MODULE 1-1

COST ACCOUNTING FUNDAMENTALS

INTRODUCTION

Imagine that you are a reputable accounting manager of an organization and was tasked to
formulate ideas for opening an extension of the company, a branch, what will be your thoughts on this?
What will be your suggestions? What might be the bases of your ideas? What would you want to achieve?
Which factors will you consider?

An organization is a group of people united for a

common purpose. Organizations are run by managers who
carry out three basic functions in the management process.
These common functions include Planning, Directing, and
Controlling. Planning is the process of identifying alternatives
and selecting the one that best furthers the organization’s
objectives. Directing is the process by which managers, given
their assigned level of responsibilities, run day-to-day
operations and involves mobilizing people to carry out the
plans. Controlling involves obtaining feedback to ensure that
all parts of the organization are following the plan, and involves
evaluation of actual versus expected results.

For every function in an organization, decision making is very crucial. Each decision made may
either improve the position of an organization or not. One of the major players in the management decision
making of an organization, from planning to evaluation of results, is Modern Cost Accounting.

Cost Accounting and Other Accounting Systems

The study of modern cost accounting yields insights into what managers and accountants do in
an organization. It explains how they use cost accounting information to choose strategy, communicate it,
and determine how best to implement it. They also use this information to coordinate their decisions about
designing, producing and marketing a product or service.

Cost Accounting is the subfield of accounting that records, measures and reports information
about costs. It is sometimes considered as a subset of management accounting. It is very useful in
manufacturing businesses since they have the most complicated costing process. (A cost is a sacrifice of
resources and generally represented in the accounting system by outlay of cash or promises to pay cash
in the future or the expectation of the value of an asset.)

Cost Accounting provides information to management accounting and financial accounting. It

measures and reports financial and other information related to the organization's acquisition and
consumption of resources.

Management Accounting measures and reports financial and nonfinancial information that help
managers make decisions to fulfil the goals of an organization. Managers use management accounting
information to choose, communicate and implement strategy. On the other hand, Financial Accounting
provides reports directed to external parties. It measures and records business transactions and provides
financial statements that are based on International Financial Reporting Standards (IFRS). These reports
are directed towards investors, government regulators, creditors and other parties the organization. Figure
1.1 summarizes the significant differences between Financial Accounting and Management Accounting and
Figure 1.2: summarizes the relationship of Modern Cost Accounting System to Uses of Cost Information.
Figure 1.1: Financial Accounting and Management Accounting Compared

ACCOUNTING
Recording, organizing, summarizing and reporting of financial and operational data

Financial Accounting Management Accounting

• Reports to various interested parties 1) • Reports to managers within the organization for
External (owners, lenders, tax authorities, planning, directing and motivating, controlling
regulators) and 2) Internal (managers) and performance evaluation.
• Emphasis on summaries of financial • Emphasis is on future-oriented data needed in
consequences of past activities. decision-making.
• Objectivity and verifiability of data are • Relevance is emphasized.
emphasized.
• Precision of information is required. • Timeliness of information is required.
• Only summarized data for the entire • Detailed segment reports about departments,
organization are prepared products, customers, and employees are
• Must follow IFRS. prepared.
• Mandatory for external reports. • Need not follow IFRS.
• Not mandatory

Figure 1.2: Relationship of Modern Cost Accounting System to Uses of Cost Information

Cost Accounting Systems

Contractual and regulatory requirements

(e.g. Income tax reporting)

Planning & Performance

Decision Making
Evaluation

By internal Managerial By internal

managers Accounting managers

By external readers of Financial By external readers of

financial statements Accounting financial statements

RELATIONSHIP OF COST ACCOUNTING TO OTHER FIELDS OF STUDY

Cost accounting interfaces with many other fields of study. One of the primary uses of cost
accounting - valuing inventory and cost of goods sold for external reporting to shareholders is part of
financial accounting. Cost accounting is closely related to microeconomics. Some think of differential cost
analysis, in particular, as a form of applied microeconomics. Cost accounting provides data for use in
decision models for finance, operations management and marketing. Cost accounting also relates to
motivational behavior because it is used in planning and performance evaluation. Finally, tools from
statistics, mathematics, and computer Sciences are used to perform cost analyses.
Information for Decision Making

The goal of cost accounting is to assist managers in achieving the maximum value for their
organization. One of the fundamental services of cost accounting is measuring the effects of decisions on
the value of the organization. As providers of information (accountants) or as the users of information
(managers), one should understand how the information can and will be used to increase value. Designing
accounting systems that accomplish this goal, therefore becomes an important task of cost accounting.

The Value Chain and Value-Added Activities

The value chain is the set of activities that transforms raw resources into the goods and services
that end users purchase and consume, and the treatment of disposal of any waste generated by them.
Much of our decision about cost accounting shall deal on the part of the value chain that comprises the
activities of a single organization or firm. However, an important objective of modern cost accounting is to
ensure that the entire value chain is efficient as possible. It is necessary for the firm to coordinate with
vendors, suppliers, distributors and customers to achieve this objective. The cost accounting system
provides much of the information necessary for this coordination.

Value-added activities are those activities that customers perceive as adding utility to the goods or
services they purchase. The value chain comprises activities from research and development through the
production process to customer service. Managers evaluate these activities to determine how they
contribute to the final products and service, quality and cost.

ACCOUNTING AND THE VALUE CHAIN

Cost accounting continues to experience dramatic changes. Developments in information

technology (IT) have nearly eliminated manual bookkeeping. Emphasis on cost control is increasing in
banks, hospitals, manufacturing industries (from computers to automobiles), airlines, school districts and
many other organizations that have traditionally not focused on it. Cost accounting has become a necessity
in virtually every organization, including fast-food outlets, professional organizations and government
agencies.

One reason for this rapid change is that managers at each stage of the value chain require
information on the performance of products, services, suppliers, Customers and employees. Managers of
the activities and cost accountants must work together at each stage to make decisions that increase firm
value. Because these processes themselves have undergone great change in recent years, cost
accountants and cost accounting methods must continuously adapt to changes in business areas.

The below are the application of cost accounting to the business functions in which management/ cost
accountants provide information to help managers make decisions.

1. Cost Accounting in Research and Development

This involves generating and experimenting with ideas related to new products, services or
processes. Lean manufacturing techniques are not simply about production. Companies partner with
suppliers in the development stage to ensure cost-effective designs for products. Product engineers need
cost accounting information to make decisions about alternative materials.

2. Cost Accounting in Design

An important activity in product development in design. Product designers must write detailed
specifications on a product's design and manufacture. This is often referred to as design for
manufacturability (DFM). The design of a product can have a significant impact on the cost to manufacture
it. Designs that are complex might add additional functions, which, while making a product more desirable,
may also require complex and expensive manufacturing processes. Cost accountants help designers
understand the trade-off by using methods such as activity-based costing, which considers the activities or
processes that will required to bring a product to market.

3. Cost Accounting in Purchasing

Companies now partner with suppliers to increase the efficiency in the supply chain. Partnering
requires information on the performance of partners to ensure the relationship adds value. Performance
measures are being used to evaluate the performance of key suppliers and business partners. The use of
cost accounting methods such as target costing, activity-based costing performance measures and
incentive systems that support teamwork helps firms manage their partnerships to keep the supply chain
"lean and add value throughout the chain.

4. Cost Accounting in Production

Operations managers and financial accountants use cost information in the production stage to
understand and report the costs of the multiple products produced. One of the most important developments
in production, associated with lean manufacturing, is the use of just-in-time (JIT) methods. Using just-in-
time methods, companies produce or purchase units just in time for use, keeping inventories at a minimum.
If inventories are low, accountants can spend less time on inventory valuation for external reporting and
more time on managerial activities.

Modern cost accounting systems have helped managers better understand the relative costs so
that appropriate inventory policies can be set and targeted improvements sought. The production process
is not limited to manufacturing. Service firms, such as banks, insurance companies, and theme parks,
produce or provide services demanded by customers. Efficient use of capacity (employees) in providing
services is critical in increasing value. Managers look to cost accounting information to help them
understand and plan capacity.

5. Cost Accounting in Marketing

Marketing managers require cost accounting information to understand the profitability of different
customer groups. Advances in accounting information systems that capture data at various levels of detail
have made possible customer relationship management (CRM), which allows firms to target more precisely
those customers who are profitable by assessing the costs to serve a customer along with the revenues a
customer generates.

6. Cost Accounting in Distribution

Managers use accounting information to determine where in the supply chain value-added activities
will take place. Cost accountants work with managers to estimate whether it is more efficient (less costly)
to perform an activity in the firm or to have another firm perform the service. This is referred to as
outsourcing. Firms frequently consider activities in the distribution stage for outsourcing. As business
becomes more global, specialized information on markets, regulations, and customs is critical to the speed
of delivery. As a result, cost information often identifies specialized companies as being more efficient in
distributing products, as opposed to handling distribution internally.

7. Cost Accounting in Customer Service

Many companies have adopted the concept of total quality management (TQM), which means
that the organization is managed to excel on all dimensions and the customer ultimately defines quality.
The customers determine the company's performance standards according to what is important to them
(which is not necessarily what is important to product engineers, accountants, or marketers). Companies
can indicate the high quality to consumers through the product warranty. Cost accountants help managers
make decisions about quality in two ways. First, cost of quality (COQ) systems identify the costs
associated with producing defective units as well as the lost sales associated with poor quality products.
Second, they provide information on the projected warranty claims, which can be compared to the increase
in revenues estimated from offering a longer or more comprehensive warranty.

How Value is Created in the Organization

The trends described in the preceding section in the way organizations do business, create exciting
times in cost accounting and excellent future opportunities for one to make important contributions to
organizations. Keep in mind that these new methods are not ends in themselves. They are tools to help
one add value to organizations and their employee, customers, shareholders and communities.

SCOPE OF MODERN COST ACCOUNTING

While the traditional role of cost accounting to record full product cost data for external reporting and pricing
remains important, cost accounting for decision making, planning and performance evaluation has gained
importance in recent decades. Consequently, cost accounting must actively work with management to
determine what accounting information is needed.

A costing system typically accounts for costs in two basic stages, namely:
a. Cost accumulation and
b. Cost assignment

Cost Accumulation involves the collection of cost data in some organized way by means of an accounting
system. For example, a book publisher that purchases rolls of newsprint for printing books accumulates the
cost of individual rolls bought in any one month to obtain the total monthly cost of paper.

Cost Assignment. Beyond accumulating costs, the costing system traces direct costs and allocates
indirect costs to designated cost objects (such as the different books the publisher publishes). This process
enables the managers to calculate total costs and unit costs of products and service and use this information
for pricing, product mix and cost management decisions.

The scope of cost accounting has broadened to include application of mathematical and statistical
techniques to cost analysis, consideration of how accounting affects managerial decisions models used in
finance, economics, and operations management; and examination of the motivational impact of
Accounting. Cost accounting is no longer restricted to manufacturing companies. It is now used in virtually
every organization, including banks, schools, fast-food outlets, professional organizations, hospitals and
government agencies.

COST MANAGEMENT FRAMEWORK

Managers worldwide are becoming increasingly aware of the importance of the quality and timeliness of
products and service sold to their external customers. In turn, accountants are becoming increasingly
sensitive to the quality and timeliness of accounting information required by managers.

While the accounting system provides information (e.g. product costs downtime) for management
decisions, cost management refers to active use of this information to plan and control costs. Cost
management requires managers to actively seek ways to reduce costs. Much cost management occurs
well before the accounting system recognizes costs, for example, the product design stage often offers
more cost management opportunities than controlling manufacturing operations.
Primary Applications of Cost Accounting Systems

I. Cost accounting systems provide data (e.g., financial statements) for compliance with reportorial,
contractual and regulatory requirements

When costs are used by outsiders, such as shareholders or creditors to evaluate performance of top
management and make investment decisions about the organization we say costs are used for financial
accounting
purposes.

Government agencies and commissions such as the Bureau of Internal Revenue (BIR), Social Security
System (SSS), Securities and Exchange Commission (SEC) and so forth require periodic reports for tax
and other multiple compliance purposes.

Cost accounting has moved from an emphasis of on inventory and cost of goods sold valuation for external
financial reporting to an emphasis on cost uses for managerial purposes in recent years. While cost
accounting still provides data essential for external financial reporting, it has also recently achieved a very
crucial role in management.

II. Obtaining information for planning and control and performance evaluation

When costs are used inside the organization by managers to plan and as a basic of decision evaluate
performance of operations or personnel making we say costs are used for managerial accounting purposes.

One of the most commonly used tool for planning and control is budgeting. A budget forces management
to look forward, to translate strategy into plans to coordinate and communicate within the firm and to provide
a benchmark for evaluating performance. Managers at the end of a reporting period compare actual results
to planned performance. The reasons for the differences between actual and planned performance are
analysed and the information provided by these variances and other nonfinancial measures as feedback
to:
a. Promote learning and future improvement
b. Control and evaluate the performance of various decisions, departments and managers.

III. Analyzing the Relevant Information for Making Decision

Business managers are constantly faced with problems of deciding what products to sell, what production
methods to use, whether to make or buy component parts, what prices to charge, what channels of
distribution to use, whether to accept special orders at special prices, and so forth. Decision making is often
a difficult task that is complicated by the existence of numerous alternatives and massive amounts of data,
some of which may be relevant while others are not. Management and cost accountants help managers
identify what information is relevant and what information is irrelevant when making decisions.

ORGANIZATIONAL ENVIRONMENT

The cost accounting function is typically the responsibility of the controller. In most corporations, the
controller is the chief accounting officer. In some firms, the controller has the rank of corporate vice
president and reports directly to the company president. In others, the controller and the treasurer may both
report to financial vice president who is responsible for both accounting and financial affairs.

The chief accounting officer, the controller is responsible for both external and internal accounting reports.
External reports include published financial statements and reports to taxing authorities like the Bureau of
Revenue Service and regulatory bodies like the Securities and Exchange Commission (SEC), Bangko
Sentral ng Pilipinas (BSP), Insurance Commission (IC) and so forth.

Internally, the controller is responsible, for supplying management with accounting data for planning,
performance evaluation, and decision making and for overseeing the company's internal control system. In
addition, the controller maintains all cost and other accounting records, including inventories, receivables,
payables, and fixed asset accounts.

All managers in the organization, not just financial professionals, use cost accounting information. Because
our focus is on cost accounting and decision making, we will often be viewing a decision from an operational
manager's perspective. As a financial or operational manager in an organization, one will work closely with
many financial professionals.

Figure 1.3 shows the list of the typical financial titles in organizations and examples of their activities. If you
work in the accounting or finance function in an organization, you are likely to have one of these jobs.
Whatever your job is, you will work in cross-functional teams or people from many areas such as
engineering, production, marketing, finance and accounting.

Figure 1.3 Key Financial Managers in an Organization

Title Major Responsibilities and
Primary Duties
Chief financial officer (CFO) • Manages entire finance and
accounting function
Treasurer • Manages liquid assets
• Conducts business with banks
and other financial institutions
• Oversees public issues of stock
and debt
Controller • Plans and designs information
and incentive systems
Internal auditor • Ensures compliance with laws,
regulations and company policies
and procedures
• Provides consulting and auditing
services within the firm
Cost accountant • Records, measures, estimates,
and analyses costs
• Works with financial and
operational manager to provide
relevant information for decisions
Example Activities
• Signs off on financial statements
• Determines policy on debt
versus equity financing
• Determines where to invest cash
balances
• Obtains line of credit
• Determines cost accounting
policies
• Maintains the accounting records
• Ensures that procurement rules
are followed
• Recommends policies and
procedures to reduce inventory
losses
• Evaluates costs of products and
processes
• Recommends cost-effective
methods to distribute products

ETHICAL ISSUES AND GUIDELINES

We have discussed decisions that one makes in using or preparing cost accounting information. The design
of cost systems is ultimately about the assignment of costs to various activities, products, projects,
corporate units, and people. How that is done affects prices, reimbursement, and pay.

As can be learned from current events involving embezzlement, channel staffing and so forth, the design
of the cost accounting system has the potential of being misused to defraud customers, employees or
shareholders. As a user or preparer or cost information, one has to be aware of the implication the way in
which information is used. More importantly, one needs to be aware of when the system has the potential
for abuse.

As professional accountant, managers or business owners, he/she will face ethical situations on an
everyday basis. Many accountants, managers and business owners have found themselves in serious
trouble because they did small things, none of which appeared seriously wrong, only to find that these small
things added up to big trouble. If you know the warning signs of potential ethical problem, you will have a
chance to protect yourself and set the proper moral tone for your company and your professions at the
same time.
The Code of Conduct

Managements accountants which include cost accountant have important ethical responsibilities that are
related to competence, confidentiality, integrity and objectivity. In a nutshell, the accountant has the
responsibility to comply with the Standards of Ethical Conduct for Practitioners of Management
Accounting and Financial Management issued by the Institute of Management Accountants. (See
Figure 1.4)

In this Code, it is stated that management (and cost) accountants have a responsibility to maintain the
highest levels of ethical conduct. They also have a responsibility to maintain professional competency,
refrain from disclosing confidential information, and maintain integrity and objectivity in their work. These
standards recommend that accountants faced with ethical conflicts follow the established policies that deal
with them.
The IMA guidelines suggest that when faced with as ethical dilemma, just answer the following questions:
• Will my actions be fair and just to all parties concerned?
• Would I be pleased to have my closest friends and relation learn of my actions?
Figure 1.4
Standards of Ethical Conduct for Practitioners of Management
Accounting and Financial Management

Practitioners of management accounting and financial management have an obligation to the public, their profession, the organization
they serve, and themselves, to maintain the highest standards of ethical conduct. In recognition of this obligation, the Institute of
Management Accountants has promulgated the following standards or ethical conduct for practitioners of management accounting and
financial management. Adherence to these standards, both domestically and internationally, is integral to achieving the objectives of
Management Accounting. Practitioners of management accounting and financial management shall not commit acts contrary to these
standards nor shall they condone the commission of such acts by others within their organizations.

Competence. Practitioners of management accounting and financial management have a responsibility to:
• Maintain an appropriate level of professional competence by ongoing development of their knowledge and skills.
• Perform their professional duties in accordance with relevant laws, regulations, and technical standards.
• Prepare complete and clear reports and recommendations after appropriate analysis of relevant and reliable information.

Confidentiality. Practitioners of management accounting and financial management have a responsibility to:
• Refrain from disclosing confidential information acquired in the course of their work except when authorized, unless legally obligated
to do so.
• Inform subordinates as appropriate regarding the confidentiality of information acquired in the course of their work and monitor their
activities to assure the maintenance of that confidentiality.
• Refrain from using or appearing to use confidential information acquired in the course of their Work for unethical or illegal advantage
either personally or through third parties.

Integrity. Practitioners of management accounting and financial management have a responsibility to

• Avoid actual or apparent conflicts of interest and advise all appropriate parties of any potential conflict.
• Refrain from engaging in any activity that would prejudice their ability to carry out their duties ethically.
• Refuse any gift, favor, or hospitality that would influence or would appear to influence their actions.
• Refrain from either actively or passively subverting the attainment of the organization’s legitimate and ethical objectives.
• Recognize and communicate professional limitations or other constraints that would preclude responsibility judgment or successful
performance of an activity.
• Communicate unfavorable as well as favorable information and professional judgments or opinions.
• Refrain from engaging in or supporting any activity that would discredit the profession.

Objectivity. Practitioners of management accounting and financial management have a responsibility to:
• Communicate information fairly and objectively.
• Disclose fully all relevant information that could reasonably be expected to influence an intended users understanding of the reports,
comments, and recommendations presented.

Resolution of Ethical Conflict. In applying the standards of ethical conduct practitioners of management accounting and financial
management may encounter problems in identifying unethical behavior or in resolving an ethical conflict. When faced with significant
ethical issues, practitioners of management accounting and financial management should follow the established policies of the
organization bearing on the resolution of such conflict. If these policies do not resolve the ethical conflict, such practitioner should consider
the following courses of action:

• Discuss such problems with the immediate superior except when it appears that the superior is involved, in which case the problem
should be presented initially to the next higher managerial level. If a satisfactory resolution cannot be achieved when the problem is
initially presented, submit the issues to the next higher managerial level.
• If the immediate superior is the chief executive officer, or equivalent, the acceptable reviewing authority may be a group such as the
audit committee, executive committee, board of directors, board of trustees, or owners. Contact with levels above the immediate
superior should be initiated only with the superior's knowledge assuming the superior is not involved. except where legally prescribed,
communication of such problems to authorities or individuals not employed or engaged by the organization is not considered
appropriate.
• Clarify relevant ethical issues by confidential discussion with an objective advisor (e.g. IMA Ethics Counseling Service) to obtain a
better understanding of possible courses of action.
• Consult your own attorney as to legal obligations and rights concerning the ethical conflict.
• If the ethical conflict still exists after exhausting all levels of internal review, there may be no other recourse on significant matters
than to resign from the organization and to submit an informative memorandum to an appropriate representative of the organization
after resignation, depending on the nature of the ethical conflict, it may also be appropriate to notify other parties