NATIONAL UNIVERSITY OF SCIENCE AND TECHNOLOGY

Department of Electronic Engineering

Engineering Management [TEE 3255]

6: Accounting (Financial,
Cost & Management
Accounting)
 Lesson Outline

• Introduction
• Financial Accounting
• Fundamentals of Financial Analysis
• Cost Accounting
• Activity-Based Costing (ABC)
• Management Accounting
• Conclusion
Introduction
 Introduction

• Accounting can be defined as ‘the process of

identifying, measuring, and communicating
economic information to permit informed
judgements and decisions by users of the
information’.
 Introduction

• Financial Accounting has two principal

components namely; bookkeeping and the
preparation of financial statements.
• The information that is produced by financial
accounting is usually historical, backwards
looking.
• Its largely used by decision-makers external to
the organisation to which the data relates.
 Introduction

• Management Accounting is the second side to

accounting which also consists of two
components and looks forward.
• Cost accounting which is one where costs are
recorded and management accounting where the
data is processed and converted into reports for
managers and other decision-makers within the
organisation.
 Introduction

Internal Users Ask?

Cash to pay bills? Cost per unit?

Give raises? Which product is profitable?

 Introduction

External Users Ask?

Earning enough? Compare to competition?

Will the company be able to pay bills when due?

 Introduction

• Every business has three primary financial tasks

that determine its success or failure:
1. Making profit—avoiding loss and achieving profit goals by
making sales or earning other income and by controlling
expenses
2. Cash flow—generating cash from profit and securing cash
from other sources and putting the cash inflow to good use
3. Financial health—deciding on the financial structure for the
entity and controlling its financial condition and solvency
 Introduction

• Effective engineers must know how to read

financial statements in order to monitor the firm’s
activity, performance, profitability & market
position and assess the financial health of a firm.
• Doing so will allow them to initiate proper
projects at the right time to add value to their
employers
Financial Accounting
 Financial Accounting

• Financial Accounting - keeps track of a company's

financial transactions.
• Using standardized guidelines, the transactions
are recorded, summarized, and presented in a
financial report or financial statement such as an
income statement or a balance sheet.
 Financial Accounting

• Financial accounting is based upon the

accounting equation:
Assets = Liabilities + Owners' Equity
• If assets total $300 and liabilities total $200, then
owners' equity must be $100.
Financial Accounting Principles
 Financial Accounting Principles

1. Accrual Principle
• According to the accrual principle of accounting, companies
recognize revenues when earned, with the assumption that
the collection of this revenue from approved credit
accounts and the delivery of the promised products or
services are both reasonably ensured.
2. Matching
• Expenses are recognized by matching them with the
revenue generated in a given accounting period.
 Financial Accounting Principles

3. Dual Aspects
• The assets of a company are always equal to the claims
against it. Each transaction has a dual effect in that it
induces two entries in order to maintain a balance between
assets and claims (Double entry bookkeeping).
4. Full Disclosure Principle
• All relevant information is disclosed to the users of the
company’s financial reports.
 Financial Accounting Principles

5. Conservatism
• Assets are to be recorded at the lowest value consistent
with objectivity.
• While profits are not recorded till recognized, losses are
recorded as soon as they become known.
6. Going Concern
• It is assumed that the company’s business will go on
forever.
• This assumption justifies the current practice of using
historical data (e.g., the original acquisition costs) and a
reasonable method of depreciation
Accounting Books & Accounting Cycle
 Accounting Books

• Types of Books:
1. Journal
a) Sales Journal – for credit sales.
b) Purchases Journal – for credit purchases.
c) Returns Inwards Journal – for returns inwards.
d) Returns Outwards Journal – for returns outwards.
e) Cash Book – for receipts and payments of cash and cheques.
f) Journal proper/General Journal – for other items.
2. Ledger
a) Sales Ledger. This is for customers’ personal accounts.
b) Purchases Ledger. This is for suppliers’ personal accounts.
c) General Ledger. This contains the remaining double entry accounts
e.g. expenses, fixed assets, and capital.
 Accounting Books

• Cash receipts journal

Key Financial Statements
 Key Financial Statements

• A Financial Statement is a quantitative way of

showing how a company is doing.
• Typically, companies use three financial
statements:
1. Income statement
(Profit and Loss accounts)
2. Balance sheet
3. Funds (Cash) flow
statement
 Income Statement

• The Income statement is an accounting report that

matches sales revenue with pertinent expenses
that have been incurred during a specified period,
usually a fiscal quarter or year.
• Also known as the profit or loss statement,
earnings statement or operating and revenue
statement.
 Income Statement

• The income statement contains the following key

entries:
• Sales revenue, CGS, Gross margin, Expenses,
Depreciation, EBIT (earnings before interests and
taxes), Net income (also called profit, earnings, or
net operating profit after tax (NOPAT)), Dividend,
Earnings per share, Costs and Cash flow.
 Income Statement

• The Profit and Loss statement uses data from the

business and 3 simple calculations to determine
the net profit / net loss.
1. Gross Margin = NET SALES − Cost of Goods Sold
2. Net Operating Profit = GROSS MARGIN − Selling and
Administrative Expense
3. Net Profit before Taxes = Net Operating Profit + Other
Income −Other Expense
4. Net Profit (or Net Loss) = Net Profit before Taxes −
Income Taxes
 Financial Period

Gross margin

Net Operating Profit

Net Profit Before Taxes

 Income Statement
Year 2013 (Millions of $) Year 2014 (Millions of $)
Sales (net) revenue 8380.30 8724.70
Cost of goods sold 6181.20 6728.80
Gross margin 2199.10 1995.90
GS&A expenses 320.7 318.8
Pensions, benefits, R&D, insurance, and others 494.6 538.7
State, local, and miscellaneous taxes 180.1 197.1
Depreciation 297.2 308.6
EBIT 906.5 632.7
Interest and other costs related to debts 82.9 114.4
Corporate tax (32.05%) 264.00 (20.84%) 108.00
NOPAT 559.6 410.3
Common stock dividend 151.6 172.8
Retained earnings 408 237.5
Income Statement

Profit and loss account

$ $
Gross profit 80,000
Discount received 3,000
83,000
Wages 25,000
General expenses 10,000
Discount allowed 1,000 36,000
Net profit 47,000
 Balance Sheet

• The balance sheet is an accounting report that

lists the company’s assets and the ways in which
these assets are financed through liabilities and
owners’ equity at a specific point in time.
• Liabilities are claims of creditors (such as banks,
bondholders, and suppliers) against the company.
• Owners’ equity represents the claims of owners
(shareholders) against the company.
 Balance Sheet

• The following key entries are included in a

balance sheet:
• Assets, Current assets , Cash, Accounts receivable, Inventory,
Prepaid expenses, Fixed assets, Other assets (patents,
leases, franchises, copyrights, and goodwill), Accumulated
depreciation, Net fixed assets, Liabilities, Current liability
(CL), Accounts payable, Deferred income, Deferred income
tax, Long-term liability, Bonds, Debentures, Convertible
bonds, Owners’ equity (net worth), Stock, Capital surplus,
Retained earnings, Book value and Stock price
 Balance Sheet

• Assets are items of value with a measurable

worth. There are three classes of assets: current,
fixed and all others.
1. Current assets are convertible to cash within
12 months.
2. Fixed assets are tangible assets of long,
useful life (more than 12 months), such as
land, buildings, machines, and equipment.
 Balance Sheet

• The organization of entries in a balance sheet

follows this specific convention:
a. Assets are listed before liabilities, which are then followed
by owners’ equity.
b. CAs and CLs are enumerated ahead of non-CAs and CLs,
respectively.
c. Liquid assets are listed before all other assets with less
liquidity.
d. The listing of CLs follows no specific order, except that
accounts payable must always be listed first in this
category.
 Balance Sheet

• Assets - Within the assets segment, accounts are

listed from top to bottom in order of their liquidity,
that is, the ease with which they can be converted
into cash.
• Accounts receivable - money which customers
owe the company, perhaps including an allowance
for doubtful accounts (an example of a contra
account), since a certain proportion of customers
can be expected not to pay.
 Balance Sheet

• Intangible assets - these include non-physical,

but still valuable, assets such as intellectual
property and goodwill; in general, intangible
assets are only listed on the balance sheet if they
are acquired, rather than developed in-house.
 Balance Sheet

• Example
• Joseph Phiri inherits $50,000 from his grandfather. He decides
to invest in a bookshop which he names ‘Masvingo Modern
Book Store’. Joseph completes the following transactions
during the first few weeks.
1. Opens a bank account in the name of the business and deposits $45
000.
2. Purchases a cash register for $5,000 and a typewriter for $7,000 from
Officequip Ltd and pays by cheque.
3. Buys books and stationery for re-sale from the Academic Book Supply
Company for $25,000 on credit.
4. Buys more books for resale from Longman Zimbabwe Ltd for $20,000
and pays by cheque.
 Balance Sheet

• Example
5. Borrows $20,000 from his brother Kudakwashe and uses the cash to
buy a delivery van for $25,000. Pays the balance in cash.
6. Sells books on credit to St John’s College for $25,000; the cost of these
books was $20,000.
7. Pays Academic Book Supply Company $10,000 by cheque.
8. Receives a cheque from St John’s College for $15,000 in part payment
of their account.
9. Sells books and exercise notebooks to local school children. Cash
sales for the day amount to $10,000. The cost of the goods sold was
$8,000.
10. Settles Academic Book Supply Company’s account by paying the
balance.
 Balance Sheet

• $50 000 is considered as his start up, i.e. his capital. He deposits $45 000 into
his bank, and this becomes his bank balance. The rest becomes his cash balance
($5 000).
 Balance Sheet

• Note that in creating a balance sheet, each and

every transaction affects two or more accounts
such that the net effect is zero. For instance,
there has to be a corresponding decrease in the
value of an entry in the balance sheet, for each
increase. This is the principle of double entry.
 Balance Sheet

• The capital invested remains unaltered

• The acquisition of two new fixed assets for $12,000 has changes the asset structure.
• The bank balance decreases by $12 000.
• Office equipment amounting to $12 000 has been introduced.
 Balance Sheet

• The company now owes its creditors (Academic Book Supply Co.) the amount $25 000.
• The business now owns stock of the same amount.
• NB: Cash and bank balances have been combined.
 Balance Sheet

• Stock has increased by $20,000.

• Cash (bank, rather) has decreased by the same amount.
 Balance Sheet

• A loan of $20 000 has been introduced.

• A delivery van which is valued at $25 000 is now a part of our asset list.
• Cash has also decreased by $5 000
 Balance Sheet

• This transaction affects the balance sheet in three ways:

• Stock has decreased by cost price i.e. by $20,000.
• A net profit of $5 000 has been obtained, which adds to the capital.
• Sale on credit creates a current asset called ‘Debtors’, amounting to $25 000.
 Balance Sheet

• Creditors have decreased by $10 000, and cash has decreased by the
same amount.
 Balance Sheet

• Debtors have decreased by $15 000, and cash has increased by the
same value.
 Balance Sheet

• This transaction affects the balance sheet in three ways:

• Capital has increased by the amount of profit made on the sale of stationery.
• Stock has gone down by the cost of sales (cost of goods sold) $8,000.
• The cash balance has increased by the amount of cash sales ($10 000).
 Balance Sheet

• The cash balance has decreased by $15 000, and the creditors have
been cleared.
 Balance Sheet
$ $ $ $
Fixed assets Capital and Liabilities
Cash register 5000 Capital 50000
Typewriter 7000 Add Net Profit 7000
Delivery van 25000 57000
37000
Long-term Liabilities
Current assets Loan – Kuda 20000
Stock 17000
Debtors – St John’s 10000
Cash 10000
Bank 3000 40000
77000 77000
 Funds (Cash) Flow Statement

• The funds flow statement is a financial statement

that measures the cash generated and / or used
by a company in a given period.
 Funds (Cash) Flow Statement

Cash Operating Investing Financing

Inflows Activities Activities Activities

Cash Operating Investing Financing

Outflows Activities Activities Activities
 Linkage between Statements

• These 3 financial statements are linked to one

another.
• The net profit in the income statement is linked with
the retained earnings in the balance sheet.
• The inventory account in the balance sheet is linked
with the sales revenue in the income statement.
• The accumulated depreciation in the balance sheet is
linked with the annual depreciation charge included in
the income statement.
Fundamentals of Financial Analysis
 Fundamentals of Financial Analysis

• Financial analysis is done to assess the

effectiveness of the company’s management in
achieving the objectives (i.e. growth, profitability,
and return on investment (ROI)) set forth by the
company’s board of directors with respect to a
number of critically important business factors
e.g. liquidity, activities, profitability, capitalization,
and stock value.
 Performance Ratios

• The critically important business factors are

• Liquidity
• Activities
• Profitability
• Capitalization
• Stock value
• Performance ratios include ratios for each of the
factors.
 Performance Ratios

• Liquidity is the firm’s capability to satisfy its CLs,

such as buying materials, paying wages and
salaries, paying interests on long-term debt, and
other necessary expenditures. Without liquidity,
there can be no activity.
• Working capital = CAs - CLs.
• Current ratio = CA/CL
 Performance Ratios

• Activity: The changes in sales and inventory.

Successful activity leads to profitability.
• Inventory turnover ratio
• Asset turnover ratio
• Working capital turnover ratio
• Sales to employee ratio
 Performance Ratios

• Profitability: If the company is profitable, it can

readily secure the required liquidity to keep its
operations continuing.
• Gross margin percentage
• Net income-to-sales ratio
• Net income to owners’ equity ratio
• Net income to total asset ratio
 Performance Ratios

• Capitalization: The total capital deployed by

company management is the sum of the
company’s long-term liabilities and owners’ equity
• Interest coverage ratio
• Long-term debt to capitalization ratio
• Return on invested capital
• Debt-to-equity ratio
 Performance Ratios

• Stock value: This is the market price or value of

the company’s stock as defined by the financial
markets.
• Earnings per share
• Price to earning ratio
• Market to book ratio
• Dividend payout ratio
Balanced Scorecard
Balanced Scorecard
Strategy Is a Step In a Continuum
MISSION
Why we exist
VALUES
What’s important to us
VISION
What we want to be
STRATEGY
Our game plan

STRATEGIC OUTCOMES

Satisfied Delighted Efficient and Effective Motivated & Prepared

SHAREHOLDERS CUSTOMERS PROCESSES WORKFORCE
Balanced Scorecard
MISSION
Why we exist
VALUES
What’s important to us
VISION
What we want to be
STRATEGY
Our game plan
BALANCED SCORECARD
Implementation & Focus
STRATEGIC INITIATIVES
What we need to do
PERSONAL OBJECTIVES
What I need to do

STRATEGIC OUTCOMES

Satisfied Delighted Efficient and Effective Motivated & Prepared

SHAREHOLDERS CUSTOMERS PROCESSES WORKFORCE
 Balanced Scorecard

• All financial ratios are determined on the basis of

past performance data (they are “trailing”
indicators).
• They cannot foretell the future performance.
• Because financial ratios are oriented toward the
short term, management tends to overemphasize
short-term financial results, often to the extent of
neglecting the company’s long-term growth.
 Balanced Scorecard

• The narrow focus of these financial ratios makes

them no longer completely relevant to today’s
business environment, in which customer
satisfaction, employee innovation, business joint
ventures, global orientation and continuous
betterment of business processes are key
elements of company competitiveness in the
marketplace
 Balanced Scorecard

• The Balanced Scorecard suggests that corporate

performance metrics must cover four areas:
1. Financial: Shareholder value
2. Customers: Time, quality, performance and service,
and cost
3. Internal business processes: Core competencies and
responsiveness to customer needs
4. Innovation and corporate learning: Value added to the
customer, new products, and continuous refinement
 Balanced Scorecard

• Balanced
Scorecard
Perspectives
 Balanced Scorecard (Manufacturing)

Financial Cash flow, quarterly sales growth and operational income,

increased market shares, and return on equity
Customer Percentage of sales from new products, percentage of sales from
proprietary products, on-time delivery as defined by customers,
share of key account’s purchase, ranking by key accounts, and
number of collaborative engineering efforts with customers
Internal Manufacturing capabilities versus competition, manufacturing
business excellence (cycle time, unit cost, and yield), design engineering
process efficiency, and new product introduction schedule versus plan
Innovation and Time to develop next-generation technology, speed to learn new
learning manufacturing processes, percentage of products that equal 80%
of sales, and new product introduction versus competition
 Balanced Scorecard (Manufacturing)
Strategic Map: Balanced Scorecard: Strategic Initiatives:
Linked Objectives Measures & Targets
Net income Increase by 25%
Financial

Increase Net
Income growth

Increase Maintain Increase by 15% Change Licensing and

Customer

Customer Retention Rate Maintenance contracts

Retention

Improve Call Issue Improve by 30% Standardised Call Centre

Internal

Centre turnaround processes

Performance
time
Voluntary Reduce by 25% Salary and Bonus
& Growth
Learning

Reduce Employee
Turnover turnover rate upgrade
 Balanced Scorecard (Manufacturing)
Strategy Map:
Diagram of the
Strategic Theme:
cause-and-effect Statement of How success in
Operating Efficiency
relationships what strategy achieving the The level of Key action
between strategic Financial
Profitability must achieve strategy will be performance or programs
objectives and what’s measured and rate of required to
Increase critical to its tracked improvement achieve
Lower Costs
Revenue
success needed objectives
Customer
Flight Lowest
is on time prices

Objectives Measurement Target Initiative

Internal
Fast ground • Fast ground • On Ground Time • 30 Minutes • Cycle time
turnaround turnaround • On-Time • 90% optimization
Departure
Learning

Ground crew
alignment
 Balanced Scorecard

• In general, balanced scorecard metrics for a given

company must be developed inline with the
corporate strategy and vision, using a top-down
approach.
• A unique strength of balanced scorecard metrics is
that they link the company’s long-term strategy with
its short-term actions.
 Balanced Scorecard

• According to a Harvard Business Review article,

Apple Inc., uses five performance indicators:
1. customer satisfaction;
2. core competencies;
3. employee commitment and alignment;
4. market share;
5. shareholder value.
Capital Formation
 Capital Formation

• Capital formation refers to activities undertaken

by a company to raise capital for short-term and
long-term investment purposes.
• Many companies routinely pursue some external
financing resources, such as equity or debt
financing, or both.
 Equity Financing

• Equity financing is the raising of capital by issuing

company stocks.
• Stocks are certificates of company ownership,
which typically carry a par value of $x.
• Shareholders are those who own stocks.
• Basically, there are two kinds of stocks: common
stocks and preferred stocks (whose dividends
have a priority over those of common stocks).
 Debt Financing

• Debt is the liabilities incurred by the company to

make contractual payments (e.g., interest
payments) under specified terms.
 Debt Financing

• Companies create creditors by issuing industrial

bonds or taking loans from financial institutions.
• Debts are usually secured by a certain part of the
company’s assets.
• Creditors have the legal power to enforce
payments and thus potentially drive companies
into bankruptcy.
 Debt Financing

• When a company declares bankruptcy, it must

satisfy the claims of creditors in a specific order:
(a) secured debts (bonds or loans), (b) lawyers’
fees, (c) unpaid wages, and (d) stockholders.
• Note that bankruptcy lawyers have a payment
priority ahead of the hardworking employees and
risk averse shareholders
Capital Assets Valuation
 Capital Assets Valuation

• Financial management deals with three general

types of capital assets valuation problems:
a) assets in place (operations)
b) opportunities
c) acquisitions or joint ventures
 Capital Assets Valuation

• Capital budgeting problems related to assets in

place are those that deliver a predictable string of
cash flows in the immediate future. E.g. building a
new plant facility, developing new products or
entering a new regional market.
• Sometimes these problems are grouped under
the heading of operations, as investment in
operations usually leads to immediate cash flows.
 Capital Assets Valuation

• Problems related to opportunities arise from

decisions that do not generate an immediate flow
of cash but preserve a likelihood that future gains
may be realized. E.g. R&D and marketing efforts.
• Problems related to acquisition may require the
company to participate in equity investment and to
share future equity cash flows with its business
partners e.g. joint ventures, creation of supply
chains etc.
Cost Accounting
 Cost Accounting

• Cost Accounting is that branch of accounting

dealing with the classification, recording,
allocation, summarisation and reporting of
current and prospective costs.
 Cost Accounting

• Different industries follow different methods to

establish the cost of their product.
• This varies by the nature and specifics of each
business. There are different principles and
procedures for performing the costing. However,
the basic principles and procedures of costing
remain the same.
 Cost Accounting

• Cost accounting
provides the detailed
cost information that
management needs to
control current
operations and plan for
the future.
 Why Cost Accounting?

• Cost control is a very important management

function in both profit-seeking and non-profit
organizations.
• A profit-seeking organization strives to maximize its
financial gains for its owners e.g., sales revenue
minus costs.
• A non-profit organization seeks to maximize its
service value to its respective target recipients while
minimizing operations costs.
 Why Cost Accounting?

• Cost control
• Budgeting
• Performance measurement
• Determining reimbursements
• Setting fees and prices
• Program evaluations
• Economic choice decisions
Classification of Cost
 Classification of Cost

• Historical costs underpin financial accounting as

we know it today. Income from sales has been
• included simply so as to enable profits to be
shown.
Classification of Cost
 Classification of Cost

• Product costs are the costs attributed to the units

of goods manufactured.
• They are included in the calculation of the cost of
goods manufactured in the trading account, and
would normally be part of the valuation of unsold
goods if the goods to which they refer had not
been sold by the end of the period. Product costs
are, therefore, charged against revenue only
when the goods they relate to are sold.
 Classification of Cost

• Period costs are non-manufacturing in nature, i.e.

selling and distribution, administration and
financial expenses. They are treated as expenses
of the period in which they are incurred
irrespective of the volume of goods sold.
Classification of Cost
 Classification of Cost

• Direct cost - A cost that can be easily traced to an

individual cost object.
• Direct Materials - are those materials which become part of the finished goods,
subject to the proviso that the expense involved in tracing the cost is worthwhile.
Some items which, strictly speaking, are direct costs, may be treated as indirect
materials because their cost cannot be ascertained easily.
• Direct Labour - comprises of those labour costs which are incurred in converting
direct materials into finished goods, also subject to the proviso that the expense
involved in tracing this cost is worthwhile.
• Direct expenses are those expenses which can be traced directly to the product being
manufactured. These are fairly rare, but an example would be a royalty payment
where the production of each unit produced resulted in, say, $1 being due to the owner
of a patent on that product.
• Prime cost = direct material cost + direct labour cost + direct expenses
• Factory cost or Work cost = prime cost + factory overhead
 Classification of Cost

• Indirect (overhead) cost - A cost that supports

more than one cost object.
• Indirect manufacturing costs / factory indirect expenses /
manufacturing overheads / overheads– all the expenses
concerned with the manufacturing process which have not
been treated as being of the direct type.
• Production cost - the total of prime cost + indirect
manufacturing costs is called production cost.
• Total cost – sum of production cost and administration,
selling and distribution and finance expenses
 Classification of Cost

• To summarise
$
Direct materials 000
add Direct labour 000
add Direct expenses 000
Gives: Prime cost 000
add Indirect manufacturing costs 000
Gives: Production cost 000
add Administration expenses 000
add Selling and distribution expenses 000
add Finance expenses 000
Gives: Total cost 000
Cost control
 Cost control

• Control of expenditure is possible only if you can

trace the costs down to employees who are
responsible for such costs.
• A convenient and frequently adopted approach to
collecting costs is through cost centres
• Costs are collected from cost centres for
individual cost units
 Cost control

• A cost centre may be a single machine used for

jobbing work i.e. a lot of separate jobs to
customer’s specifications.
• It could, however, be a group of similar machines
or a production department.
 Cost control

• By comparison, factory indirect expenses are

‘indirect’ and so cannot be traced to product
centres.
• Instead, these are traced to cost centres which
give service rather than being concerned with
work directly on the products.
• Such cost centres are, therefore, known as
‘service centres’.
Costing Approaches
 Costing Approaches

• There are a number of ways costs can be

gathered and collated. The two most commonly
used are absorption costing and marginal costing.
 Costing Approaches

• Absorption costing involves allocating all direct

costs and factory indirect expenses to products.
• The factory indirect expenses are seen as adding
to the value of work in progress and, therefore, to
finished goods.
• The production cost of any article is comprised of
direct materials, direct labour, any direct
expenses and a share of factory indirect expense.
 Costing Approaches

• Variable costs are costs that tend to vary directly

with the production rate
• Fixed costs are costs that are relatively
independent of changes in the production rate.
• The division of costs into those that are fixed and
those that are variable is not always
straightforward. Even something often assured to
be a fixed cost, such as factory rent, is not always
‘fixed’.
 Costing Approaches

• Marginal costing takes account of only the

variable cost of products rather than the full
production cost.
• By ignoring the fixed costs, it is possible to see
how much something contributes towards the
profitability of a business.
 Costing Approaches

• In Standard costing a cost is predicted in advance

of production, based on predetermined standards
under a given set of operating conditions.
• Standard costs are compared with actual costs
periodically, and revised to avoid losses due to
outdated costing
 Costing Approaches

• Historical costing unlike standard costing, uses

actual costs, determined after they have been
incurred.
• Some (if not most) organizations use the
historical costing system of accounting for costs.
 Costing Approaches

• Direct Costing refers to the practice of charging

all direct costs to operations, processes or
products and leaving all indirect costs to be
written off against profits in the period in which
they arise is termed as direct costing.
• The technique differs from marginal costing
because some fixed costs can be considered as
direct costs in appropriate circumstances.
Costing Systems
 Costing Systems

• What most businesses want to know is how much

each item it produced has cost to make. As a
result, simply knowing the total cost is not
sufficient. These costs must be analysed further.
• They also want to know what costs are likely to be
in the future. Again, more analysis is needed.
• Cost accounting is the process of measuring and
recording all these costs.
 Costing Systems

• Having decided which costing approach to adopt,

you then need to decide which costing system to
adopt. The one you choose will depend upon how
your products or services are produced. There are
two main types of costing system namely job
costing and process costing.
 Costing Systems

• In Job costing costs are ascertained for each

work order separately as each job has its own
specifications and scope
• It is used when production consists of separate
jobs. When a job is long-term, the term ‘project
costing’ is often used.
• For instance, where a Rolls-Royce is made to each
customer’s specifications, each car can be regarded
as a separate job.
 Costing Systems

• Job costing also applies where batches of items

are made.
• For example, a jam bottling company may make jam
in batches of 10,000 bottles and then switch over to
making a different type of jam for the next batch. A
printer may print a batch of 2,000 copies of a book.
• The ‘job’ can thus be one item or a batch of similar
items. When a batch is involved, it is usually referred
to as ‘batch costing’.
 Costing Systems

• Process costing is used where production is

regarded as a continuous flow of different
processes.
• Each process can result in either a finished good
or a raw material for the next process and must
be evaluated separately.
• E.g. the manufacturing of clothes involves several processes.
• Another example would be a car manufacturer that produced
one model of car for an extended period.
Costing Systems
Product or Service Costing
 Cost of Goods Sold (CGS)

• The CGS includes direct and indirect costs.

• The direct costs consists of materials (DM) and
labour (DL) costs.
• Indirect costs, namely the Factory Overheard (FO)
also called factory burden. FO includes all costs
other than DM and DL.
• The difficulty in product costing is the inclusion of
indirect costs which are more difficult to track.
 Traditional Method (finding Indirect Costs)

• Traditionally all overhead costs for the upcoming

year are estimated into a single cost pool (e.g., FO,
utilities, safety program, training, and salaries of
foremen and factory managers).
• This total is then divided by the estimated number
of labour hours to be worked resulting in an
hourly overhead rate.
 Traditional Method (finding Indirect Costs)

• For each product, the required labour hours are

estimated. The total overhead cost for the product
is then equal to the required labour hours
multiplied by the hourly overhead rate
• Let us assume that a factory has $800000 in overhead
(e.g., salary of manager, benefits, and other general
charges), 2000 direct hours per employee per year, and
20 employees.
• Hourly overhead rate = $800000/ (2000 × 20)) = $20/hr
 Activity-Based Costing (ABC)

• Activity-based costing is the process of using cost

drivers as the basis for the apportionment of
indirect manufacturing costs to individual
products.
• Costs are attributed to cost units on the basis of
the benefit received from indirect activities, e.g.
ordering, setting up equipment so that the item to
be produced can be manufactured, and assuring
quality.
 Sequential Steps to Implement ABC

• It is advisable to form a cross-functional team

when implementing the ABC method of allocating
indirect costs.
• The team should determine the cost objects e.g.
costs to serve customer
 Sequential Steps to Implement ABC

• The team then needs to

1. define activities , which add value to the cost
objects.
2. determine cost drivers i.e. the agents that
cause costs to be incurred in the activities
3. attribute activity costs to cost objects.
ABC – What is it?
ABC System is based on activities, linking spending on resources to
the products/services produced/delivered to customers. It uses a
two-stage overhead allocation:
(i) Tracing costs to activities
(ii) Tracing costs from activities to products/jobs

Conventional Costing Activity Based Costing

Expenses Resources Economic Element

Activities Work Performed

Cost Objects Cost Objects Product or service

 Tracing Cost to Activities

• This step is to identify major activities that

cause/drive overhead costs to be incurred.
• Some of the activities are related to production
volume e.g. production runs, salary of supervisors
• While others are not e.g. inspection/ handling of
materials, setting up equipment etc.
• The cost of resources consumed in performing
these activities are grouped into cost pools.
Tracing Cost to Activities
Common Activities Associated Costs Cost Driver
Processing purchase Labour costs for workers determining order quantities, Number of purchase
order for materials contacting vendors, and preparing purchase orders orders processes
Handling material Labour costs for workers handling material, depreciation of Number of material
equipment used to move material requisitions
Inspecting incoming Labour costs for workers performing inspections, Number of receipts
material depreciation of equipment used to test strength of materials,
tolerances, etc.
Setting up equipment Labour costs for workers involved in setups, Number of setups
depreciation of equipment used to adjust equipment
Producing goods using Depreciation on manufacturing equipment Number of machine-
manufacturing equip. hours
Supervising assembly Salary of assembly supervisors Number of assembly
workers labour-hours
Inspecting finished Labour cost for finished goods inspections, depreciation of Number of
goods equipment used to test whether finished goods meet inspections
customer specifications, etc.
Packing customer Labour cost for packing workers, cost of packing materials, Number of boxes
orders etc. packed
 Tracing Costs from Activities to Products

• The next step is to assign costs to products/jobs

using cost drivers as a measure of activity. They
identify the linkage between activities and cost
objects and serve as quantitative measures of the
output of activities. Three types of cost drivers
are:
• Transaction
• Duration
• Intensity (Direct charging)
 Activity-Based Costing (ABC)

• A well-practiced ABC method offers specific

insights that include
a) a clearer picture for management of what generates
profits and losses for the company
b) the ability to track operating profits for specific cost
objects (such as customers, orders, and products)
c) the ability to determine whether a service centre is
efficient or deficient
d) the possibility of identifying the relative profitability
among products & customers.
Illustration of ABC in Industry
 Illustration – Traditional Costing System
Montex Pen Total and Product Profitability (Amt. in $.)
Blue Black Red Purple
Total
Particulars Pens Pens Pens Pens
(1) (2) (3) (4) (5)
Production/Sales volume 25,000 20,000 4,500 500 50,000

Unit sale price 45 45 46.5 49.5

Sales (a) 11,25,000 9,00,000 2,09,250 24,750 22,59,000

Material costs 3,75,000 3,00,000 70,200 8,250 7,53,450

Direct labour costs 1,50,000 1,20,000 27,000 3,000 3,00,000

Overheads (300% of Direct Labour)
4,50,000 3,60,000 81,000 9,000 9,00,000
Total costs (b) 9,75,000 7,80,000 1,78,200 20,250 19,53,450
Total operating income [(a) – (b)]
1,50,000 1,20,000 31,050 4,500 3,05,550
Return on sales (%) 13.3 13.3 14.8 18.2 13.5
 Illustration – Activity Based Costing
Let us now do a step-wise cost allocation of overhead costs and prepare ABC
Products Profitability Report for the Montex Pen Manufacturing Company as per
data provided in previous example
(A) The total overheads (aggregating $ 9,00,000) were comprised of the
following:
Expense category Expenses ($)
Indirect labour 3,00,000
Fringe benefits 2,40,000
Computer system 1,50,000
expenses Machinery
1,20,000
Maintenance
Energy Total 60,000
30,000
9,00,000
 Step 1
The activities and activity expenses of the Company are summarised below:

Cost driver Total

Overhead
Handle Run expenses
cost items production Set up
Support
machine ($.)
machines
runs products

Indirect labour and 1/2 —

50% 40% 10% 4,20,000
fringe benefits
Computer expenses 80% — 20% — 1,50,000
Machine depreciation — — — 100% 1,20,000

Maintenance — — — 100% 60,000

Energy Activity — — — 100% 30,000

Expenses ($.) 3,30,0001 1,68,0002 72,0003 2,10,0004 7,80,000

1 ($ 4,20,000 × 0.50) + ($ 1,50,000 × 0.80) = $ 2,10,000 + $ 1,20,000 = $3,30,000

2 ($ 4,20,000 × 0.40) = $ 1,68,000
3 ($ 4,20,000 × 0.10) + ($ 1,50,000 × 0.20) = $ 42,000 + $ 30,000 = $ 72,000
4 ($ 1,20,000 + $ 60,000 + $ 30,000) × 1.00 = $ 2,10,000
 Step 2

Products
Activity Cost Driver Blue Black Red Purple
Total@
Pens Pens Pens Pens

Direct labour-hour/unit 0.02 0.02 0.02 0.02 1,000

Machine-hour/unit 0.20 0.20 0.20 0.20 10,000

Production runs 70.00 65.00 50.00 15.00 200

Setup time/run 4.00 2.40 5.60 5.60 —

Total setup time (hour) 280.00 156.00 280.00 84.00 800

Number of products 1.00 1.00 1.00 1.00 4

@Total labour and machine-hours are obtained by multiplying the unit amounts by the quantity of each type
of pen sold, that is, 25,000 blue, 20,000 black, 4,500 red and 500 purple pens.
 Step 3

The activity cost driver rates and the activity expenses assigned to products are shown below:

Activity
Activity Activity cost cost Activity cost
Activity
expenses driver driver driver rate
quantity

Handle 3,30,000 Number of 200 $ 1,650 per run

Production production
runs runs

Set up machines 1,68,000 Number of 800 $. 210 per setup Hour

setup hours

Support products 72,000 Number of 4 $. 18,000 per

products Product

Run machines 2,10,000 Number of 10,000 $. 21 per

machine-hours machine-hour

Total 7,80,000
 Step 4
Activity Expenses Assigned to Products

Activity ACDR ACDQ Activity ACDQ Activity ACDQ Activity ACDQ Activity
for Exp.: for Exp.: for exp.: Red for Exp.:
Blue Blue Black Black Red purple Purple

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

Handle
Production 1,650 70 1,15,500 65 1,07,250 50 82,500 15 24,750
Run

Setup
210 280 58,800 156 32,760 280 58,800 84 17,640
Machines

Support
18,000 1 18,000 1 18,000 1 18,000 1 18,000
Products

Run
2.10 5,000 1,05,000 4,000 84,000 900 18,900 100 210
Machines

Note: ACDR = Activity Cost Driver Rate; ACDQ = Activity Cost Driver Quantity
 Exhibit 3 Activity-Based Costing Products Profitability Report
Black Purple
Particulars Blue Pens Red Pens Total
Pens Pens

Sales revenues 11,25,000 9,00,000 2,09,250 24,750 22,59,000

Material cost 3,75,000 3,00,000 70,200 8,250 7,53,450

Direct labour cost 1,50,000 1,20,000 27,000 3,000 3,00,000

Overheads:
50% fringe benefit on direct
60,000 48,000 10,800 1,200 1,20,000
labour

Handle production runs 1,15,500 1,07,250 82,500 24,750 3,30,000

Setup machines 58,800 32,760 58,800 17.640 1,68,000

Support products 18,000 18,000 18,000 18,000 72,000

Run machines 1,05,000 84,000 18,900 2,100 2,10,000

Total 3,57,300 2,90,010 1,89,000 63,690 9,00,000

Operating income 2,42,700 1,89,990 (76,950) (50,190) 3,05,500

Return on sales(%) 21.7 21.1 (36.8) (202.8) 13.5

Miscellaneous Topics
 Economic Quantity of Ordering

• The procurement costs of parts, materials, and

other supply items directly affects total product
costs.
• The ordering process must take into account the
quantity needed, purchase price, order processing
fees, shipping costs, and the time value of money.
• Managers may need to know how to arrive at the
economic quantity of ordering in order to
minimize the total cost of procurement.
 Economic Quantity of Ordering

• Example
A manufacturing company buys 6000 steel bars a
year at a fixed price of $18 each. It costs the
company $85 to process and place each order.
Assuming 10% interest compounded annually,
what is the most economic quantity to order at
one time?
 Economic Quantity of Ordering
Let N = Number of orders placed in a year; C = Total cost of ordering at year end

N=1: C = 6000 x 18(1 + 0.1) + 85

N=2: C = 3000 × 18(1 + 0.1) + 85 + 3000(18)(1 + (0.1/2)) + 85
N=3: C = 2000 × 18(1 + 0.1) + 85 + 2000(18)(1 + (0.1)(2/3)) + 85 + 2000 x 18[1 + (0.1)(1/3)] + 85

Hence,
N = N : C = 6000 × 18(1 / N) [N – (0.1 / N)(N + (N -1) + (N – 2) + … + 1)] + 85N
To find the minimum C by differentiation,

dC / dN = 0 = 5400(1 / N – (N + 1)/ N2) + 85

N = 7.98 = 8

No. of Units per order = 6000 / 8 = 750

The economic quantity to order is 750 units, and eight times per year (every 6.5 weeks)
 Payback period

• The Payback period (PB) is defined as the number

of years that the original capital investment for
the project will take to be paid back by its annual
earnings
• PB = P / CF
• where:
• P = Capital investment; CF = Annual cash flow
realized by the project
Management Accounting
 Management Accounting

• Management Accounting produces the financial

forecasts that guide planning.
• It embeds controls into the flow of operating data
and uses them to control activities within the
context of the plans.
• It evaluates performance and uses the
information that is produced to underpin the
forecasts that guide planning.
 Management Accounting

• Management Accounting is devoted to

information needed by the management of the
company (as opposed to financial accounting
which produces information for external parties).
 Other aspects of Mgt. Accounting

• Management accounting is, therefore, all about

establishing the costs incurred in producing the
output of a business and in maintaining a
budgeting system that provides managers with
the capability to plan and control activity and so
meet the objectives of the organisation.
Budgeting and budgetary control
 Budgeting and budgetary control

• Budgeting: the process of creating an overall blue

print of a comprehensive plan of operations and
actions expressed in financial terms.
 Budgeting and budgetary control

• Budgetary Control: a method of managing costs

through preparation of budgets.
• Budgetary Control: is the establishment of budgets
relating to the responsibilities of executives of a
policy and the continuous comparison of the actual
with the budgeted results, either to secure by
individual action, the objective of the policy or to
provide a basis for its revision. CIMA (Chartered
Institute of Management Accountants)
 Budgeting and budgetary control

• Functions of a Budget:
1. Planning
2. Coordination
3. Communication
4. Control and performance evaluation
 Budgeting and budgetary control

• Budgetary control involves a comparison of actual

results against the budgets through a system
called variance analysis.
• Management accountants then pass reports to
management concerning the extent to which
budgets are being met.
• This enables managers to control activities and to
step in and stop situations where the budget is
being ignored or overlooked.
 Budgeting and budgetary control

• Process of Budgetary control

 Budgeting and budgetary control

• E.g. if the variance analysis reveals that the gross

profit on an item is lower than was budgeted, this
could be because costs have risen or the selling
price has fallen.
• The management accountant uses special
formulae to pinpoint the cause and passes the
information to management so that they can
exercise control if required.
Conclusion
 Conclusion

• There are 3 important financial statements:

income statements, balance sheets, and funds
flow statements
• Ratio analysis uses the financial data contained in
these statements to assess companies’ financial
health.
• Equity and debt financing are the two most
common ways of obtaining financing.
 Conclusion

• Product/service costs have direct and indirect

cost components.
• All production activities add value but create cost.
• ABC is a cost accounting method that
redistributes indirect cost (incurred in producing
product/service) in accordance with the specific
production activities involved.
 Conclusion

• When applied properly, the ABC method will

generate cost-based insights, which could form a
new basis for companies to take management
action, such as changing the product/service mix,
simplifying a specific production process, and/or
revising pricing policies in order to more directly
account for the activities needed to respond to
customer demands.
End of Accounting (Financial, Cost &
Management Accounting)