = total assetscurrent liabilities)

Ratios on ROI
Return on Net worth = Net profit after tax ------------------------ * 100 Net worth Net worth = Share capital + reserves & surplus accumulated losses

Cash Flow Analysis

A cash flow statement depicts change in cash position from one period to another. cash stands for cash and bank balances. Cash flow statement is useful for short term planning It helps to make reliable cash flow projections for the immediate future.

Difference between CFS and FFS

CFS Only with change in cash position Mere record of cash receipts and payments More for short term use Improvement in cash improves funds position FFS Change in working capital position Needed for short term solvency Long term use Improvement in funds position need not necessarily improve cash

Advantages
Helps in efficient cash management Helps in internal financial management Discloses the movement of cash Discloses success or failure of cash planning

Limitations
Cash flow does not reflect net income as it does not consider non cash transactions Cash position can be manipulated by collecting ahead or deferring some payments FFS, CFS and Income statement each has its own use and one can not replace the other

CFS
Sources of Cash Internal External Applications of Cash

CFS
Internal sources Cash flow from operating activities Net profit + Depreciation + Amortization of non cash expenses + Loss on sale of fixed assets + Gain on sale of fixed assets + Provisions made in the P&L account + Transfer to reserves

CFS
Adjustment for changes in current assets and current liabilities Adjusted Net profit + Decrease in sundry debtors + Decrease in bills receivables + Decrease in inventories + Decrease in prepaid expenses + Decrease in accrued income + Increase in sundry creditors + Increase in bills payable + Increase in outstanding expenses contd..

CFS
Adjustment for changes in current assets and current liabilities - Increase in sundry debtors - Increase in bills receivables - Increase in inventories - Increase in prepaid expenses - Increase in accrued income - Decrease in sundry creditors - Decrease in bills payable - Decrease in outstanding expenses

CFS
Increase in cash Decrease in current asset Increase in current liability Decrease in cash Increase in current asset Decrease in current liability

CFS
External sources Issue of shares Issue of debentures Raising of deposits Raising of loans secured and unsecured Raising of bank borrowings Sale of assets and investments

CFS
Applications of cash Purchase of fixed assets Repayment of loans secured, unsecured Repayment of bank borrowings Repayment of deposits Redemption of debentures Redemption of preference shares Loss from operations Tax paid Dividend paid

Cost Concepts
Important inputs in managerial decision making is cost data Cost data is classified based on managerial needs Managerial needs are Income measurement Profit planning Costs control Decision making

Relating to Income Measurement

Product cost and Period cost Absorbed cost and Unabsorbed cost Expired cost and Unexpired cost Joint product cost and Separable cost

Relating to Income Measurement

Product cost and Period cost Only variable costs are taken as product costs, as they are affected by production volume Period costs vary with the passage of time and not with volume of production, viz., fixed costs

Relating to Income Measurement

Absorbed cost and Unabsorbed cost Since fixed costs also contribute to production, they need to be shared by the volume produced SFOR Standard Fixed Overhead Rate SFOR = Fixed cost / Units produced Absorbed costs = units produced * SFOR Unabsorbed costs =AFC(Units produced*SFOR) AFC = Actual Fixed costs

Relating to Income Measurement

Expired cost and Unexpired cost Expired cost can not contribute to the production of future revenues Unexpired cost has the capacity to contribute to the production of revenue in the future., example, inventory

Relating to Income Measurement

Joint product cost and Separable cost Joint Product costs are the costs of a single process that simultaneously produce multi products and can not be attributed to any one product Separable costs can be attributed exclusively and wholly to a particular product

Relating to Profit Planning

Fixed, Variable, Semi variable / Mixed cost Future cost and Budgeted cost

Relating to Profit Planning

Fixed, Variable, Mixed costs Fixed costs are associated with those inputs which do not vary with changes in volume of production (Committed and Discretionary) Variable costs which vary with volume of production Mixed cost are partly fixed and partly variable

Relating to Profit Planning

Future cost and Budgeted cost Future costs are reasonably expected to be incurred at some future date as a result of a current decision They are estimated costs based on expectations When an operating plan involving future costs is accepted and incorporated formally in the budget for a specific period, such costs are referred as budgeted costs

Relating to Control
Responsibility costs Controllable and Non controllable costs Direct and Indirect costs

Relating to Control
Responsibility costs This concept applies more as responsibility accounting Costs are classified with the persons / centers responsible for their incurrence

Relating to Control
Controllable costs are those which can be controlled / influenced by the responsibility centers/persons Non controllable costs are those which can not be influenced

Relating to Control
Direct costs are those which can be identified in their entirety to a particular product in a responsibility center Indirect costs are common costs which are shared among products / departments

Relating to Decision making

Relevant cost and Irrelevant cost Incremental cost and Differential cost Out of pocket cost and sunk cost Opportunity cost and Imputed cost

Relating to Decision making

Relevant costs are those influenced by a decision and hence are important for decision makers, typically variable costs Irrelevant costs are not affected by the decision taken and hence decision makers do not worry about them, typically committed fixed costs

Relating to Decision making

Incremental costs are additional costs incurred if management chooses a particular course of action as against another Differential costs are difference in costs between any two available alternatives

Relating to Decision making

Out of pocket costs are costs which involve fresh outflow of cash on decision taken Sunk costs are those which have already been incurred where current decisions have no impact on.

Relating to Decision making

Opportunity costs represent benefits foregone by not choosing one alternative in favour of another that can be quantified Imputed costs are the hypothetical costs that must be considered while arriving at the right decision

Marginal Costing
Marginal cost is the cost of producing one additional unit Variable cost varies with the level of production Fixed cost remains constant for a range of capacity utilization Therefore for a given range of capacity utilization, the marginal cost is the variable cost per unit.

Marginal Costing (Contd.)

If the level of capacity utilization changes, the fixed cost changes. Then the incremental fixed cost has to be shared by the additional capacity produced Then the Marginal Cost is the sum of variable cost per unit and the incremental fixed cost per unit

Marginal Costing (Contd.)

For a given capacity level, the marginal cost is only the variable cost. This is because the fixed cost will not change up to a certain level of production When the fixed cost changes with the change in capacity utilization, the marginal cost is the sum of variable cost per unit and the incremental cost per unit

Marginal Costing (Contd.)

Under Absorption costing, all costs, both fixed and variable costs are allocated to the product Under marginal costing, only variable costs are allocated to the product and the fixed costs are recovered out of the contribution

Break Even Analysis

Sales minus Variable cost = Contribution minus Fixed cost = Profit or Loss

Break Even Analysis (Contd.)

BEP (in Units) = Fixed cost (in Rs.) ---------------------------------Contribution per unit (in Rs.) Contribution per unit (in Rs.) = SP(in Rs.)/unit VC(in Rs.)/unit

Break Even Analysis (Contd.)

Profit Volume Ratio = Contribution (P/V ratio) ------------------ * 100 Sales

Break Even Analysis (Contd.)

BEP (in Rs. = Fixed Coat (in Rs.) ----------------------P/V ratio

Break Even Analysis (Contd.)

Margin of safety = Actual sales BEP sales Margin of safety ratio = Actual sales BEP sales -----------------------------Actual sales Profit = Margin of safety * P/V ratio

Budgetary Control
Budgeting is tool of planning Planning involves specification of the basic objectives that the organisation will pursue and the fundamental policies that will guide it

Budgetary Control (Contd.)

Steps in Planning: Objectives defined as the broad and long range position of the firm Specified goal targets in quantitative terms achieved in a specified period of time Strategies to achieve these goals Budgets to convert goals and strategies into annual operating plans

Budgetary Control (Contd.)

A budget is defined as a comprehensive and coordinated plan, expressed in financial terms, for the operations and resources of an enterprise for some specified period I the future. As a tool, a budget serves as a guide to conduct operations and a basis for evaluating actual results

Budgetary Control (Contd.)

The essential elements of a budget are: Plan Financial terms Operations and Resources Specific future period Comprehensive coverage Coordination

Budgetary Control (Contd.)

The main objectives of budgeting are: Explicit statement of expectations Communication Coordination Expectations as framework for judging performance

Budgetary Control (Contd.)

The overall budget is known as the Master budget. Classification Operating budgets and Financial budgets Operating budgets include cash flows from the operations of the firm viz., sales, collections of receivables, etc Financial budgets include cash flows from collection and payments of financial nature viz., borrowings, external raising of money, taxes pais and dividend paid, etc

Budgetary Control (Contd.)

Operating budget Sales budget Production budget Purchase budget Direct labour budget Manufacturing expenses budget Administrative and Selling expenses budget

Budgetary Control (Contd.)

Financial Budget Budgeted income statement Budgeted statement of retained earnings Cash budget Budgeted balance sheet

Budgetary Control (Contd.)

Budgets prepared at a single level of activity, with no prospect of modification in the light of changed circumstances, are referred to as fixed budgets A flexible budget estimates costs at several levels of activity While fixed budget is rigid in nature, flexible budget contains several estimates / plans in different assumes circumstances It is a useful tool in real world situations, that is, unpredictable environment

Budgetary Control (Contd.)

The framework of flexible budget covers Measure of volume Cost behaviour with change in volume

Inventory Costing
Inventories are assets: Held for sale in the ordinary course of business (finished goods) In the process of production for such sale (work in progress) In the form materials or supplies to be consumed in the production process or in the rendering of services (raw materials) Purchased and held for resale

Inventory Costing
Inventories should be valued at the lower of cost or net realizable value Net realizable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make such sale

Inventory Costing
The cost of inventories should comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition Cost of purchase consists of the purchase price inclusive of the taxes and duties, freight inwards and other acquisition costs directly attributable to the purchase and trade discounts, rebates, duty drawbacks and other similar items are deducted in determining the cost of purchase

Inventory Costing
Costs of conversion include costs directly related to production like labor, factory overheads, etc. In this process, if any byproduct, waste or scrap are produced, their net realizable value is removed from the cost of conversion Other costs included in the cost of inventories are only those incurred in bringing the inventories to their present level like design cost, etc.

Inventory Systems
Periodic System: inventory is determined by a
periodic count as of a specific date. As long as the check is frequent enough to avoid negligence, this system is acceptable. The net change between the beginning and ending inventories enters the calculation of cost of goods sold Perpetual System: inventory records are maintained and updated continuously as items are purchased and sold. It has the advantage of providing up to date inventory information on a timely basis, but needs a full fledged record maintenance

Inventory Cost Methods

In selecting the inventory cost method, the main objective is the selection of the method that clearly reflects its usage and the periodic income. Frequently, the identity of the goods and their specific related costs are lost between the time of acquisition and the time of their use. When similar goods are purchased at different times, it may not be possible to identify and match the specific costs of the item sold. This has resulted in certain accepted costing methods

Inventory Cost Methods

First In First Out Method (FIFO) Last In First Out Method (LIFO) Weighted Average Method

Inventory Cost Methods

FIFO: here costs are charged against revenue in the order in which they occur. The inventory remaining on hand is presumed to consist of the most recent costs. In other words, items are converted and sold in the order in which they are purchased.

Inventory Cost Methods

LIFO: this method matches the most recent costs incurred with the current revenue, leaving the first cost incurred to be included as inventories.

Inventory Cost Methods

Weighted Average Method: this method assumes that costs are charged against revenue based on an average of the number of units acquired at each price level. The resulting average price is applied to the ending inventory to find its value. The weighted average is determined by dividing the total cost of the inventory available, including any beginning inventory, by the total number of units.

Inventory Cost Methods

Date Jan 15 Mar 20 May 10 June 8 Oct 12 Dec 21 Total Op.inv Cl. inv Units

10000 20000 50000 30000 5000 5000 120000 10000 14000

Cost per unit Total cost 5.10 51000 5.20 104000 5.00 250000 5.40 162000 5.30 26500 5.50 27500 621000 5.00 50000

Under FIFO
Dec purchases 5000@5.50 = 27500 Oct purchases 5000@5.30 = 26500 June purchases 4000@5.40 = 21600 Ending inventory 14000 = 75600 (using FIFO)

Under LIFO
Opening inventory 10000@5.00 = 50000 Jan purchases 4000@5.10 = 20400 Ending inventory 14000 = 70400 (using LIFO)

Under Weighted Average Method

Weighted average cost =total cost/total units Wei. Ave. cost = 671000/130000 = 5.1615 Closing inventory 14000@5.1615 = 72261

Comparison
Under FIFO = 75600 Under LIFO = 70400 Under WA method = 72261

Comparison
In periods of inflation, the FIFO method produces the highest ending inventory, resulting in the lowest cost of goods sold and the highest gross profit. LIFO produces the lowest ending inventory resulting in the highest of goods sold and the lowest gross profit The WA method yields results between those of the above two methods

Emerging Concepts
The transition from Cost Accounting to Strategic Cost Management (SCM) Cost Analysis is traditionally viewed as the process of assessing the financial impact of alternative managerial decisions SCM involves usage of cost data to develop superior strategies to gain sustainable competitive advantage

SCM
The process of SCMTarget Costing Activity Based Costing Quality Costing Life Cycle Costing Value Chain Analysis

Target Costing
Target Cost is defined as a market based cost that is calculated using a sales price necessary to capture a predetermined market share Target Cost = Sales Price (for the target market share desired profit) Target costing is market driven design methodology It estimates the cost for a product and then designs the product to meet the cost

Target Costing
It is Cost Management tool which reduces a products costs over its entire life cycle. It includes actions management must take to Establish reasonable target costs Develop methods for achieving those targets Develop means to test the cost effectiveness of different cost-cutting scenarios

Activity Based Costing (ABC)

Applying overhead costs to each product or service based on the extent to which it is caused by them is the primary objective of overhead costing This is carried out using a single pre determined overhead rate based on a single activity measure With ABC, multiple activities are identified in the production process that are associated with costs

Activity Based Costing (ABC)

The events within these activities that cause costs are called cost drivers The cost drivers are used to apply overheads to products and services when using ABC

Activity Based Costing (ABC)

The following five steps are used in ABC: Choose appropriate activities Trace costs to activities Determine cost drivers for each activity Estimate the application rate for each cost driver Apply costs to products

Activity Based Costing (ABC)

Overhead account Indirect labor Depreciation-building Depreciation-machinery Electricity Cost driver Man hour cost Sq. feet used Machine time Watts used

Quality Costing
A quality costing system monitors and accumulates the costs incurred by a firm in maintaining or improving product quality The cost of lowering the tolerance for defective units come from the increased cost of using a better tehnolgy Total Quality Control (TQC)/ Total Quality Management (TQM) is a management process based on the belief that quality costs are minimized with zero defects

Life Cycle Costing

Products have definite phases of life Cost, revenue and profits vary in these phases Each phase has different threats and opportunities Different functional emphasis comes with each phase

Life Cycle Costing

Different phases areIntroduction Growth Maturity Saturation Decline

Value Chain Analysis

Value chain is the linked set of value creating activities from the basic raw material sources to the end use product delivered into final customer The primary focus is to create low cost strategy relative to competitors

Value Chain Analysis

It highlights Linkages with suppliers Linkages with customers Process linkages within the value chain of a business unit Linkages across business unit value chain within the firm