Cost Accounting Week 1

CHAPTER 1 | MANAGEMENT, THE

CONTROLLER, AND COST
ACCOUNTING

1. MANAGEMENT
Management is composed of three groups; operating management, middle management,
and executive management.

A. Planning
The construction of a detailed operating program is the process of sensing external
opportunities and threats, determining desirable objectives, and employing resources to
accomplish these objectives.
Effective planning requires participation and coordination of all parts of the entity.
The companies best able to maximize profits are those that produce goods or services at
an excellent level of quality and value, in a volume, at a time and place, at a cost, and at a
price that will win cooperation of employees, gain the goodwill of customers, and meet
social responsibilities.
i. Strategic plans
Strategic plans are formulated at the highest levels of management, take the broadest
view of the company and its environment, are the least quantifiable, and are formulated
at irregular intervals by an essentially unsystematic process that begins with identifying
an external threat or opportunity.
Strategic planning decisions shape the future nature of the firm, its products, and its
customers, and they have the potential to alter the external environment.
ii. Short-range plans
Short-range plans, often called budgets, are sufficiently detailed to permit preparation
of budgeted financial statements for the entity as of a future date (typically the end of
the budget period).
These plans are prepared through a systematized process, are highly quantified, are
expressed in financial terms, focus mainly on the organization itself by taking the
external environment as a given, and usually are prepared for periods of a month,
quarter, or year.
iii. Long-range plans
Long-range plans, or long-range budgets, typically extend three to five years into the
future. In terms of their degree of detail and quantifiability, long-range plans are an
intermediate step between short-range plans and strategic plans.
As a long-range plan is revised and refined during the early portions of the planning
period, it serves as a starting point for successive sets of short-range plans.

B. Organizing
Organizing is the establishment of the framework within which activities are to be
performed.
Organizing requires bringing the many functional units of an enterprise into a
coordinated structure and assigning authority and responsibility to individuals.
Organizing efforts include motivating people to work together for the good of the
company.
Organization usually involves the establishment of functional divisions, departments,
sections, or branches.

C. Control
Control is management’s systematic effort to achieve objectives. Activities are
continually monitored to see that results stay within desired boundaries. Actual results
of each activity are compared with plans, and if significant differences are noted,
remedial actions may be taken.
The control process in business always includes a human decision maker. In addition,
the information on which control actions are based includes financial information, and
the control activity is periodic rather than continuous.
D. Authority, responsibility, accountability
i. Authority is the power to direct others to perform or not perform activities.
Authority is the key to the managerial job and the basis for responsibility.
Delegation is essential to organizational structure.
ii. Responsibility, or obligation, is closely related to authority. It originates
principally in the superior-subordinate relationship in that the superior has the
authority to require specific work from others.
iii. Accountability—reporting results to higher authority.

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 E. The organization charts
An organization chart shows an entity’s principal management positions, helps to
define authority, responsibility, and accountability, and is essential in developing a cost
accounting system capable of reporting the responsibilities of individuals.
The coordinated development of a company’s organization with the cost and budgetary
system leads to an approach to accounting and reporting called responsibility
accounting.
Most organization charts are based on the line-staff concept. The assumption of this
concept is that all positions or functional units can be categorized into two groups: the
line, which makes decisions, and the staff, which gives advice and performs technical
functions
Another type of organization chart is based on the functional-teamwork concept of
management, which emphasizes the most important functions of an enterprise:
resources, processes, and human interrelations

2. THE CONTROLLER’S PARTICIPATION IN PLANNING AND CONTROL

The controller is the executive manager responsible for the accounting function. The
controller coordinates management’s participation in planning and controlling the
attainment of objectives, in determining the effectiveness of policies, and in creating
organizational structures and processes.
Effective control depends on communicating information to management. By issuing
performance reports, the controller advises other managers of activities requiring
corrective action.
The principle of management by exception is a belief that managers should be
provided with information that directs their attention to activities that require
corrective action.

3. THE COST DEPARTMENT

The cost department, under the direction of the controller, is responsible for gathering,
compiling, and communicating information regarding a company’s activities. This
department analyzes costs and issues performance reports and other decision-making
data to managers for use in controlling and improving operations.
The manufacturing departments, under the direction of engineers and factory
superintendents, design and control production. In research and design, cost estimates
are used in deciding whether to accept, improve, or reject a design
The personnel department interviews and selects employees and maintains personnel
records, including wage rates. This information forms the basis for computing payroll

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 costs and for calculating the labor-related costs of any activity, service, or good
produced.
The treasury department is responsible for financial administration of a company. In
scheduling cash requirements and expectations, it relies on budgets and related reports
from the cost department.
The marketing department needs a quality product at a competitive price to attract
customers. Prices generally are not set merely by adding a predetermined percentage to
cost, but costs cannot be ignored.
The public relations department has the function of maintaining good relations
between the company and its public, especially its customers and stockholders.. The
cost department provides information for public releases concerning these areas.
The legal department uses cost information as an aid in maintaining compliance with
contracts and laws.

4. THE ROLE OF COST ACCOUNTING

A. Budgeting
The budget is the quantified, written expression of management’s plans. All levels of
management should be involved in creating it. A workable budget promotes
coordination of personnel, clarification of policies, and crystallization of plans. It also
creates greater internal harmony and unanimity of purpose among managers and
workers.
Budgeting plays an important role in influencing individual and group behavior at all
stages of the management process, including
i. (1) setting goals,
ii. (2) informing individuals about what they should contribute to the
accomplishment of the goals,
iii. (3) motivating desirable performance,
iv. (4) evaluating performance, and
v. (5) suggesting when corrective action should be taken.

The following elements have been suggested as means for motivating personnel to aim
for goals set forth in a budget.
i. A compensation system that builds and maintains a clearly understood
relationship between results and rewards.
ii. A system for performance appraisal that employees understand with regard to
their individual effectiveness and key results, their tasks and their

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 responsibilities, their degree and span of influence in decision making, as well as
the time allowed to judge their results.
iii. A system of communication that allows employees to query their superiors with
trust and honest communication.
iv. A system of promotion that generates and sustains employee faith in its validity
and judgment.
v. A system of employee support through coaching, counseling, and career
planning.
vi. A system that considers not only company objectives, but also employees’ skills
and capacities.
vii. A system that does not settle for mediocrity, but reaches for realistic and
attainable standards, stressing improvement and providing an environment in
which the concept of excellence can grow.

B. Controlling cost
Systems designed to achieve these goals are called responsibility accounting systems.
Other activities, called non-value-added activities, generally are a result of the
complexity of production settings and are not specific to the production of any
particular good or service.

C. Pricing
Management’s pricing policy ideally should assure long-run recovery of all costs and a
profit, even under adverse conditions.

D. Determining profit
Cost accounting is used to calculate the cost of the output sold during a period; this and
other costs are matched with revenues to calculate profits.

E. Choosing among alternatives

Cost accounting provides information concerning the different revenues and costs that
might result from alternative actions. Based on this information, management makes
short-range and long-range decisions concerning entering new markets, developing
new products, discontinuing individual products or whole product lines, buying versus
making a necessary component of a product, and buying versus leasing equipment.
In the decisions to add new products and discontinue existing products, reliable cost
information is especially crucial to the competitive success of the firm. Misstated costs
create the possibility that undesirable business might be initiated or continued and

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desirable business rejected. In these ways, cost information plays an essential role in
identifying, evaluating, and selecting strategies for the organization.

F. Cost accounting and manufacturing technology

Factory automation, which has spread rapidly, results in capital-intensive processes,
often with computerized systems that use robot-controlled machinery.
Technology is changing the nature of costs, producing, for example, lower inventory
levels, less use of labor, and increasing levels of fixed costs.

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CHAPTER 2 | COST CONCEPT AND
THE COST ACCOUNTING
INFORMATION SYSTEM

1. THE COST CONCEPT

Cost concepts have developed according to the needs of accountants, economists, and
engineers. Accountants have defined cost as “an exchange price, a forgoing, a sacrifice
made to secure benefit. In financial accounting, the forgoing or sacrifice at date of
acquisition is represented by a current or future diminution in cash or other assets.”
G. Cost object
A cost object, or cost objective, is defined as any item or activity for which costs are
accumulated and measured.
Because of the multiple needs in cost finding, planning, and control, cost accounting
systems are multidimensional. The design of cost accounting systems and their
implementation must address these multiple requirements.
H. Traceability of costs to cost object
The traceability of costs to a cost object varies by degree. A common way of
characterizing costs is to label them as either direct or indirect costs of a particular cost
object, as if there were only two degrees of traceability. In fact, degrees of traceability
exist along a continuum.
I. Cost traceability in service industries
The traceability of costs is as important for decision-making in-service businesses as in
manufacturing. For routine pricing decisions, bidding on jobs, and dropping or adding a
service, knowing the costs of different services is of paramount importance in any
competitive environment, and the traceability of costs is as fundamental in calculating
the cost of a service as it is in calculating the cost of a manufactured good.

5. THE COST ACCOUNTING INFORMATION SYSTEM

The cost accounting information system must reflect the division of authority so that
individual managers can be held accountable. The system should be designed to
promote the concept of management by exception.
Although the accounting records will not provide all the necessary information for
effective management, the accountant who designs the system must know how
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employees are paid, how inventories are controlled, how equipment is costed, machine
capacities, and other operating information.
The information system should focus management’s attention.
Some requirements for record keeping and reporting are imposed on an organization by
external forces.
A. Sensitivity to changing methods
Highly automated, robotics-oriented manufacturing may employ little if any labor
directly traceable to each unit of output; this minimizes planning and controlling direct
labor and calls for methods of cost allocation that are not based on labor. The just-in-
time (JIT) philosophy seeks to reduce dramatically the investment in inventories, which
alters accounting’s traditional focus on tracking large stocks of work in process.

B. Nonfinancial performance measures

Many managers have found that the usefulness of nonfinancial performance measures is
not limited to performance evaluation. The reasons for the increased attention being
given to nonfinancial measures include:
i. Dissatisfaction with financial measures.
ii. Growing recognition that traditional financial measures are affected by
phenomena that are not necessarily relevant to the purpose at hand.
iii. Dissatisfaction with the slow pace at which a company’s accounting and data
processing.
iv. Dissatisfaction with financial measures of plant utilization.
v. Dissatisfaction with financial measures of processing efficiency.
Nonfinancial performance measures respond to these problems by using simple
physical data rather than allocated accounting data, by being unconnected to the
general financial accounting system, by being selected to measure only one specific
aspect of performance rather than to be “all things for all purposes,” or by a
combination of these factors.
Some nonfinancial performance measures are simple counts or percentages of desirable
or undesirable events and are intended to measure the efficiency or effectiveness of a
production process.
One popular measure of this type is manufacturing cycle efficiency, which measures
processing time as a fraction of the total time a unit is in the factory. It is calculated as:
Processing time/[Processing time + waiting time + moving time + inspection time]
A third type of nonfinancial performance measure indicates success in simplifying a
process.

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6. CLASSIFICATION OF COSTS
Cost classifications are essential for meaningful summarization of cost data. The most
commonly used classifications are based on the relationship of costs to the following:
i. The product (a single lot, batch, or unit of a good or service)
ii. The volume of production
iii. The manufacturing departments, processes, cost centers, or other subdivisions
iv. The accounting period.
v. A decision, action, or evaluation

B. Costs in relation to the product

i. Manufacturing
1. Manufacturing cost—also called production cost or factory cost—is
usually defined as the sum of three cost elements: direct materials, direct
labor, and factory overhead.
a. Direct materials – are all materials that form an integral part of the
finished product and that are included explicitly in calculating the
cost of the product. The ease with which the materials items can be
traced to the final product is a major consideration in classifying
items as direct materials.
b. Direct labor – is labor that converts direct materials into the finished
product and can be assigned feasibly to a specific product.
c. Factory overhead – also called manufacturing overhead, production
overhead, indirect production costs, manufacturing expenses, or
factory burden – consist of all manufacturing cost not traced directly
to specific output, or except direct materials and direct labor.
d. Indirect materials – are those materials needed for the completion of
a product but not classified as direct materials because they do not
become part of the product. Indirect materials also include materials
that could, theoretically, be viewed as direct material but are not
worth the effort of being treated as direct cost for accounting
purposes.
e. Indirect labor – is labor not directly traced to the construction or
composition of the finished product.
ii. Commercial expenses
1. Commercial expenses fall into two broad classifications: marketing
expenses and administrative expenses (also called general and
administrative expenses).
2. Marketing expenses begin at the point at which the factory costs end.
That is, when manufacturing has been completed and the product is in

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 salable condition. They include the expenses of promotion, selling, and
delivery.
3. Administrative expenses include expenses incurred in directing and
controlling the organization. Not all such expenses are allocated as
administrative expenses. The salary of a vice-president in charge of
manufacturing can be treated as a manufacturing cost, and the salary of
a vice-president in charge of marketing can be treated as a marketing
expense.

C. Costs in relation to the volume in production

i. Variable costs
The total amounts of variable costs change in proportion to changes in activity within a
relevant range:
1. Supplies 5. Receiving costs
2. Fuel 6. Royalties
3. Small tools 7. Communication costs
4. Spoilage, salvage, and 8. Overtime premium
reclamation expenses 9. Materials handling
ii. Fixed costs
Fixed Costs are constant in total amount within a relevant range of activity. Fixed costs
may be thought of as the costs of being in business, while variable costs are the costs of
doing business.
1. Salaries of production 6. Insurance—property and
executives liability
2. Depreciation 7. Wages of security guards
3. Property tax and janitors
4. Patent amortization 8. Maintenance and repairs
5. Supervisory salaries of buildings and grounds
9. Rent
iii. Semivariable costs
Some costs contain both fixed and variable elements; these are called semivariable
costs.
1. Inspection 6. Materials and inventory
2. Cost-department services services
3. Payroll-department 7. Water and sewage
services 8. Maintenance and repairs
4. Personnel-department of plant machinery
services 9. Payroll taxes
5. Factory office services 10. Heat, light, and power

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D. Costs in relation to manufacturing department or other segments
i. Producing and service department
In a producing department, manual and machine operations such as forming and
assembling are performed directly on the product or its parts.
In a producing department, forming and assembling are performed directly on the
product or its parts.
The terms direct and indirect can also be used in connection with charging overhead
costs to departments of any organization. If a cost is traceable to the department in
which it originates, it is referred to as a direct departmental cost; the salary of the
departmental supervisor is an example.
If a cost is shared by several departments that benefit from its incurrence, it is referred
to as an indirect departmental cost; building rent and building depreciation are
examples of indirect departmental costs. In this cost classification system, the
department is the cost object.
ii. Common costs and joins costs
Common costs are costs of facilities or services employed by two or more operations.
Joint costs occur when the production of one product makes it inevitable that one or
more other products are also produced. The meat-packing, oil and gas, and liquor
industries are good examples of production that involves joint costs. In such industries,
joint costs can be allocated to joint products only by arbitrary calculations.

E. Costs in relation to a decision, action, or evaluation

Differential cost is one name for a cost that is relevant to a choice among alternatives.
Differential cost is sometimes called marginal cost or incremental cost. If a differential
cost will be incurred only if one particular alternative is followed, then that cost can also
be called an out-of-pocket cost associated with that alternative.
A cost that has already been incurred and is, therefore, irrelevant to a decision is
referred to as a sunk cost. In a decision to discontinue a product or division, some of the
product’s or division’s costs may be unaffected by the decision; these are called
unavoidable costs. The avoidable costs, in contrast, are relevant to the decision.

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