Definition of Cost Accounting

Cost accounting is one of the branches of accounting. Cost accounting is the process of determining
the cost of producing some of products, providing some of services or undertaking some activities.
So cost accounting as the branch of accounting dealings with the classification, recording, allocation,
summarization and reporting of current and prospective cost. Therefore identification, accumulation,
assignment, and analysis of cost of products or activities are done in cost accounting.

Why cost accounting?

Cost accounting is a recent development born in the response to the needs of managerial personnel
for detailed information about cost of a product or unit of service. In the initial stages of its
evolution, cost accounting confined to itself to accumulation of historical costs and presentation of
the same for sole purpose of cost finding or product costing. With the passage of time, however, the
scope of cost accounting was broadened and provision of information for cost control and cost
minimization became more important than product cost.

So cost accounting is necessary for the achievement of the following purposes:

 Cost ascertainment: Cost finding for product or service is, even today, the basic objective of
cost accounting. For the purpose of asserting the cost of a product, process or operation, it is
necessary to record the expenses incidental thereto, subjectively as well as objectively. In the
process of recording expenses are reclassified according to the purpose for which they are
incurred. After reclassification, these expenses are allocated and apportioned amongst the
respective products, process or operation for building up total cost for each of these. Cost per unit
is achieved at by dividing the total cost by the number of units produced.

 Cost control: This is, in fact, the principal purpose of cost accounting. This objective is achieved
by setting standard of performance. Actual costs are compared with the pre-determined
standards. Deviation, if any, is immediately corrected. The controlling function is performed by
managers at different levels to ensure that operation or process costs are under control.
 Decision making: Choosing amongst alternatives is also one of the objectives of cost accounting.
Cost information, presented to management regularly at stated intervals of time .enables
management to make short-term and long-term decisions. Thus cost information is of immense
use of formulating operating policies of a business enterprise.

 Fixation of selling price: Cost per unit facilities fixation of selling price. Unless the cost is
known, the required percentage of profit cannot be added to cost, since selling price is equal to
cost plus profit. The need for reliable cost data becomes apparent specially during a period of
depression when the selling price has to be fixed below the total cost. furthermore in the
competitive world, to determine the selling price efficiently is needed, so that customers get
products in lower price than other competitor of the enterprise, that will ensure to sell the more
products and more profit.

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Financial Accounting versus Management Accounting/Cost Accounting
Different point of Financial Accounting Management Accounting/Cost
views Accounting

Purpose Profit determination and Cost ascertainment, cost control and

true and fair view of decision making
financial position

Reporting to users External users Internal users

Focus Focused on whole Focused on organizational units,

enterprise segments, or responsibility centers

Emphasis Emphasis is on accuracy Emphasis is on timeliness and promptitude

mandatory It is mandatory for all It is voluntary for all business enterprises

business enterprises

Principles It is subject to the It is not subject to the Generally Accepted

Generally Accepted Accounting Principles(GAAP)
Accounting
Principles(GAAP)

Time period It is past oriented as is It is future oriented as is taken decision for

prepared statements taking future. Time period is long.
past transactions. short
period of time

Cost concepts

Cost, expense and loss: cost is the sacrifice of resources to attain specific objectives. So cost is the
expenditure incurred or attributable to a thing or activity is actual, if money is involved. Cost is
incurred to get utility. The utility may be got immediately or in future. If the utility is got in future,
that cost will be assets. Like cost of land, building, equipment. If the cost is expired-that means no
hope for getting future benefits from that cost, the cost will be either expenses or losses. If the benefit
or utility is received already, the cost will be expenses. Example rent expense, interest expense. If the
benefit is not received yet and in future no hope for getting the benefit from that incurred cost, the
cost will be losses. For example loss for sale of share, loss for sale of equipment. So all expenses are
costs but all costs are not expenses.

Cost

Expired Deferred

Expenses losses Assets

Total cost and unit cost: Total cost is the cost for total units produced by an enterprise in an
operation. Example total cost of production. Unit cost is per unit of cost product or service in relation
to which cost is ascertained.
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Cost object: cost object is anything to which cost measurement is desired. Example is products,
services, departments, processes and operations.

Mark up: Mark up is cost plus profit. That means profit is charged on cost. Example is 10% profit
on cost. In here cost will be 100%.

Margin: Margin is profit which is charged on sales value. Example is 10% profit on sales. In here
sales will be 100%.

Prime cost is direct materials plus direct labor costs that are needed to produce the finished product.

Conversion cost is direct labor + manufacturing overhead that is used to "convert" raw materials
into product (finished).

Classification of cost

On the basis of manufacturing and non-manufacturing:

Cost

Manufacturing cost Non manufacturing cost

Direct materials Office and Administrative overhead

Direct labor Marketing and selling overhead

Manufacturing overhead

On the basis of elements of cost

Material cost; material is the basic substance of the products. Cost of the basic commodities
supplied to the enterprise to convert into finished product of that enterprise. For Example cotton will
be the material for spinning mills.

Labor cost; cost of remunerating own employees who converts the raw material into finished
products. For example may be wages and salaries for factory employees.

Overhead cost; all the costs except materials and labor cost, are overhead costs that are needed to
produce the product but cannot be traced directly in an economic faceable way to the product
produced. For example indirect material cost, indirect labor cost, factory overhead cost.

On the basis of behavior of cost

Variable cost: Cost variable in total into proportion to the changes of volume or level of activity. In
variable cost, cost varies in total but constant in per unit. For example direct material cost, direct
labor cost.

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Fixed cost: Cost fixed in total within a relevant range of short time period but varies in per unit.
Relevant range is the specific period of time when the relationship between cost and activity or
number of units is certainly known. For example depreciation expenses, rent expense, interest
expense.

Mixed cost: Mixed cost is the combination of fixed cost and variable cost. Mixed cost may be semi-
variables or semi-fixed cost. When the variable portion of cost is higher than fixed portion of cost
then it will be semi-variable cost. When the fixed portion is higher than the variable portion of cost
then that mixed cost will be semi-fixed cost. Example of mixed cost is maintenance cost, cost of
goods sold.

On the basis of decision making

Relevant cost: The cost which is relevant for decision making among the alternatives. Relevant cost
is future cost and varies among the alternatives. All variable costs are relevant.

Irrelevant cost: Cost which does not affect the alternatives. Such costs are common among the
alternatives. Most of the cases all the fixed costs are irrelevant.

Opportunity cost: opportunity cost is the forgone benefits from the second best alternative due to
rejecting this alternative and accepting the first alternative. When more than one option is available
but the options are mutually exclusive then the company has to accept one option that gives highest
financial benefits. So in this case company has to reject all other options and the benefit of the best
option from rejecting options is opportunity cost of that company. This is opportunity cost as
company cannot take all the opportunities at the same time due to resource constraints or other
factors.

Sunk cost: sunk cost is past cost which has already been incurred so does not directly affect on the
decision making. This type of cost is not altered as a result of managerial decision to change the level
or nature of business activities. Example is equipment purchased and if the decision is changed so
the newly equipment will not be in use. But as the equipment is purchased already so this has no
effect on further decision making.

On the basis of direct and indirect

Direct cost: direct cost is directly traceable to the product or service in an economic feasible way.
For example cost of timber for table chair, cost cloth for making shirt.

Indirect cost: indirect cost can’t be traced directly to the product or service in an economic feasible
way. For example cost of gum or iron that are needed to produced table, chair. Cotton needed to
stitch the shirt.

Cost Function

Y = MX + C

Where:

Y is total cost or mixed cost.

M is multiplier that is variable cost per unit and constant over the period.
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X is number of units produced.

And C is fixed cost that is constant over the period whatever the number of units produced.

Problem: Behavioral classification of cost

Frankel limited is a merchandising company, is the distinguishing distributor of a product that is

gaining rapid market acceptance. The company’s revenues and expenses for the last three months are
below:

  A J
pril May une
  Sales units 3000 3750 4500
  Sales revenue 420000 525000 630000
  less: Cost of Goods Sold 168000 210000 252000
Gross Margin 252000 315000 378000
  Less: Operating expenses;      
  Shipping expense 44000 50000 56000
  Advertising expense 70000 70000 70000
  Salaries & commission 107000 125000 143000
  Insurance expense 9000 9000 9000
  Depreciation expense 42000 42000 42000
  Total operating expenses 272000 296000 320000
  Net Operating Income -20000 19000 58000

Requirement

A. Identify the behavioral classification of cost as variable, fixed and mixed cost.
B. Using High-low method separate the fixed and variable cost from mixed cost
C. Using contribution margin format provide the Income Statement for 4500units.
D. What is cost function for 5000 units? Determine the total cost for mixed items.

Solution

A. Identification of costs

Cost
identificatio
  April May June n
Sales units 3000 3750 4500  
Cost of goods sold($) 168000 210000 252000  
per unit cost of goods sold Variable
(Cost of goods sold/Sales unit) 56 56 56 cost
Shipping expense($) 44000 50000 56000  
14.6666 13.3333 12.4444
Per unit shipping expense 7 3 4 mixed cost
Advertising expense($) 70000 70000 70000  
23.3333 18.6666 15.5555
Per unit advertising expense 3 7 6 Fixed cost
Salaries & commission($) 107000 125000 143000  
Per unit salaries & 35.6666 33.3333 31.7777 Mixed cost
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 commission($) 7 3 8
Insurance expense($) 9000 9000 9000 Fixed cost
Depreciation expense($) 42000 42000 42000 Fixed cost

B. Separation of cost under High –low method

Shipping expense

Per unit variable cost will be =

( cost of hig h er level−cost of lower level )

(number of units of hig h er level−number of units of lower level)

= (56000-44000)

( 4500-3000)

= $ 8 per unit

Cost function:Y = MX+C

Total cost = per unit variable cost × number of units + fixed cost

Or, $56000 = $8× 4500+ fixed cost

Or, fixed cost = $56000-$36000

=$20000

Salaries & commission

Per unit variable cost will be =

( cost of hig h er level−cost of lower level )

(number of units of hig h er level−number of units of lower level)

= (143000-107000)
( 4500-3000)
= $ 24 per unit
Cost function: Y = MX+C
Total cost = per unit variable cost × number of units + fixed cost

Or, $143000 = $24× 4500+ fixed cost

Or, fixed cost = $143000-$108000

=$35000

C. Frankel limited

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 Income statement (Contribution Margin Format)
For the month ended June 30

 Components of Income Statement June

Sales units 4500
Sales revenue($) 630000
less: Variable expenses:($)  
Cost of goods sold 252000
Shipping expense 36000
Salaries & commission 108000
Total variable expenses 396000
Contribution Margin($) 234000
less: Fixed expenses($)  
Shipping expense 20000
Advertising expense 70000
Salaries & commission 35000
Insurance expense 9000
Depreciation expense 42000
Total Fixed expense 176000
Net Operating Income($) 58000
D.

Cost function for 5000 units will be ,Y = M× 5000 + C

Total cost for Shipping expense = $8×5000+ $20000

=$60000

Total cost for Salaries & Commissions= $24×5000+ $35000

=$155000

Problem:Cost Sheet preparation from cost classification

The following information has been taken from the accounting record of klear –seal company for the
last year ended December 31,2011.

Name of Accounts Amount ($)

Advertising expense 60000
Raw materials inventory (january 1,2011) 90000
Raw materials inventory (december 31,2011) 60000
Utilities expense,factory 36000
Direct labor cost 150000
Depreciation cost, factory 162000
Purchase of raw material inventory 750000
Free sample-distribution expense 20000
Sales-man salaries 40000
Marketing expense 20000

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 Sales revenue 2500000
Insurance expense,factory 40000
Supplies 15000
Office rent 100000
Administrative salaries expense 50000
Depreciation cost, office equipment 120000
Indirect labor cost 300000
Maintenance cost,factory 87000
Work-in-process inventory(january 1,2011) 180000
Work-in-process inventory(december 31,2011) 100000
Finished goods inventory (january 1,2011) 260000
Finished goods inventory (december 31,2011) 210000

Required

A. Prepare a schedule of cost of goods manufactured/cost sheet and cost of goods sold.
B. Prepare income statement for the year ended 31st December, 2011.
C. Determine the bidding price under the following circumstances:
I. Direct material cost $ 15000, direct labor cost $12000.
II. Factory Overhead cost is 80% of the direct labor cost.
III. Office &administrative cost and selling &marketing cost will be a fixed percentage of
cost of production/cost of goods manufactured.
IV. The company wants to make profit on sales/ margin on sale as 20%.

Solution

A.

Klear-Seal Company limited

Statement of cost of goods sold
For the year ended 31st December,2011
Components of cost amount($) amount($)
Raw materials inventory (january 1,2011) 90000  
Add: purchase of raw material inventory 750000  
Raw materials inventory available to consume 840000  
less: Raw materials inventory (december 31,2011) 60000
Raw materials inventory consumed   780000
Add: Direct labor cost   150000
Prime cost   930000
Add: Factorry overhead costs    
Utilities expense,factory 36000  
Depreciation cost, factory 162000  
Insurance expense,factory 40000  
Supplies 15000  
Indirect labor 300000  
Maintenance cost,factory 87000  
Total Factory overhead costs   640000
Total manufacturing cost   1570000
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 Add:work-in-process inventory(january 1,2011)   180000
    1750000
Less:work-in-process inventory(december 31,2011)   100000
Cost of Goods Manufactured   1650000
Add:Finished goods inventory (january 1,2011)   260000
Cost of Goods available to sales   1910000
Less:Finished goods inventory (december 31,2011)   210000
Cost of Goods sold   1700000

B.
Klear-Seal Company limited
Income Statement
For the year ended 31st December,2011
Components of Income Statement Amount($) Amount($)
Sales revenue   2500000
Less:Cost of Goods Sold   1700000
Gross Margin   800000
Less: Office & Administrative overhead
expenses    
Office rent 100000  
Administrative salaries expense 50000  
Depreciation cost, office equipment 120000  
Total office & Administrative expenses 270000  
less: Selling & Marketing Overhead expenses  
Advertising expense 60000  
Free sample-distribution expense 20000  
Sales-man salaries 40000  
Marketing expense 20000  
Total Selling & Marketing overhead expenses 140000  
Total office & Administrative expenses and total 4100
selling & marketing Overhead Expenses 00
Net Operating Income   390000

C. Bidding price

Amount($)
Direct material cost 15000
Direct labor cost 12000
prime cost 27000
Add Factory overhead cost 12000x80% 9600
Manufacturing Cost 36600
Add: Office& Administrative Overhead
expense(270000/1650000)x36600 5989
Add: Selling& marketing Overhead expense(140000/1650000)x36600 3105
Total operating Cost 45694

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 Add: Margin(20/80)x45694 11424
Bidding Price 57118

Cost-volume-profit (CVP) analysis.

CVP analysis examines the behavior of total revenues, total costs, and operating income (profit) as
changes occur in the units sold, the selling price, the variable cost per unit, or the fixed costs of a
product. The reliability of the results from CVP analysis depends on the reasonableness of the
assumptions. The Appendix to the chapter gives additional insights about CVP analysis; it explains
decision models and uncertainty.

Assumptions of CVP Analysis

1. The analysis assumes a linear revenue function and a linear cost function.

2. The analysis assumes that price, total fixed costs, and unit variable costs can be accurately
identified and remain constant over the relevant range.

3. The analysis assumes that what is produced is sold.

4. For multiple-product analysis, the sales mix is assumed to be known.

5. The selling price and costs are assumed to be known with certainty

Sensitivity analysis is a “what if” technique that managers use to examine how a result will change
if the original predicted data are not achieved or if an underlying assumption changes. In the context
of CVP analysis, sensitivity analysis examines how operating income (or the breakeven point)
changes if the predicted data for selling price, variable cost per unit, fixed costs, or units sold are not
achieved. The sensitivity to various possible outcomes broadens managers’ perspectives as to what
might actually occur before they make cost commitments. Electronic spreadsheets, such as Excel,
enable managers to conduct CVP-based sensitivity analyses in a systematic and efficient way.

An aspect of sensitivity analysis is the margin of safety, the amount by which budgeted (or actual)
revenues exceed the breakeven quantity. The margin of safety answers the “what-if” question: If
budgeted revenues are above breakeven and drop, how far can they fall below budget before the
breakeven point is reached?
CVP-based sensitivity analysis highlights the risks and returns that an existing cost structure holds
for a company. This insight may lead managers to consider alternative cost structures. For example,
compensating a salesperson on the basis of a sales commission (a variable cost) rather than a salary
(a fixed cost) decreases the company’s downside risk if demand is low but decreases its return if
demand is high. The risk-return tradeoff across alternative cost structures can be measured as
operating leverage. Operating leverage describes the effects that fixed costs have on changes in
operating income as changes occur in units sold and contribution margin. Companies with a high
proportion of fixed costs in their cost structures have high operating leverage. Consequently, small
changes in units sold cause large changes in operating income.

Degree of Operating Leverage = Contribution Margin/ Operating Income

Knowing the degree of operating leverage at a given level of sales helps managers calculate the
effect of changes in sales on operating income.
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Question1.: Following data relates to a manufacturing company:

Number of units produced and sold each year 6,000 and selling price per unit $20.
Variable cost per unit:
Direct materials $2
Direct labor $4
Variable Manufacturing Overhead $1
Variable selling and Administrative expenses $3
Fixed costs per year:
Fixed manufacturing overhead $30,000
Fixed selling and administrative expenses $10,000

Requirement

I. Compute BEP in units and in value. (BEP= Break –Even –Point).

II. Compute Degree of Operating Leverage (DOL) and prove it by assuming 20% increase in
sales.
III. Prepare income statement if the selling price increases by $2.00 per units, fixed cost increases
by $15,000 and the sales volume decreases by 10%.
IV. Compute the BEP in units if selling price increases by 10% and variable cost increases
by15%.
V. Calculate Margin of Safety in value and in units.
VI. What will be the amount of units to achieve the target profit before tax $250, 000? Tax rate is
25% on profit.
VII. What will be the amount of units to achieve the target profit after tax $250, 000? Tax rate is
25% on profit.

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