Module –II

Cost &
Management Accounting
Books:

• Text Books:
• Cost Accounting – A managerial Perspective by Horngren,
Datar & Foster, Pearson
• Management Accounting - Text, Problems & Cases by
Khan & Jain, TMH
• Reference:
• Managerial Accounting by Garrison, Noreen & Brewer
Management Accounting

• Management Accounting is the process within an

organization that provides information used by managers
in planning, implementing, & controlling the organization’s
activities.
Managerial Accounting vs. Financial Accounting
Financial Managerial
Accounting Accounting
1. Users Investors, creditors, and Managers, employees, and
other external users other internal users
2. Time focus Historical perspective Future emphasis

3. Emphasis Objectivity and Relevance

Verifiability for planning and control

4. Importance Precision of information Timeliness of information

5. Subject focus Summarized data for Detailed segment reports

the whole organization of an organization

6. Requirements Structured and often Relatively flexible

controlled by GAAP (no GAAP)
Cost Estimation & Management

• COST: Resources sacrificed or forgone to achieve a

specific objective. Usually measured as the monetary
amount that must be paid to acquire goods & service.

• COST OBJECT: Any activity or item for which a separate

measurement of cost is desired. Any change made in any
of the cost drivers will cause a change in the total cost.

• Expl.: No of units produced, No. of set-ups, No.of items

distributed etc.
 Flow of Manufacturing Activities
Materials Activity Production Activity Marketing Activity
(raw materials) (goods in process) (finished goods)

Goods in Process
Raw Materials Finished Goods
Beginning
Beginning Inventory Beginning
Inventory Inventory

Raw Materials
Used Goods
Raw Materials
Purchases Manufactured
Direct Labour Used

Factory Overhead
Used
Financial Reports Raw Materials Goods in Finished Goods Cost of Goods
Process Sold (income
Ending Inv. Ending Inv.
Ending Inv. statement)
(balance sheet) (balance sheet)
(balance sheet)
 Cost System
• A costing system accounts for costs in two basic stages –
Accumulation & then assignment/ allocation.

1. Cost Accumulation: Collection of cost data in an

organized way by means of an accounting system – eg.
Raw materials used, fuel consumed, labour payment etc.

2. Cost Allocation: After accumulation, cost system allocates

or traces the cost to cost objects.
Cost Allocation
Direct vs. Indirect Costs
• Direct Costs of a cost object are related to the particular
cost object & can be traced to it in an economically
feasible (cost effective) way.

• Eg.: Cost of can or bottle is a direct cost of a soft drink

producer.

• ‘Cost Tracing’ is used to describe the assignment of direct

cost to particular cost object.
Indirect Cost

• Indirect costs of a cost object are related to the particular

cost object but can not be traced to it in a cost effective
way.

• Eg.: Cost of Quality – Control personnel conducting tests

on multiple soft-drink products.

• ‘Cost Allocation’ is used to describe the assignment of

indirect costs to particular cost object.
Cost Allocation
Service Departments

Electricity Maintenance Factory

Accounting

Stage 1

Machining Assembly
Department Department

Stage 2

Job 236 Job 237 Job 238

 Reporting Requirement
• Explaining manufacturing and nonmanufacturing costs and how they are
reported in the financial statements;
• Computing the cost of providing a service or manufacturing a product;
• Determining the behaviour of costs and expenses as activity levels change
and analysing cost–volume–profit relationships within a company;
• Assisting management in profit planning and formalizing these plans in the
form of budgets.
• Manufacturers compute cost of goods sold by adding the beginning finished
goods inventory to the cost of goods manufactured and subtracting the
ending finished goods inventory (Cost of Goods Manufactured Schedule)
• Merchandisers compute cost of goods sold by adding the beginning
merchandise inventory to the cost of goods purchased and subtracting the
ending merchandise inventory.
• Statement of Cost or Cost Sheet
 Cost Identification & Allocation
• (1) Material : (a) Direct - (i) specific for a job/process; (ii) Components purchased or
produced, (iv) Primary packing materials. (v) Material passing from one process to another.
• (b) Indirect - used for purposes ancillary to production & can be conveniently assigned to
specific physical units - oil, grease, consumable stores, printing & stationary material etc.

• (2) Labour: (a)Direct - wages paid to workers which can be conveniently and economically
traceable to units of products ;
• (b) Indirect - for the purpose of carrying tasks incidental to goods or services provided -
cannot be practically traced to specific units of output -wages of store-keepers, foreman,
time-keepers, supervisors, inspectors etc.

• (3) Expenses: (a) Direct - identifiable with the cost unit- cost of special layout, design or
drawings, hiring of a particular tool or equipment for a job; fees paid to consultants in
connection with a job etc.;
• (b) Indirect - cannot be directly, conveniently & wholly allocated to cost centre or cost units-
rent, rates and taxes, insurance, power, lighting and heating, depreciation etc.
 Cost of Goods Manufactured (COGM) Schedule
(https://www.accountingtools.com/articles/the-cost-of-goods-manufactured-schedule.html)
• The cost of goods manufactured schedule is used to calculate the cost of all items produced during
an operating cycle - & then is used to calculate the COGS for the reporting period - Schedule
contains:
• Opening raw materials inventory
Add, Cost of raw materials purchased
Less, Ending raw material inventory balance = Raw materials used
• Add, Direct Labour Cost
Add, Manufacturing Overhead = Total Manufacturing cost
• Add/ Less, Change in WIP Inventory = Cost of goods manufactured
• This information is then used to derive the cost of goods sold with the following additional
calculation:
• Beginning Finished Goods Inventory
Add, Cost of goods manufactured
Less, Ending finished goods inventory = Cost of goods sold
• The COGS then appears in the Income Statement of the reporting entity, where it is subtracted
from Net sales to determine the Gross Margin.
• The COGM is the total amount a company spends to produce goods, turn them into inventory and
put them up for sale – considers all expenses related to the manufacturing of inventory including
direct materials, factory overhead and labor expenses - Also known as the cost of goods
completed.
 Example - COGM Schedule
• X Ltd. has the following cost and expense data for the year ending December
31, 20XX (Amount in $).
• Raw materials, 1/1/XX 30,000; Insurance, factory 14,000
• Raw materials, 12/31/XX 20,000; Taxes, factory building 6,000
• Raw materials purchased 205,000; Sales (net) 15,00,000
• Indirect materials 15,000; Delivery expenses 1,00,000
• Work in process, 1/1/XX 80,000; Sales commissions 1,50,000
• Work in process, 12/31/XX 50,000; Indirect labor 90,000
• Finished goods, 1/1/XX 110,000; Factory machine rent 40,000
• Finished goods, 12/31/XX 120,000; Factory utilities 65,000
• Direct labor 350,000; Depreciation, Factory building 24,000
• Factory manager’s salary 35,000; Administrative expenses 3,00,000
 Required
• (a) Prepare a cost of goods manufactured schedule for X Ltd. for
20XX.

• (b) Prepare an income statement for the Company for 20XX.

• (c) Assume that Company’s ledgers show the balances of the

following current asset accounts: Cash $17,000, Accounts Receivable
(net) $120,000, Prepaid Expenses $13,000, and Short-term
Investments $26,000. Prepare the current assets section of the
balance sheet for the Company as of December 31, 20XX.

• Extracted from –Accounting Principles, by :Weygand, Kimmel,& Kieso – 9th

Edition.
 Elements of Cost
COST

Materials Labour Other Expenses

Direct
Direct Indirect Direct Indirect
Indirect

OVERHEADS

Production or Selling &

Office & Administrative Distribution
Works Overhead Overhead Overhead
Cost Sheet / Statement of Cost
• A document which provides for assembly of the detailed cost
of a cost centre or cost unit
• Prepared as per ‘output costing’ or ‘unit costing’ or ‘single
costing’ method usually used in following industries:
1.Production consists of a single product or few varieties of
same product with variations in size, shape, quality etc.,
2.Production is uniform & on continuous basis
• Brick Works, Cement, Quaries, Brewaries, Dairies, Steel
Mills, Paper Mills, Sugar Mills etc.
 Statement of Cost
Direct Material
(+) Direct Labour
(+) Direct Expenses Inventoriable Costs/
PRIME COST Unexpired Costs/
(+) Factory Overheads Manufacturing Cost
WORKS/FACTORY/
MANUFACTURING COST
(+) Office & Administrative
Overheads Period Costs/
COST OF PRODUCTION Expired Costs/
(+) Selling & Distribution Non- Manufacturing Expenses
Overheads
COST OF SALES
“Factory overheads’ are not expenses – they are part of Inventoriable cost & will funnel
into the expense stream only when the inventoriable costs are released as ‘COGS’.
Product V.s. Period Cost
• Each of the manufacturing cost components—direct materials, direct
labor & manufacturing overhead—are Product costs - are integral
part of producing the finished product - Firms, when incurred, record
them as inventory.
• As per the matching principle, these costs do not become expenses
until the firm sells the finished goods inventory- Here, these are
recorded as expense in the form of COGS.

• Period costs are matched with the revenue of a specific time period
rather than included as part of the cost of a salable product.
• Nonmanufacturing costs - include selling & administrative expenses -
in order to determine net income, firms deduct these costs from
revenues in the period in which they are incurred.
Product Versus Period Costs
 Computation of Cost Sheet
• From the following information, prepare a cost sheet for period ended on 31st
March 2019.
• Opening stock of raw materials - Rs. 12,500
• Purchases of raw materials- Rs.1,36,000
• Closing stock of raw materials- Rs.8,500
• Direct wages - Rs.54,000
• Direct expenses - Rs.12,000
• Factory overheads 100% of direct wages
• Office and administrative overheads 20% of works cost
• Selling and distribution overheads- Rs.26,000
• Cost of opening stock of finished goods- Rs.12,000
• Cost of Closing stock of finished goods- Rs.15,000
• Profit on cost 20%
Items Excluded from Cost
• Following items are of financial nature & thus not included while
preparing a ‘Statement of Cost’

• Cash discount, Interest payment, preliminary expenses written off,

goodwill written off, Provision for taxation & bad debts, donations,
Payment of income tax & dividend, profit/ loss on sale of fixed assets
etc.

• Scrap Treatment: unavoidable residual material arising in certain

manufacturing process – deducted either from factory overheads or
factory cost while preparing a cost sheet
Costs Classification by Relevance
•Sunk Cost
• All costs incurred in the past that cannot be changed by any decision
made now or in the future.
• should not be considered in decisions/Irrelevant
• Example: Company procured a special – purpose machine for Rs.
50,000 several years ago for making a product that is now obsolete
and no longer being sold.
• Even though the in hindsight the purchase of the machine may have
been unwise, the Rs.50,000 cost has already been incurred & can not
be undone.
Costs Classification by Relevance
• Out-of-pocket cost
• require future outlays of cash
• associated with a particular decision
• relevant for future decisions
Example: The wages of the person setting up a machine for a new
production run are an out-of-pocket cost. However, the cost of the
lost opportunity to be producing profitable output during the setup
time is not an out-of-pocket cost.
• (The cost of not earning profits during the setup time, known as an
opportunity cost, is often far greater than the out-of-pocket costs.)
 Costs Classification by Relevance

• Opportunity Cost
• The potential benefit that is given up when one alternative
is selected over another.
• Example: If a firm is not investing its surplus fund in the
9% debenture issue of another firm, it could be earning
7.5%p.a. from investment in a financial company. The
opportunity cost of investment in a financial company for
one year is the debenture interest foregone.
• These costs are not usually entered in the accounting
records of an organization, but these must be explicitly
considered in every decision a manager makes.
 Costs Classification by Behavior
• Cost behavior refers to
• how a cost will react to changes in the level of business activity.
• Fixed costs
• Do not change when activity changes. Remains fixed in total for a
given period of time despite wide changes in the related level of total
activity or volume (within the relevant range).
These are period costs i.e. Lease rental, Insurance of factory
buildings etc.
• Variable costs
• Change in proportion to changes in the volume of activity. These are
basically product costs i.e. Direct Material Cost, Direct Labour Costs,
power, repair etc.
 Variable Costs
Total variable costs change when activity changes.
Variable costs per unit do not change as activity increases.

Variable costs per unit

Total variable costs

Volume of activity Volume of activity

 Examples of Variable Costs
1. Merchandising companies – cost of goods sold.
2. Manufacturing companies – direct materials, direct labor, and variable
overhead.
3. Merchandising and manufacturing companies – commissions, shipping costs,
and clerical costs such as invoicing.
4. Service companies – supplies, travel, and clerical.
Fixed Cost
• Total fixed costs remain unchanged when activity changes
within a relevant range. Some examples of fixed costs include
rent, insurance premiums, or loan payments
• Fixed costs per unit decline as activity increases.

Fixed costs per unit

Total fixed costs

Volume of Activity Volume of Activity

 Is Labour a Variable or a Fixed Cost?
• The behavior of wage and salary costs can differ across countries,
depending on labor regulations, labor contracts, and custom.
• In France, Germany, China, and Japan, management has
little flexibility in adjusting the size of the labor force.
Labor costs are more fixed in nature.
• In the United States and the United Kingdom, management
has greater latitude. Labor costs are more variable in nature.
• Within countries managers can view labor costs differently depending
upon their strategy. Most companies in the United States continue to
view direct labor as a variable cost.
Relevant Range...

– is a band of volume in which a specific relationship exists between cost and

volume.
• Outside the relevant range, the cost either increases or decreases.
• A fixed cost is fixed only within a given relevant range and a given time span.
 Relevant Range – Step Cost
• Step-Wise Costs
• remain fixed over limited ranges of volumes but increase by a lump
sum when volume increases beyond maximum amounts.
• Example: additional production supervisors must be added when
another shift is added.
Supervisory Salaries

Production Volume
Mixed Costs:
(Semi- fixed/ Semi-variable costs)
The total mixed cost line can be expressed
as an equation: Y = a + bX

Where: Y = The total mixed cost.

a = The total fixed cost (the
Y vertical intercept of the line).
b = The variable cost per unit of
Total Utility Cost

activity (the slope of the line).

X = The level of activity.

Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours) Utility Charge

5-33
Estimating Cost – Volume Relationship

• Several methods are used to estimate the cost volume relationship, i.e. to
arrive at the total fixed cost & the unit variable cost in the equation –

• TC = TFC + (UVC * X)
1. Judgment Method
• Using judgment in deciding how much of cost of each item or category
will vary with volume & what will be the amount of fixed cost.

• Appropriate where;
• Cost estimation for a situation where historical data are irrelevant viz, a
proposal to introduce a new product with a new process.
• The reliability of the results depends on the experience & skill of the
estimator.

• Also known as ‘Account-by-Account Method’ as the analyst considers

each account in the cost structure & judges whether the costs in that
account are variable, fixed or semi-variable.
 2. High – Low Method
1. Estimate total costs at each two volume levels, which
identifies two points on the line – the upper & lower limits of
the relevant range are selected for the purpose

2. Subtract total cost at lower volume from the higher one &
also subtract the corresponding lower volume from the
higher

3. Divide the difference in cost by difference in volume to arrive

at the Unit Variable Cost (UVC)

4. Multiply either of the volumes by UVC & subtract the result

from the total cost at that volume to arrive at the Fixed Cost
 The High-Low Method – An Example
Month Machine Total The variable cost per
Hours Maintenance machine hour is equal to
Cost ($) the change in cost
January 51 784.6 divided by the change in
February 46 710 hours.
March 52 799.52
April 57 874.12
May 68 1038.24
June 96 1456
July 88 1336.64

5-37
 Limitations of High Low Method

• Assumes an over simplified linear analysis of cost behavior in

comparison to ABC which provides a better analysis of the behavior
of cost relating to distinct activities.
• Computation is based on just 2 activity levels only - Linear
regression analysis, in lieu, incorporates data of all activity levels
and is thus more statistically reliable.
• Does not account for the effect of inflation on a portion of financial
data which could result in overestimation of the variable cost
element of a mixed cost – however, it can be overcome by
adjusting the financial data for the effect of inflation before applying
the method.
 3. Scatter Diagram
• Make a diagram in which actual costs recorded in past
periods are plotted (on the vertical axis) against the volume
of levels in those periods ( on the horizontal axis).

• Data on costs & volumes for each of the preceding several

months may be used for the purpose.

• Draw a line that best fits the observation by visual inspection

of the plotted points.

• The FC & TVC values are then determined by reading the

values for any two points on the line and using the High-Low
Method discussed previously.
Scatter diagram with High-Low Method of Cost Estimation

Indirect 1,456 x
x x
Labour x x
Cost function =
Costs 710 x
x x
$23.68 + $14.92 per
($) machine hour

46 96
Machine Hours
Variable cost = Change in cost / Change in volume
= ($1,456 – $710) / (96 - 46) = $14.92 per MH
Fixed cost = Mixed cost at high point - variable cost
= $1,456 - (96 x $14.92)
= $23.68 per week
Regression Analysis Method
• Regression analysis is a statistical method that measures the
average amount of change in the dependent variable (x) that
is associated with a unit change in one or more independent
variable (s)
• Simple linear regression - one independent variable
• Multiple regression - more than one independent variable

• Allows for the evaluation of the quality of the cost function

• Coefficient of determination (R-Squared) measures the goodness of
fit of the line to the underlying data
• t-value measures the potential error of the estimated variables
4. Linear Regression
Method of Least Square
• This approach provides two mathematical properties that are
missing in all previous methods.

• Σy = na + b Σx…………..(1)
• Σxy = a Σx + b Σx2 ……..(2)

• Where Σy = Total cost; Σx = Total Volume

• a= Total Fixed cost;
• b= Variable cost per unit;
• n= No. of time period
• Σxy = Cost, time, volume summed
Discussion Case
• M/s Excell Furniture has experienced different levels of factory overhead cost in relation
to machine hours during recent years. The costs at the high and low activity levels
during the past 4 years are as follows.
• Level of Activity High Low
• Factory Overhead $ 644,000 $ 564,000
• Machine Hours 55,000 35,000
• The factory overhead consists of four items: indirect materials, maintenance,
depreciation and electric power. The company has analysed these costs at the high
level of activity and determined that costs are incurred at that level as follows:
• Indirect materials (variable) $ 55 000
• Maintenance (mixed) 164 000
• Depreciation (fixed) 304 000
• Power (variable) 121 000
• Total $644 000
• Required:
• (i) Establish the cost function (y = a +bx) for total factory overhead. (ii) If machine hours
of 51 000 are expected for the next year, what is the estimate for total overhead? (iii)
Calculate how much of the total factory overhead is maintenance cost at the low activity
level of 35 000 machine hours.
Behavioural Classification resulting
in……
• Marginal Costing System
• It is a costing system which treats only the variable manufacturing costs as
product costs. The fixed manufacturing overheads are regarded as period
cost
Marginal Costing System

• Revenue
• minus All Variable manufacturing costs (direct labor +
direct material + variable overhead)
• Equals Contribution margin
• minus Fixed manufacturing costs/ Fixed selling and
administrative costs
• equals Net income