Chapter 1: Introduction to Cost and Management Accounting

Accounting information is provided to users to help them make better decisions. Users
require different information for different purposes. Management accountants address the
information needs of managers.

This unit begins with the purposes of accounting and will define management accounting. It
then compares management accounting against financial accounting. The unit concludes with
a brief discussion on major themes in management accounting. This will give us a framework
for studying the succeeding chapter.

Upon completing study of this unit, you should be able to:

 describe the major users of accounting information.
 name the types of questions a good accounting system helps to answer.
 explain the four fundamental management processes that help organizations to attain
their goals.
 explain the major differences between management and financial accounting.
 briefly describe some of the major contemporary themes in management accounting.

1.1 INTRODUCTION

Management Accounting

Management Accounting is the process of identifying, measuring, analyzing,

interpreting, and communicating information for the pursuit of an organization's goals.

This is also known as "cost accounting."

Investopedia Says:

The key difference between managerial and financial accounting is that managerial
accounting information is aimed at helping managers within the organization make decisions.
In contrast, financial accounting is aimed at providing information to parties outside the
organization.

1
Cost Accounting is a branch of accounting dealing with the classification, recording,
allocation, summarization and reporting of current and prospective costs and analyzing their
behaviors. Cost accounting is frequently used to facilitate internal decision making and
provides tools with which management can appraise performance and control costs of doing
business.

Your study of accounting so far has probably focused on financial accounting, which is
concerned with the preparation of information about an organization’s past operations. This
information is reported to individuals and groups external to the organization, such as
creditors and stockholders, in the form of financial statements (balance sheet, income
statement, and statement of cash flows). These external groups and individuals use the
financial statements to assist with making such decisions as generating a loan or investing in
the stock of a company.

In this course, you will study cost & management accounting, which is also concerned with
providing information to assist with decision-making. Unlike financial accounting, however,
management accounting provides information for internal decision makers; that is, the
managers of an organization. Managers use this information to make decisions, such as how
many units to produce, what price to charge for the product, and whether to purchase a new
piece of equipment. Since the decisions managers make are different from those made by
creditors and stockholders, managers often need different information than do creditors and
stockholders. In addition, the information that managers’ need differs with the type of
decision they are making.

1.2 ACCOUNTING SYSTEMS AND THEIR PURPOSES

All accounting information is accumulated to help someone (may be a company president, a

production manager, a sales manager, a shareholder, a small business owner, a politician and
others) to make economic decisions. In general, users of accounting information fall into
three categories:

2
 i) Internal managers who use the information for short-term planning and controlling
routine operations.
ii) Internal managers who use the information for making non-routine decisions and
formulating overall policies and long-range plans. Examples of these non routine
decisions include:
 Investment in equipment.
 Pricing products and services.
 Choosing which products to emphasize or de-emphasize.
iii) External parties, such as investors, creditors and government authorities, who use the
information for making decisions about the company.

Each of the above purpose of an accounting system may require different ways of aggregating
or reporting data. Despite these differences, most organizations prefer a general-purpose
accounting system that can supply appropriate information for all three types of users.

An accounting system is a formal mechanism for gathering, organizing, and communicating

information about an organization’s activities. A good accounting system helps an
organization achieve its goals and objectives by helping to answer the following three types of
questions:
I. Scorecard questions. Am I doing well or poorly?
II. Attention-directing questions. Which problems should I look into?
III. Problem solving questions. Of the several ways of doing the job, which is the best?

To answer each of the above questions, one can classify accounting data as scorekeeping data,
attention-directing data and problem-solving data, respectively. Furthermore, depending upon
the classification of accounting information, the accountant’s task of supplying information
can be identified as scorekeeping task, attention-directing task and problem-solving task.
Scorekeeping task: This is an accumulation and classification of data. This aspect of
accounting enables both internal and external parties to evaluate organizational performance.
The collection, classification and reporting of scorekeeping information is the task that
dominates day-to-day accounting. Examples of scorekeeping (scorecard) task include:
 Posting daily cash collections to customers’ accounts.
 Preparing journal entries for depreciation of equipment.

3
  Processing monthly payroll.

Attention-directing task: It is the task of reporting and interpreting information that helps
managers to focus on operating problems, imperfections, inefficiencies, and opportunities.
This aspect of accounting helps managers to concentrate on important areas of operations
promptly enough for effective action. Attention directing is commonly associated with
current planning and control, and with the analysis and investigation of recurring routine
internal accounting reports. The following activities fall under attention directing based on the
function that the accountant is performing.
 Interpreting why a branch did not meet its sales quota.
 Interpreting variances on a post office supervisor’s performance report.
 Analyzing for the president, the impact of net income of a contemplated new product.

Problem solving task: This task of the accountant involves quantification of the likely results
of possible courses of actions and often recommends the best course to follow. Problem
solving is commonly associated with nonrecurring decisions, situations that require special
accounting analyses or reports. Examples of activities performed by an accountant that could
be classified as problem-solving task include:
 Preparing, a cost comparison of two computerized manufacturing control systems for
a production manager,
 Analyzing the cost of several different ways to blend raw materials in the factory.

Sometimes this classification of accounting information may overlap. A single data may
serve to answer one or more of the questions to be dealt with a good accounting system. For
example, the scorecard and attention-directing data are closely related. The same information
may serve as a scorecard function for a manager and an attention-directing function for the
manager’s superior. Consider a performance report in which actual results of decisions and
activities are compared with previously determined plans. By pinpointing where actual results
differ from plans, such performance reports can show managers how they are doing and show
the managers’ superiors where to take action. In addition, the actual results help answer
scorecard questions of financial accounting, which is concerned with reporting the results of
the organization’s activities to external parties.

4
In contrast, problem-solving information may be used in long-range planning and in making
special, nonrecurring decisions, such as whether to make or buy parts, replace equipment, or
add or drop a product. These decisions often require expert advice from specialists such as
industrial engineers, budgetary accountants, and statisticians.

Exhibit 1-1 Users of Accounting Information

Major Means Major Ends
(Types of Accounting Information) (Helping Decisions)

Problem solving information Managers for long-range planning and special

decisions.

Scorekeeping information Managers for planning and controlling routine

Attention-directing information operations.
Problem solving information

Outsiders- investors, tax collectors,

Scorekeeping information regulators, and others.

Check Your Progress –I

1. All accounting information is accumulated to help someone to make decision. Describe

the major users of accounting information.
……………………………………………………………………………………………
……………………………………………………………………………………………
2. For each of the activities listed below identify the function that the accountant is
performing-scorekeeping, attention directing, or problem solving.
a. Preparing a report of overtime labor costs by production department.
b. Analyzing the costs of acquiring and using each of two alternate types of welding
equipment.
c. Analyzing deviations from the budget of the factory maintenance department.
d. Assisting in a study by the manufacturing vice-president to determine whether to
buy certain parts need in large quantities for manufacturing products or to acquire
facilities for manufacturing these parts.
e. Daily recording of material purchase vouchers.

5
 f. Investigating reasons for increased returns and allowances for drugs purchased by
a hospital
g. Computing and recording end-of-year adjustments for expired fire insurance on
the factory warehouse for materials.

1.3 COMPARISON BETWEEN FINANCIAL ACCOUNTING AND MANAGEMENT

ACCOUNTING

Management accounting is entirely new area of accounting that has gained importance, for the
last 4 or 5 decades. The historical development of management accounting is a relatively
recent phenomenon, especially compared with financial accounting. Financial accounting is a
very old system of accounting that was developed to meet the requirements of business for
recording, classifying, and summarizing mercantile transactions. In contrast, management
accounting was relatively sophisticated and provided the essential information needed to
manage the mass production of textiles, steel, and other products. Management accounting
has its roots in the industrial revolution of the 19 th century. During this period, there was little
need for elaborate financial accounting systems, since most firms were tightly controlled by a
few owner-managers, and corporate borrowing was based largely on personal relationships.

1.3.1 Limitations of Financial Accounting

For quite a long period in the history of accounting, managers in the discharge of their
managerial functions used the financial accounting. And it was limited and inadequate in
regard to the information that it can supply to management. The following are some of the
limitations of financial accounting, among others:
It shows only overall performance: Financial accounting provides information about profit,
loss, cost etc. of the collective activities of the business as a whole. It does not give data
regarding departments, products, processes and sales territories, etc.

6
Historical in nature: Financial accounting is historical in nature, since the data are
summarized only at the end of the accounting period. There is no system of computing
predetermined costs for example.

No performance appraisal: In financial accounting, there is no system of developing norms

and standards to appraise the efficiency of the use of materials, labor ad other costs by
comparing the actual performance with what should have accomplished during a given of
time.

Not helpful in evaluating strategic decisions. The financial records are based on certain
conventions and concepts. Few of these are not relevant in decision- making by management
of any undertaking. For example, financial accounting is not helpful to evaluate decision
listed here below:
 What should be the level of output for a desired profit under the given
conditions of production?
 What is the impact of prices level changes on the economic position of the
enterprise?
 What should be the reasonable cost per unit of output?
 Should we build a new plant or modernize the old one?
 How far we can go in lowering prices to increase our sales volume?
 Is our plant operating efficiently and economically?
 Which of our costs are out of line, and how can they can be controlled?
 Are our sales prices set realistically in relation to costs?

Owing to the limitations of financial accounting as an effective tool of management, we need

some system of accounting which may help the management in the successful discharge of its
important duties of planning, implementation of plans, controlling and evaluation of business
performance. As the name suggests, Management accounting is any form of accounting that
is useful to management in the discharge of its managerial functions for efficient utilization of
business resources to achieve the fundamental objective of optimizing profit. Put differently,
management accounting can be defined as the process of identifying, measuring,
accumulating, analyzing, preparing, interpreting and communicating information that helps
managers to fulfill organizational objectives.

7
1.3.2 Distinction between Financial Accounting and Management Accounting

There are several major differences between financial accounting and management
accounting. They differ in primary users, in orientation of reports, in point of emphasis
between the past and the future, in the type of data provided to users, and in several ways.
These differences are described here below.

Primary Users: One important difference between management and financial accounting
information is the intended users. Financial accounting reports are prepared for the use of
external parties such as shareholders and creditors, whereas management accounting reports
are intended to be used by managers inside the organization. However, this does not mean
that financial accounting is not useful to management.

Emphasis on the Future/Time Orientation: Since planning is such an important part of the
manager’s job, management accounting has a strong future orientation. In contrast, financial
accounting primarily provides summaries of past financial transactions. The difficulty with
summaries of the past is that the future is not simply a reflection of what has happened in the
past. Changes are constantly taking place in economic conditions; customer needs and
desires, competitive conditions, and so on. All of these changes demand that manager’s
planning be based in large part on estimates of what will happen rather than on summaries of
what has already happened.

Emphasis on Precision: Management accounting information is usually less precise than

financial accounting information. The latter reports on events that have already occurred, and
are governed by structured reporting rules. Therefore, financial accounting is composed of
measurements that are often very precise. Management accounting information, which
focuses on future actions, is composed of estimates and forecasts. It is not possible for
estimates and forecasts to be as precise as measurements of past activities.

Reporting Flexibility /Freedom of Choice: Financial accounting statements prepared for

external users must be prepared in accordance with International Financial Reporting
Standards (IFRS). External users must have some assurance that the reports have been
prepared in accordance with some common set of ground rules. These common ground rules

8
enhance comparability and reduce fraud and misrepresentation, but they do not necessarily
lead to the type of reports that would be most useful in internal decision-making.

Management accounting is not bound by generally accepted accounting principles. Managers

set their own ground rules concerning the content and form of internal reports. The only
constraint is that the expected benefits from using the information should outweigh the costs
of collecting, analyzing, and summarizing the data.

Reporting Entity: Financial accounting information tends to report the activities of the
organization as a whole. This is because creditors and stockholders are usually concerned
with performance of the whole organization. If a bank loans money to a business, the loan is
not to the manager of a product line, but instead to the company as a whole. Likewise, a
stockholder purchases stock in the company as a whole, not in a specific product of the
company.

Management accounting tends to focus on segments of the organization because most

managers are responsible for the operations of only a segment of the organization, not the
whole organization. Therefore, the managers are interested in operations of their specific
segments. These managers may wish to know about specific products, particular groups of
customers, or employees in a particular department of the organization. If the manager is
making decisions about products, the accountant will organize the data by product. If the
decision compares different sales territories, the data will be organized by sales territory.
Compulsion: Financial accounting is mandatory; that is, the preparation of financial
accounting reports and statements is must in certain undertakings (in case of a company form
of organization) where these are a necessity in others. Various outside parties such as
regulatory bodies and the tax authorities require periodic financial statements. Management
accounting, on the other hand, is not mandatory. A company is completely free to use or not
to use management accounting. There are no regulatory bodies or other outside agencies that
specify what is to be done, or, for that matter, whether anything is to be done at all. Since
management accounting is optional, the important question is always, “Is the information
useful?” rather than,” Is the information required?”

9
Description /Nature of Data Reported: Since many of the decisions that managers make
require non-financial information, management accounting information includes quantitative
data that is not financial. For example, accountants often report production quantities,
capacity utilization estimates, material scrap rates, quality control measures, employee
turnover statistics, and market share estimates.

In addition to non-financial quantitative data, management accounting reports non-monetary

events, like technical changes, political changes, market competition and so on. However,
almost exclusively monetary transactions are recorded in financial accounting.

Publication: Management accounting statements are prepared for the benefit of management
only and these are not published. Furthermore, they are confidential. In contrast, financial
accounting statements like income statement, balance sheet and others are published for the
benefit of the public.

Source of Data: In financial accounting, the sources of information are journal and ledger
accounts that form the basis for drawing income statement and balance sheets. Thus, the
source of information is almost exclusively drawn from the organization’s basic accounting
system, which accumulates financial information. But management accounting draws
information both from internal as well as external sources. The external sources of
information may be the magazines, newspapers and other publications.
Delineation of Activities: Management accounting is less sharply defined. That is, there is
heavier use of related disciplines such as economics, statistics, decision science and
behavioral sciences. Financial accounting, however, is more sharply defined because there is
lighter use of related disciplines.

Time Span: Financial accounting presents 1 year or 1-quarter reports whereas management
accounting presents reports covering shorter or longer periods, varying from hourly to 10 to
15 years.

Items of Difference Financial Accounting Management Accounting

Primary Users External decision makers, such as Internal decision makers-managers at various
creditors, stockholders, tax levels.
authorities and regulators
Time orientation Past Oriented Future oriented
Precision Precision of information is No emphasis is given to actual figures.

10
 required Approximate figures are considered more
useful than exact figures.
Freedom of choice Must follow GAAP Need not follow GAAP
Reporting entity Organization as a whole. That is, Detailed segment reports about departments,
only summarized data for the divisions, products, customers and employees
entire organization are presented. are prepared.
Compulsion Mandatory for external reports Not mandatory
Description Monetary Monetary and non-monetary
Publication Financial accounting statements Management accounting statements are not
are published published
Source of data Internal sources Both internal and external sources
Delineation of activities More sharply defined Less sharply defined
Time span Less flexible, usually 1 year or 1 Flexible, varying from hourly to 10 to 15
quarter years.
Exhibit 1-2 Summarizes the Differences Between Financial and Management
Accounting Information

From the above exhibit, the distinction between financial accounting and management
accounting becomes quite clear. Although many differences exist between them, they are
similar in at least two ways.
i. Both rely on the same accounting information system. It would be a waste of money
to have two different data collecting systems existing side by side. One part of the
overall accounting system is the cost accounting system, which accumulates cost data
for use in both management and financial accounting. For example, production cost
data typically are used in helping managers set prices, which is a management
accounting use. However, production cost data also are used to value inventory on a
manufacturer’s balance sheet, which is a financial accounting use.
ii. Both rely heavily on the concept of responsibility, or stewardship. Financial
accounting is concerned with stewardship over the company as a whole; management
accounting is concerned with stewardship over its parts, and this concern extends to
the last person in an organization who has any responsibility over cost.

Check Your Progress – II

1. Consider the following short descriptions. Indicate whether each

description more closely relates to a major feature of financial accounting (Use FA) or
management accounting (Use MA).

11
 a) The field is more sharply defined.
b) Is characterized by detailed reports.
c) Has a future orientation.
d) Is constrained by generally accepted accounting principles.
e) Has less flexibility.
2. Why does management accounting tend to be less precise than financial
accounting information?
……………………………………………………………………………………………
……………………………………………………………………………………………
3. Explain the two main similarities between financial accounting and
management accounting information.
……………………………………………………………………………………………
……………………………………………………………………………………………
4. Give an example of a primary user of financial accounting information and
management accounting information.
……………………………………………………………………………………………
……………………………………………………………………………………………

1.4 MAJOR THEMES IN MANAGEMENT ACCOUNTING

Several major themes influence all aspects of management accounting. Among others, the
three themes will be described briefly now. Because of their important, they will also be
mentioned often in succeeding units.

Information and Incentives: The need for information is the driving force behind
management accounting. Management accounting information is supplied to a decision
maker to facilitate and influence decision. Information usually is provided to a manager to
assist her/him in choosing among alternative. Often, that information is also intended to
influence the manager’s decision. Information usually is provided to a manager to assist
her/him in choosing among alternative. Often, that information is also intended to influence
the manager’s decision.

12
To illustrate, let us consider Fitun Regional Hospital’s annual budget. As part of the budget
approval process, the administrator and the trustee will make important decisions that
determine how the hospital’s resource will be allocated. Throughout the year, the decisions of
management will be facilitated by the information contained in the budget. Management
decisions also will be influenced by the budget, since at year-end actual expenditures will be
compared with the budgeted amounts. Expenditures will then be requested for any significant
deviations.

Behavioral Implications: The reactions of both individuals and groups to management

accounting information will significantly affect the course of events in an organization. How
will Fitun Regional Hospital’s chief of surgery react to a budget? How much detail should be
included in the quarterly reports to the administrator? If too much detail is provided, will the
administrator be overloaded with information and distracted from the main points?

All of these questions involve the behavioral tendencies of people. The better a management
accountant’s understanding of human behavior is, more effective he or she will be as a
provider of information.

Cost – Benefit Balance: Information is a commodity. Like other goods, information can be
produced, purchased and consumed. As it is true of all goods and services, information
entails both costs and benefits. The cost of providing management accounting information to
the managers, for example, include the cost of compensation for the controller and
Accounting Department personnel, the cost of purchasing and operating computers, and the
cost of the time spent by the information users to read, understand, and utilize the
information. The benefits include improved decisions, more effective planning, and
efficiency of operations at lower costs, and better direction and control of operations.

Thus, there are both costs and benefits associated with management accounting information.
The desirability of any particular management accounting technique or information must be
determined in light of its costs and benefits.

1.5 SUMMARY

13
All organizations have goals, and their managers need information as they strive to attain
those goals. Information is needed for the management functions of decision making,
planning, directing operations, and controlling. Management accounting is the process of
identifying, measuring, analyzing, interpreting, and communicating information in pursuit of
an organization's goals. Management accounting is an integral part of the management
process, and management accountants are important strategic partners in an organization’s
management team.

Management accounting differs from financial accounting in several ways. The users of
management accounting information are managers inside the organization. Management
accounting is not mandatory, it is unregulated, and draws from the basic accounting system as
well as other data sources. The users of financial accounting information are interested
parties outside the organization, such as investors and creditors. Financial accounting
information is required for publicly held companies, is regulated by the GAAP, and is based
almost entirely on historical transaction data.

1.6 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS

Check Your Progress-I

1. The major users of accounting information fall into three categories:

a) Internal managers who use the information for short-term planning and controlling
routine operations.
b) Internal managers who use the information for making nonroutine decisions (like
investment in equipment, pricing products and services and choosing which
products to emphasize or de-emphasize, etc) and formulating overall policies and
long-range plans.
c) External parties, such as investors, creditors and government authorities, who use the
information for making decisions about the company.
2. a. Scorekeeping e. Scorekeeping
b. Problem solving f. Attention directing
c. Attention directing g. Scorekeeping
d. Problem solving

14
Check Your Progress-II

1.a. FA d. FA
b. MA e. FA
c. MA
1. Management accounting information is composed of estimate and forecasts and it is not
possible for estimates and forecasts to be as precise as measurements of past activities.
2. The two main similarities between management accounting and financial accounting
information are
i. Both rely on the same accounting system
ii. Both focuses on stewardship or responsibility
3. The primary users (major audiences) of financial accounting are external parties such as
creditors, investors, suppliers, government authorities, etc. in the case management
accounting information; the major users are internal managers at various levels.

UNIT 2: INTRODUCTION TO COST BEHAVIOR AND COST ESTIMATION

2.0 AIM AND OBJECTIVES

Upon completing this unit, you should be able to:

 understand the concept of a cost driver and a cost behavior.
 describe the behavior of variable and fixed costs, both in total and on a per – unit
basis.
 explain mixed, step, and semi variable costs.
 explain the relationships between cost estimation, cost behavior, and cost prediction.
 describe and use the following cost estimation methods: high-low, visual fit, least
squares regression, engineering analysis, and account classification.
 explain the advantages and disadvantages of the visual fit method and the high low
method for developing an equation to estimate costs.
 develop an equation to estimate cost using the above methods.

15
  use a cost formula to predict costs at a new level of activity.
2.1 INTRODUCTION

An understanding of cost behavior-how a cost will react or change as changes take place in
the level of business activity, is the key to many decisions in an organization. Managers who
understand how costs behave are better able to predict what costs will be under various
operating circumstances. For example, a decision to double production of a particular product
line might result in the incurrence of far greater costs than could be generated in additional
revenues. To avoid such problems, a manager must be able to accurately predict what costs
will be various levels. This unit focuses on measurement of cost behavior, which means
understanding and quantifying how activities of an organization affect levels of costs.

2.2 UNDERASTADING COST DRIVER AND COST BEHAVIOR

COST DRIVERS AND COST BEHAVIOR

Activities that affect costs are often called cost drivers. An organization may have many cost
drivers. The cost of running a warehouse, for example, may be driven by:
 The total birr value of the items handled.
 The weight of the items handled.
 The number of different orders received.
 The number of different items handled.
 The fragility of the items handled, and possibly several other cost drivers.

To examine cost behavior without undue complexity, the discussion that follows focuses on
volume-related cost drivers. Volume-related cost drivers include the number of orders
processed, the number of items billed, the number of admissions to a theater and so forth. All
of these cost drivers can serve either directly or indirectly as a measure of the volume of
output of goods or services.

From a planning and control standpoint, perhaps the most useful way to classify cost is by
behavior. Cost behavior means how a cost will react or respond to changes in the level of
business activity. As the activity level rises and falls, a particular cost may rise and fall as

16
 well or it may remain constant. For planning purpose the manager must be able to anticipate
which of these will happen; and if a cost can be expected to change, he or she must know by
how much it will change. To provide this information, costs are often categorized as variable
or fixed.

Comparison of Variable and Fixed Costs

Variable Costs: A variable cost is a cost that changes in total in direct proportion to a change
in the level of activity (or cost driver). A 10% increase in the units of production, for
instance, would produce a 10% increase in variable costs. However, the variable cost per unit
remains the same as activity changes.

There are many examples of variable costs. In a manufacturing company, they would usually
include direct materials, direct labor, some items of manufacturing overhead (such as utilities,
supplies, and lubricants), and perhaps shipping costs and sales commissions. In a
merchandising company, they would include cost of goods sold, commissions to sales
persons, and billing costs.

Exhibit 2.1 Variable Cost Behavior

A. Graph of total variable cost B. Graph of unit variable cost
Total variable cost Unit variable cost

Br. 3,000

Br. 2,000

Br. 1,000 Br. 100

Activity Activity
10 20 30 (or cost driver) 10 20 30 (or cost driver)

C. Tabulation of Variable Cost

Activity (or cost driver) Variable Cost Per unit Total Variable Cost
1 Br. 100 Br. 100
10 100 1,000

17
 20 100 2,000
30 100 3,000
Total Variable Cost = Unit variable cost  Activity
Unit Variable Cost = Total Variable cost
Activity

Panel A of Exhibit 2-1 displays a graph of a variable cost. As this graph show, total variable
cost increases proportionately with activity. When activity doubles, form 10 to 20 units, total
variable cost doubles, from Br. 1,000 to Br. 2,000. In contrast, a variable cost is a cost that
remains constant on a per-unit basis no matter what our level of output. The variable cost
associated with each of activity is Br. 100, whether it is the first unit or the tenth. The table in
Panel C of Exhibit 2-1 illustrates this point.

In a nutshell, as activity changes, total variable cost increases or decreases proportionately

with the activity change, but unit variable cost remains the same.

Fixed Cost: A fixed cost remains unchanged in total as the level of activity (or cost driver)
varies. It means that they are not immediately affected by changes in the cost driver.
Some costs that are usually fixed include:
 Some manufacturing overhead costs, like
 Rent or depreciation expenses for factory building.
 Depreciation on factory machinery and equipment.
 Insurance and property taxes on manufacturing facilities and
 Production supervisory salaries.
 Some non-manufacturing costs, such as
 Office property taxes.
 Office fire insurances.
 Advertising and promotion and
 Supervisory salaries (related to administrative functions)

Fixed Costs remain fixed only over a given period of time usually the budget period. It may
change form budget-to-budget year solely because of changes in insurance, property taxes
rates, executive salary levels, or rent levels.

18
 From the graph in Exhibit 2-2, it is apparent that total fixed cost remains unchanged as
activity changes. When activity triples, from 10 to 30 units, total fixed remains constant at
Br. 1,500. However, the fixed cost per unit does change as activity level changes. If the
activity level is only 1 unit, then the fixed cost per unit is Br.1, 500(Br.1, 500¸ 1). If the
activity level is 10 units, then the total fixed cost per unit declines to Br.150 per unit (Br.1,
500¸10). The table shown in exhibit depicted here below illustrates the behavior of total fixed
cost and unit fixed cost.

Exhibit 2.2 Fixed Cost Behaviors

A. Graph of Total Fixed Cost B. Graph of Unit Fixed Cost

Total fixed cost Unit fixed cost

Br. 1,500

Br. 1,000

Br. 1,500 Br. 500

10 20 30
Activity Activity
(or cost driver) (or cost driver)

C. Tabulation of Fixed Cost

Activity( or cost driver) Fixed Cost per Unit Total Fixed Cost
1 Br.1, 500 Br.1, 500
2 750 1, 500
5 300 1, 500
10 150 1, 500
20 75 1, 500
30 50 1, 500

Fixed costs can be fixed only over a restricted range of possible levels of activity (which is
known as relevant range). For example, rent costs will rise if increased production requires a
larger or additional building. Conversely, rent costs may go down if decreased production
caused the company to move to a smaller plant.

19
The relevant range is the limits of cost drive activity with in which a specific relationship
between costs and the cost driver is valid. It refers to the range of activity in which
management expects the firm to be operating in the next planning period.
Example: Assume that Sara Electric plant has a relevant range of between 40,000 and 80,000
cases of light bulbs per month and that total monthly fixed costs with in the relevant range is
Br. 800,000. With in the relevant range of 40,000 to 80,000 cases a month, fixed costs will
remain the same. If production falls below 40,000 cases, changes in personnel and salaries
would slash fixed costs to an amount below Br. 800,000. If operations rise above 80,000
cases, increase in personnel and salaries would boost fixed costs above Br. 800,000. Refer
Exhibit 2-3.

Br. 1,200,000
Fixed costs

Br. 800,000

Br. 400,000

20 40 60 80 100

Number of cases (in 000’s)

Exhibit 2-3 Fixed Costs and Relevant Range

The basic idea of a relevant range also applies to variable costs. That is, outside relevant
range, some variable costs such as fuel consumed may behave differently per unit of cost
driver activity. For example, the efficiency of motor is affected if they are used too much or
too little.

Sometimes accountants further classify fixed costs as committed fixed costs and
discretionary fixed costs.

Committed Fixed Costs: They usually arise from an organizations ownership or use and its
basic organization structure. Committed fixed costs are large, individual chunks of cost that

20
the organization is obligated to incur or usually would not consider avoiding. Mortgage or
lease payments, interest payments on long-term debt, property taxes, depreciation on
buildings and equipment, salaries of key personnel, and insurance for plant and equipment.

Discretionary Fixed Costs: These are costs determined by management as part of the periodic
planning process in order to meet the organization’s goals. Discretionary fixed costs can be
discontinued at management’s discretion in a relatively short time in comparison with
committed fixed costs. Examples of discretionary fixed costs include amounts spend on
advertising and promotion, research and development, contributions to charitable
organizations, employee training program, system development, administrative salaries and
short term renewable costs.

Unlike committed fixed costs, managers can alter discretionary fixed costs easily up or down-
even with in a budget period, if they decide that different levels of spending are desirable.
Discretionary fixed costs may be essential to the long run achievement of the organization’s
goals, but managers can vary spending levels broadly in the short run.

Although the division of costs into variable and fixed is extremely useful, there are some costs
that do not exactly fit either of these categories. Three additional cost patterns that are not
strictly variable or fixed are mixed costs, step costs and semi variable costs.

Mixed Costs: Mixed costs include both fixed and variable components. Many costs, such as
repair and maintenance costs, are incurred in such a way that part of the cost varies with the
level of activity and part of it does not. The amount of repairs required often depends on how
much the equipment has been used. Thus, the repairs and their cost vary with the level of
production. Maintenance that is performed periodically depends only on the passage of time,
not on the level of activity. Therefore, the cost includes both a fixed component and a
variable component and is labeled a “mixed cost.” Electricity costs also are often mixed
costs. Part of the electricity cost depends on the amount of time the equipment is operated.
This part is variable. Part of the cost is incurred for lights and perhaps heating or cooling.
This part of the cost does not depend on the level of activity and therefore is fixed.

21
Telephone costs are also typically mixed costs. The telephone cost is made up of a fixed
monthly service charge and a variable charge that depends on the number of message units
used during the month.

To sum up, the fixed portion of a mixed cost represents the basic, minimum cost of just
having a service ready and available for use. The variable portion represents the cost incurred
for actual consumption of the service. The variable element varies in proportion to the
amount of service that is consumed.

Mixed cost is represented by a straight line; the following equation for a straight line can be
used to express the relationship between mixed cost and the level of activity.
y=a+bx
In this equation,
y = the total mixed cost
a = the total fixed cost (the y-intercept of the line)
b = the variable cost per unit of activity (the slope of the line)
x = the level of activity.
The behavior of mixed cost is shown graphically in Exhibit 2.4

22
Total Cost

Total cost=
Y Fixed cost + variable cost

a Fixed cost
0 x
Activity level
Exhibit 2-4 Mixed Cost Behaviors
Semi variable costs: Some costs vary with the volume of activity but not proportionately or at
a constant. They are called semi variable costs. They can be divided into two: Semi variable
costs that change at a decreasing rate and those semi variable costs that change at an
increasing rate.

In Exhibit 2-5 part (a) shows a semi variable cost that increases at a decreasing rate. This
type of cost is referred to as a learning curve cost. The term originates from the observed
decrease in labor costs that sometimes occurs, as employee become familiar with a new task.
As the graph in Exhibit 2-5(a) shows, the unit variable cost declines as activity increases. Put
differently, this cost exhibit decreasing marginal costs (the cost of producing the next unit) or
this type cost behavior is characterized by smaller cost per unit of out put as activity level
increases.
Y (Br.) Y (Br.)

0 Activity level x 0 Activity level x

(a) (b)
Exhibit 2-5 Semi variable Cost Behavior.

Diagram (b), here above, shows a semi-variable cost that increases at an increasing rate. This
type of cost behavior is characterized by larger costs per unit of output as the activity level
rises. In other words, the marginal cost per unit rises as activity increases.

Step Function Costs: Step costs, sometimes called semi-fixed costs, remain fixed over a
range of activity, but beyond some activity level they change usually by intermittent jumps

23
 rather than continuously. Step costs are costs that change abruptly at intervals of activity
because the resources and their costs come in indivisible chunks.

If the individual chunks of step cost are relatively large and apply to broad range of activity
the cost is considered a fixed cost over the range of activity. (Refer diagram (a) in Exhibit 2-
6). In contrast, accountants often describe step costs as variable when the individual chunks
of costs are relatively small and apply to a narrow range. Panel B in Exhibit 2-6 shows that
the steps in a semi-fixed cost behavior pattern are small; here in this case, the semi-fixed cost
function may be approximated by a variable cost function without much loss in accuracy.

Br. 45,000

Br. 45,000 Br. 35,000

Br. 35,000 Br. 25,000

Br. 25,000

Activity Activity
10,000 20,000 30,000 10,000 20,000 30,000

Exhibit 2-6 Step Function Cost

2.3. MEANING OF COST ACCOUNTING AND COST ACCOUNTACCY

There are different ways of defining “cost accounting” and “cost accountancy.” One of the
most comprehensive definitions provided by different scholars is provided as follows:-
Cost accounting is the process of classifying, recording, and appropriate allocation of
expenditure for determining the cost of product or service, and for the presentation of suitably
arranged data for the purpose of controlling and guidance of the management. It includes the
ascertainment of cost of every order, job, contract, process, service or units as may be
appropriate.

24
Or cost accounting can be defined as, the process of determining and accumulating the cost
of some particular product or activity. In other words, cost accounting provides the
management with detailed records of cost related to product, operations or functions.

Cost accountancy is the application of cost accounting principles, methods and techniques to
the science, art and practice of cost control and ascertainment of profitability. It is a science
because it is the body of systematic knowledge having certain principles which a cost
accountant possesses for a proper discharge of their responsibility. It is an art as it requires the
ability and skill with which a cost accountant is able to apply the principles of cost
accountancy to various managerial problems.

2.3.1. OBJECTIVES OF COST ACCOUNTING

The objectives of cost accounting are:-

1. To ascertain and determine the cost per unit of different products
manufactured.
2. To provide cost data that serve as a guide for fixing or determine the price of
products manufactured or services rendered.
3. To exercise effective control of raw materials, work in process, and finished
goods.
4. To use the resources efficiently and economically.
5. To present and interpret data for management in planning, decision making,
and controlling.
6. To help in the preparation of budgets.
7. To supply useful data to the management to take various decisions such as
introducing new products, replacement of labor by machinery etc.

2.3.2. ADVANTAGES OF COST ACCOUNTING

The implementation of cost accounting principle and practices in an organization has various
kinds of benefits. This benefits or advantages may include:-

25
 1. Profitable and non profitable activities are disclosed and steps can be taken to
eliminate or reduce those activities from which little or no benefit is obtained or to
change the method of production.
2. It enable the organization to measure the efficiency and then to maintain and
improve.
3. It furnishes reliable data for comparing costs in different department and process.
4. Cost accounting provides cost data and information in order to determine the price
of the product.
5. Cost accounting helps management in knowing the cost of different alternatives
and selecting the most advantages course of action. For example decisions like
make or buy, continue or dropping of a product and other short term decisions.
6. An adequate cost accounting system ensures maximum utilization of physical and
human resource.
2.4. MANUFACTURING COST CLASSIFICATIONS

Manufacturing firm
Manufacturing firm does not purchase readily made products or goods for sale. Rather,
production resources like materials and other resources are purchased and used in
manufacturing process to converting raw materials (in puts) in to finished products (out puts).
In a manufacturing firm product costs include all costs necessary for the manufacture of the
product. When sale is recorded, these product costs are transferred to cost of it goods sold.

There are three major costs related to a manufacturing firm:-

1. Direct materials
 Direct materials are those materials used in the manufacturing processes and that
become the significant part of the finished goods.
 Direct materials are the cost of materials which are conveniently and
economically traceable to specific units of out put.
 For example: - raw cotton in textiles, crude oil to make diesel, steel to make
automobile, metal frame and lumber to manufacture a chair and others.

26
  Note that what is raw material to one manufacturer is considered as finished
goods by the supplier of that material.
2. Direct labor
 The personals who work directly with the raw materials in converting them to
finished goods represent direct labor.
 It is defined as the labor of those workers who are engaged in the production
process.
 For example: - labor of machine operators and assembles wages and salaries that
cut and sand lumber and others.
3. Manufacturing over head
 All cost incurred in the factory that cannot be considered as direct materials or
direct labor are classified as manufacturing overhead, factory overhead, indirect
manufacturing cost, manufacturing overhead expenses or factory burden.
 For example: - factory supplies, rent, depreciation, insurance, light and power
costs, repairs, and maintenance costs and so on.
Manufacturing overhead costs are usually classified in to three major categories: -
a) Indirect materials
 Materials that are used in small amount in the manufacturing process or that cannot
easily be allocated to specific product are called indirect materials.
 For example: -
- Glue in manufacturing shoes
- Thread in manufacturing clothes operating supplies.
 Generally, it is more practical to group materials together without charging them into a
specific product. Because detailed records of minor materials require more time, and it
is also a costly process.
b) Indirect labor
 The wages and salaries of factory personnel who do not work directly on raw
Materials are called indirect labor.
 For example: -wages and salaries of such factory workers as the storeroom clerks,
janitors, superintendent, maintenance etc.
c) Other manufacturing over head

27
  Other manufacturing overhead costs, include such costs as payroll tax, rent expense,
depreciation expense, insurance expense, utility expense, repair and maintenance
expense, amortization expense and so on.
[

Moreover, manufacturing overhead costs can be categorized as variable and fixed based on
their behavior in response to changes in levels of production volume or activity.
 Variable overhead costs includes all production costs other than direct materials
and direct labor, that change in direct proportion to changes in the levels of
activity.
o The variable overhead cost includes the cost of indirect materials and
indirect labor.

 Fixed manufacturing overhead costs includes all production costs that remain
constant with in the company’s relevant range. Fixed overhead costs comprised of
costs such as depreciation expense (other than the units of production depreciation
method) on the factory plant assets, factory license fee, factory insurance and
property taxes, rent expense, salaries for managers and soon.

PRIME AND CONVERSION COSTS

The total cost of direct materials and direct labor is referred to as prime cost. Because these
costs are the primary sources for the finished product and mostly associated with and
traceable to a specific product. In other words, the summation of direct materials and direct
labor will give us the prime cost.

Prime cost = Direct material + Direct labor

Conversion cost is the sum of direct labor and factory overhead which is directly and
indirectly necessary for transforming raw materials into a salable finished product. In other
words, the incurrence of conversion costs causes direct materials to changed or converted in
to finished goods.

28
Since direct labor is included as part of prime cost and conversion costs, prime and
conversion costs cannot be added to determine product costs. To do so would be double
counting the cost of direct labor.
Conversion cost = direct labor + manufacturing over head

2.5. IDINTIFYING
WORKFLOW OF A MANUFACTURING FIRM

The firm’s cost accounting system is parallels to the flow of operations. The steps in a typical
cycle of operations of a firm that makes and sells products are outlined as follows: -
1. Procurement
 Raw materials and supplies needed for manufacturing are ordered, received, and
stored. Factory labor and services are also obtained.
2. Production
 Raw materials are transferred from the storeroom to the factory. Labor tools,
machines, power, and other costs are applied to complete the product.
3. Warehousing
 Finished goods are moved from the factory to the ware- house to be held until
they are sold.
4. Selling
 Customers are found. Products will be shipped from the warehouse and sales to
customers are recorded.

2.6. MATCHING
COST FLOW WITH WORKFLOW

After identifying the different workflows of manufacturing firm, efforts will be made to
match cost incurred in each of the respective workflows.
1. Procurement

29
  Accounts must be provided to record the purchase of materials labor and over
heads. These costs will later be charged to production.
 Typical general ledger account titles used for this purpose are raw materials,
factory payroll clearing, and manufacturing over head control respectively.
2. Production
 An account is required to gather procurement costs as they become chargeable to
manufacturing operations. This account is known as work in process.
3. Ware housing
 An account muse is set up to record the cost of goods that have been completely
manufactured. This account is referred as finished goods.
4. Selling
 The cost of completed goods that have been sold must be recorded. An account
termed as cost of goods sold is provided in the general ledger for this purpose.
 Other general ledger accounts such as Accounts receivable and sales are used for
recording the sale to the customer and the credit to income at selling price.
Procurement ------------production-------------ware housing--------------selling
-Raw materials -work process -finished goods -CGS
-Factor payroll clearing
-Manufacturing over head control
1. Procurement
 Purchase of materials, labor and over heads are recorded as debits to raw
materials, factory payroll clearing, and manufacturing over head control. As this
cost are used or applies in factory operations, they are credited to these accounts
and transferred to production.
2. Production
 Costs of materials, labor and over head transferred in to production are debited to
work in process. As goods are finished and moved from the factory, their total costs is
moved from or debited to finished goods.
3. Ware housing

30
  The cost of finished goods transferred from work in process is recorded as a debit to
finished goods. The costs of finished goods shipped from the ware house to customers
is credited to finished goods and charged (debited) to cost goods sold.
4. Selling
 As finished goods are sold and shipped from the ware house, their cost is debited to
cost of goods sold. At the end of the accounting period, this account is closed by
crediting cost of goods sold and debiting incomes summary.

2.7. RECORDING
THE COST FLOW AT EACH STAGE OF WORK FLOW

Assume that on October 1,19x4 these balances in the following accounts were available:-
Raw materials 40,000 Br
Work; in process 30,000
Finished goods 24,000
1. Additional raw materials were purchased during the month of October at a cost of
60,000 Birr on account.
Raw materials 60,000
Vouchers payable (accounts payable) 60,000
2. During the month raw material costing 70,000 Birr were used as follows:-
o Direct materials charged to the work in process Br.68, 000
o Indirect materials charged to the manufacturing over head control was Br.2,
000
Work in process 68,000
Manufacturing overhead control 2,000
Raw materials 70,000
3. During the month wages and salaries totaling 84,000 Birr were earned by the factory
employees and charged from the factory payroll register.

Factory payroll clearing 84,000

Salaries and wages payable 84,000

31
4. An analysis of records indicates that labor costs of 84,000 Birr is allocated as follows:-
 Direct labor chargeable to the work in process 60,000
 Indirect labor chargeable to man overhead control 24,000
Work in process 60,000
Manufacturing overhead control 24,000
Factory payroll clearing 84,000
5. In addition to indirect materials and indirect labors other manufacturing overhead
costs totaling 14,000 Birr incurred during the month were charged form various
journals.
Manufacturing overhead control 14,000
Vouchers payable (accounts payable) 14,000
6. It is estimated that overhead costs totaling 38,000 Birr are applied or charged to jobs
worked on during the month
Work in process 38,000
Manufacturing over head control 38,000
7. During the month, some jobs were completed and transferred to the finished goods
warehouse. The jobs cost were Br.180, 000
Finished goods 180,000
Work in process 180,000
8. During the month, finished goods costing Br.170, 000 were sold to various customers.
Cost of goods sold 170,000
Finished goods 170,000

32
2.8. PREPARING
COST OF GOODS MANUFACTURED AND COST OF GOODS SOLD
SCHEDULE

COST OF GOODS MANUFACTURED SCHEDULE

Raw materials
Raw material inventory, beginning xxx
Materials purchased xx
Freight in xx
Less:-Purchase return and allowance xx
Purchase discount xx
Net purchase xxx
Total materials available xxx
Less: - Raw materials inventory, ending xxx
Raw materials used xxx
Direct labor xxx
Manufacturing over head
Indirect materials and supplies xx
Indirect labor xx
Payroll taxes expense-factory xx
Utilizes expense xx
Repair and maintenance xx
Depreciation -factory equipment xx
Insurance expense xx
Property taxes- factory equipment xx
Total manufacturing over head xxx
Total current manufacturing cost xxx
Add: - work in process inventory, beginning X .
Less: - work in process inventory, ending xx
Cost of goods manufactured xxx

COST OF GOOD SOLD SCHEDULE

Finished goods inventory, beginning xx
Add: - Cost of goods manufactured xx
Total goods available for sale xx
Less: - finished goods inventory, ending xx
Cost goods sold xx

33
Illustration-1
The following data is related to the operations of Action Company
Jan 1, 19x2 Dec 31,19x2
Inventories
Finished goods 43,000Br 52,000Br
Raw materials 12,000 10,000
Work in process 16,000 14,000
Direct labor 85,000
Freight in 4,000
Administrative expense 30,000
Indirect labor 18,000
Indirect materials and supplies 3,000
Insurance expense factory 1,500
Depreciation- factory plans 7,500
Raw materials purchases 170,000
Payroll taxes expense- factory 4,000
Utilities factory 7,500
Property taxes factory 3,000
Raw materials purchase returns and allowance 4,000
Repair and maintenance- factory 4,000
Sales 500,000
Selling expense 85,000
Sales return and allowance 2,500

Instructions:-
1. Prepare statement of cost of goods manufactured and cost goods sold for the year
ended December 31,19x2
2. Prepare the income statement for the year ended December 31,10x2
Action Company

34
 Statement of cost of goods manufactured
For the year ended December 31,19x2
Raw materials
Raw materials, beginning 12,000
Purchase 170,000
Freight in 4,000
Less: - purchase return and allowance 2,500
Net purchase 171,500
Total materials available 183,500
Less: - raw material, ending 10,000
Raw materials used 173,500
Direct labor 85,000
Manufacturing over head
Indirect labor 18,000
Indirect material and supplies 3,000
Depreciation-factory plant and equipment 7,500
Insurance expense-factory 1,500
Payroll taxes expense-factory 4,000
Utilities factory 7,500
Property taxes-factory 3,000
Repair and maintenance factory 4,000
Total manufacturing over head 48,500
Total current manufacturing cost 307,000
Add: - work in process beginning 16,000
Less: - work in process ending 14,000
Cost of goods manufactured 309,000
Cost of goods sold- schedule
Finished goods, beginning 43,000
Add: cost of goods manufactured 309,000
Total cost of goods available for sale 352,000
Less: - finished goods, ending 52,000

35
 Cost of goods sold 300,000

Action Company
Income statement
For the year ended Dec 31,19x2

Sales 500,000
Less: - sales return and allowance 2,500
Net sales 497,500
Less: - cost of goods sold 300,000
Gross profit 197,500
Less: -Administrative expense 30,000
Selling expense 85,000
Income before tax 82,500

Illustration -2

Sunny company’s July 1995 cost of goods sold was 700,000 Birr, July 31 work in
process was 80% of July 1 work in process. Direct labor cost was 90% of manufacturing
overhead costs. During July 220,000 Birr of direct materials were purchased. Other July
information’s are as follows:-
Inventories July 1 July 31
Direct materials 54,600 50,000
Work in prices 80,000 ?
Finished goods 219,000 211,800
Required:-
1. Prepare a schedule of cost of goods sold for July
2. Prepare the July’s cost of cost of goods manufactured schedule
3. What was the amount of prime and conversion costs incurred in July?

36
 1. Cost of goods sold schedule

Fished goods, beginning 219,000

Add: - cost of goods manufacturing (CGM) X
Less: - finished goods ending 211,800
Cost of goods sold (CGS) 700,000
CGS =Finished goods, big + CGM – Finished goods, ending
700,000 = 219,000 + X - 211,800
CGM(X) = 700,000 + 211,800 – 219,000
CGM(X) = 692,800 Br.
Cost of manufactured = 692,800
2. Cost of goods manufactured schedule
Direct material, beginning 54,600
Add:-direct material purchased 220,000
Less: - direct material ending 50,000
Direct materials used 224,600
Direct labor 0.9 MOH
Manufacturing over head (MOH) 1MOH
Add: - work in process, beginning 80,000
Less: - work in process, ending (80,000x0.8.) 64,000
Cost of goods manufactured. 692,800

224,600+0.9MOH+MOH+80,000-64,000=692,800
224,600+1.9MOH+80,000-64,000 = 692,800
1.9MOH = 692,800-240,600
MOH= 238,000 Birr
Direct labor = 238,000x0.9
=214,200 Birr
3. Prime cost = Direct material + Direct labor

37
 = 224,600+214,200
= 438,800 Birr
Conversion cost = Direct labor + Manufacturing over head
= 214,200+238,000
= 452,200 Birr

2.9. IDENTIFYING
THE COST ACCOUNTING SYSTEM

Compared to financial accounting, cost accounting is relatively a recent development. The

vital importance of cost accounting has emerged because of the growth and complexity of the
modern industry. Financial information supplied by financial accounting in the form of
financial statement relates to past activity. Where as, cost accounting is not so restricted and is
concerned with the ascertainment of past, present, and expected future costs of the products
manufactured and services supplied.

Therefore, the primary objectives of cost accounting system are ascertainment of cost,
fixation of price, proper recording and presentation of cost data to the management for
measuring efficiency and for cost control. In cost accounting system terms such as cost,
costing, cost accounting, expenses, losses has to be clarified clearly.
Some of the definitions of cost are presented below.
1. A cost is the value of economic resources used as a result of producing or
doing the thing. In other words, cost is the amount of expenditure related to a
specific thing or activity.
2. A cost is the amount of resources given up in exchange for some goods or
services. Cost is an exchange price or a sacrifice made to secure benefit.

Basically, when cost is incurred, it could be in the form of deferred costs (asset) or expired
costs (expense).Deferred costs are unexpired costs which provide benefits in the future
periods and are known as assets. For example equipment, building, machinery and so on.

38
When the deferred cost (assets) are used up, to the extent used they will become an expense.
In other words, expenses are expired costs incurred and used up in the process of generating
revenue. These expenses are then matched against the revenue that they helped to generate.
Examples of expenses include depreciation expense, selling expense, office salaries etc.
In contrast, losses are reduction in the firm’s equity for which no compensating value has
been received. A loss is an expired cost resulting from the decline in the service potential of
an asset that generates no benefit to the firm. Obsolescence or destruction of stock by fire is
an example of loss.
Costing simply means ascertainment of costs. It includes the techniques and process of
ascertaining and determining costs. The technique consists of principles and rules which are
applied for ascertaining costs of products manufactured and services rendered.
The process includes the day to day routine activity of determining costs with in the method
of costing adopted by a business enterprise. Generally, costing refers to the technique and
process of determining costs of product manufactured or services rendered.

METHODS OF COSTING
There are two major types of costing a product or service:-
1. Job order costing system
2. Process costing system
1. Job order costing system
Job order costing is used in those business concerns where production is
carried out as per the customer’s order and specifications. That means, each
job or product is considered to be separate and distinct from the other jobs or
products.
Therefore, under this method costs are collected and accumulated for each job,
work order, or project separately.
This method is adopted in furniture manufacturers, construction companies,
printing (publishing) companies, accounting firms, research firms etc

2. Process costing system

39
 This costing system is used in those industries where manufacturing is done
continuously through different processing cycles. Companies which are using
this method produce homogeneous or similar products in a repetitive manner
through different process. The finished product for one process becomes the
raw material for the subsequent process.
This method of costing is suitable for textile industries, chemical industries,
paper manufacturers, cement factories etc.

2.9. SUMMARY

Management must watch costs closely in order to operate efficiently and achieve maximum
profits. Cost information permits more effective control of operations through the pinpointing
of unit costs. A statement of cost of goods manufactured is prepared to further explain the cost
of goods sold and support the income statement. Specific, up-to- date and pertinent cost
figures also help management in estimating, planning, budgeting, and evaluating.
Manufacturing costs are classified as direct materials, direct labor, and manufacturing
overhead. Manufacturing overhead is sub classified into indirect material, indirect labor, and
other manufacturing overhead.
There are two major systems for accumulating costs. The job order costing system is used
when goods are produced for a specific order. The process cost system is used when similar
goods are produced in a continuous flow. When a firm does some manufacturing on a job
basis, or a specific order basis, and some on a continuous basis, both costing systems can be
used.

2.10.Glossary
 Cost accounting can be defined as, the process of determining and accumulating the
cost of some particular product or activity.
 Costing refers to the technique and process of determining costs of product
manufactured or services rendered.
 The personals who work directly with the raw materials in converting them to finished
goods represent direct labor.

40
 Direct materials are those materials used in the manufacturing processes and that
become the significant part of the finished goods.
 Job order costing is used in those business concerns where production is carried out
as per the customer’s order and specifications.
 All cost incurred in the factory that can not be considered as direct materials or direct
labor are classified as manufacturing over head, factory over head, indirect
manufacturing cost, manufacturing overhead expenses or factory burden.
 Process costing is used in those industries where manufacturing is done continuously
through different processing cycles.

41