Unit 1: Introduction to Cost Accounting

1. The difference between financial accounting and management accounting. 2. The different classifications of costs within an organisation. 3. How to separate fixed and variable costs and use this information for forecasting. 4. Which costs are involved directly in the production of goods and services. 5. How to draw a scatter-graph and use regression analysis for forecasting. 6. The definition and reasoning behind the use of expected values. 7. Use of expected values for forecasting.
The nature and purpose of management Management accounting and management information. The nature of good information. The managerial processes of planning, control & Decision making. Strategic, Tactical &Operational Cost centers, profit centers, investment centers & revenue centers.

INTRODUCTION Accounting is divided into two main areas financial accounting and management accounting. Whereas financial accounting looks at the performance of the organisation (in the past), management accounting looks at providing the information which is used for decision making within the organisation (for the future). Decision making may be on either an operational, tactical or strategic level within the organization. How can we differentiate between these?

Strategic

Long term

Tactical Operational

Medium term Short term

DATA AND INFORMATION Many people assume that data and information are the same. They are not.
Data means facts. Data consists of numbers, letters, symbols, raw facts,

events and transactions which have been recorded but not yet processed into a form suitable for use.

Examples:

The number of tourists who visit Coxs bazar. The sales turnovers of all restaurants in Chittagong. Information is data which has been processed in such a way that it is meaningful to the person who receives it (for making decisions).

For data to be meaningful it must have certain characteristics or attributes. These are many but can be summarised by the acronym ACCURATE. Can you identify? what you think would be an attribute for each of the letters of accurate?

A C C U R A T E

Accurate Complete Cost-effective Understandable Relevant Accessible Timely Easy to use!

What do we use information for? In organisations it is used for planning, decision making and control. Each of these three uses will be highlighted throughout this subject. Before that, how would you describe each of these techniques? Planning: Management needs to decide what the objectives of the company are and how they can be achieved. Management information is used to help management plan the resources that a business will require and how they will be used. Decision making: Management at all levels within a organization take decision. Decision making always involves a choice between alternatives. Information is required that enables management to reach an information decision. Control: Once management puts a plan of action into operation, there needs to be some control over the businesss activities to make sure that they are carrying out the original plans. ORGANISATIONS No organization will operate as a single entity. Each organization would be divided up into various departments. Some of these departments would be dealing with producing our products while others would be providing a service, both to our customers and to our production departments. These will be highlighted later in the course.

All departments need to be responsible for their costs. Cost centre is defined as a production or service location, a function, an activity or an item of equipment for which costs can be ascertained. Revenue centre a centre devoted to raising revenue only. Profit centre a centre accountable for costs and revenues. Investment centre a centre which has its performance evaluated by its return on capital employed. Cost unit a unit of product or services for which costs can be ascertained. These are usually classed in relation to the unit the product is sold in. Examples: Petrol - per liter Paint - per tin Bread - per loaf Using these cost units assist us being able to cost the products made. We also need to identify service units. These will be discussed in the session on service costing. COST CLASSIFICATIONS / BEHAVIOUR Costs in any organization come in many forms and relate to many different things. We can divide or classify these costs into 3 main areas: Materials Labour Overheads Materials and labour costs speak for themselves, however overheads cover many different expenses within the business rent, administration, heating and lighting, motoring the list is endless. As well as dividing the costs into these 3 classifications each cost can be further classified into fixed, variable, stepped and semi-variable. This classification depends upon the behavior of the cost. A fixed cost is just that fixed. We pay the same amount of money per period regardless of whether we produce 0 units, 500 units or 500,000 units. An

example of a fixed cost would be the rent of a building. A fixed sum we pay each period. A fixed cost can be represented in a graph as:

Total cost

Cost per unit

Fixed cost

Level of activity Graph of fixed cost

Level of activity Graph of fixed cost per unit

Variable costs vary with the number of units of production. For example if it costs 5 to make 1 unit we assume that it costs 10 to make 2, 50 to make 10 and so on. A variable cost can be represented in a graph as:
Total cost

Level of activity Stepped costs are fixed costs which are only fixed for a certain level of production. An example of this might be a supervisor in a factory on a salary. Each supervisor is in charge of 20 workers. As soon as we employ more than 20 workers we need to employ another supervisor.

A stepped cost may be represented in a graph as:

Total cost

Level of activity In addition to splitting our costs in this manner, they can also be spilt into direct and indirect categories. Direct costs are those which are directly involved with the making of a product or service. Indirect costs are those which are incurred for other reasons. For instance, the wages of a production worker is said to be a direct cost whilst the wages (salary) of a supervisor would be considered as an indirect cost.We will deal with these classifications in more detail in future sessions. A semi-variable cost contains a fixed and a variable element. An example of this would be an electricity bill where we pay a fixed charge per period plus a variable charge for each unit of electricity consumed. A semi-variable cost can be represented in a graph as:

Total cost

Variable cost

Fixed cost Level of activity

We assume that all these relationships are linear, i.e. the act is a straight line. Unfortunately in practice this does not happen due to economies of scale (discounts for quantity purchases or sales). For the purposes of our studies we will assume that costs react to each other in a linear (straight line) relationship. Costs that are entirely fixed or variable are easy to allocate to products. A semi-variable cost is more difficult. Unless we have accurate data we have to calculate each element so that we can use the information for forecasting. The method we use is called the HIGH-LOW method. It is based upon the equation of a straight line: y = a + bx This can also be represented as: Total cost = fixed cost + (variable cost x no of units) FORECASTING An important part of cost accounting is forecasting for the future. In order to be able to forecast we need to use historic data. We can use one of three methods: 1. High-low method 2. Scatter graphs 3. Regression analysis HIGH-LOW METHOD The idea behind this technique is that if you purchase two types of item, you can deduce the price of one of them if you know the price of the other. EXAMPLE 1: 3 kgs of potatoes and a cabbage cost 1.85 5 kgs of potatoes and a cabbage cost 2.55 How much does 1 kg of potatoes cost? How much does the cabbage cost?

Solution: What we can do here is take the lowest from the highest to find the cost of 2kgs of potatoes. This then enables us to find the price of the cabbage. 5 3 = 2kgs potatoes 2.55 - 1.85 = 0.70 1 kg potatoes = 0.70/2 = 0.35 Cabbage must equal 2.55 (5 x 0.35) = 0.80 In this instance the potatoes are the variable cost and the cabbage is the fixed cost, as it does not change. Exercise 1: The following cost information is available. Output 65,000 units 105,000 units Cost 133,000 210,000 Using the above data, calculate the fixed and variable costs for the business and the total cost for 165,000 units Solution: Variable cost per unit = Total fixed cost = Total cost for 165.000 units = + ( x 165,000 units) = It is essential to master this technique as it is a common examination question and you will be required to use this technique many times during your management accounting studies. When there are more than two pairs of data given we will almost always use the highest and lowest for this technique.