College of Accountancy

MODULE 1 Module No./Title: 1 – Introduction

to Cost Accounting and Cost
Concepts

Subject Description: Cost Accounting and Control Period of Coverage: Week 1

Objectives:
1. To define and differentiate cost accounting to financial accounting.
2. To identify and describe the cost concepts.

Content:

Cost Accounting refers to that branch of accounting which deals with costs incurred in the
production of units of an organization. On the other hand, financial accounting refers to the
accounting concerned with recording financial data of an organization, in order to exhibit exact
position of the business.

Cost accounting generates information so as to keep a check on operations, with an aim of

maximizing profit and efficiency of the concern. Conversely, Financial accounting ascertains the
financial results, for the accounting period and the position of the assets and liabilities on the last day
of the period. There is no comparison between these two because they are equally important for the
users. This article presents you the difference between cost accounting and financial accounting in
tabular form.

Content: Cost Accounting Vs Financial Accounting

Comparison Chart
BASIS FOR
COST ACCOUNTING FINANCIAL ACCOUNTING
COMPARISON

Meaning Cost Accounting is an Financial Accounting is an

accounting system, through
which an organization keeps
the track of various costs
incurred in the business in
production activities.
accounting system that
captures the records of
financial information about the
business to show the correct
financial position of the
company at a particular date.
Information type Records the information
related to material, labor
and overhead, which are
used in the production
process.
Which type of Both historical and pre-
cost is used for determined cost
recording?
Users Information provided by the
cost accounting is used only
by the internal management
of the organization like
employees, directors,
managers, supervisors etc.
Valuation of At cost
Stock
Mandatory No, except for
manufacturing firms it is
mandatory.
Time of Details provided by cost
Reporting accounting are frequently
prepared and reported to
the management.
Profit Analysis Generally, the profit is
analyzed for a particular
product, job, batch or
process.
Purpose Reducing and controlling
costs.
Forecasting Forecasting is possible
Records the information which
are in monetary terms.
Only historical cost.
Users of information provided
by the financial accounting are
internal and external parties
like creditors, shareholders,
customers etc.
Cost or Net Realizable Value,
whichever is less.
Yes, for all firms.
Financial statements are
reported at the end of the
accounting period, which is
normally 1 year.
Income, expenditure and profit
are analyzed together for a
particular period of the whole
entity.
Keeping complete record of the
financial transactions.
Forecasting is not at all
 through budgeting possible.
techniques.

Definition of Cost Accounting

Cost Accounting is the field of accounting that is used to record, summarize and report the cost
information on a periodical basis. Its primary function is to ascertain and control costs. It helps the
users of cost data to make decisions regarding the determination of selling price, controlling costs,
projecting plans and actions, efficiency measurement of the labor, etc.

Cost Accounting adds to the effectiveness of the financial accounting by providing relevant
information which ultimately results in the good decision-making process of the organization. It traces
the cost incurred at each level of production, i.e. right from the input of the material till the output
produced, each and every cost is recorded.

Definition of Financial Accounting

Financial Accounting is the branch of accounting, which keeps the complete record of all monetary
transactions of the entity and reports them at the end of the financial period in proper formats that
increases readability of the financial statements among its users. The users of financial information
are many i.e. from internal management to outside parties.

Preparation of financial statement is the major objective of financial accounting in a specified manner
for a particular accounting period of an entity. It includes Income Statement, Balance Sheet, and
Cash Flow Statement which helps in, tracing out the performance, profitability and financial status of
an organization during a period.

The information provided by the financial accounting is useful in making comparisons between
different organizations and analyzing the results thereof, on various parameters. In addition to this,
performance and profitability of various financial periods can also be compared easily.

Key Differences Between Cost Accounting and Financial Accounting

The following are the major differences between cost accounting and financial accounting:

1. Cost Accounting aims at maintaining cost records of an organization. Financial Accounting

aims at maintaining all the financial data of an organization.
2. Cost Accounting Records both historical and predetermined costs. Conversely, Financial
Accounting records only historical costs.
3. Users of Cost Accounting is limited to internal management of the entity, whereas users of
Financial Accounting are internal as well as external parties.
4. In cost, accounting stock is valued at cost while in financial accounting, the stock is valued at
the lower of the two i.e. cost or net realizable value.
 5. Cost Accounting is mandatory only for the organization which is engaged in manufacturing
and production activities. On the other hand, Financial Accounting is mandatory for all the
organizations, as well as compliance with the provisions of Companies Act and Income Tax
Act is also a must.
6. Cost Accounting information is reported periodically at frequent intervals, but financial
accounting information is reported after the completion of the financial year i.e. generally one
year.
7. Cost Accounting information determines profit related to a particular product, job or process.
As opposed to Financial Accounting, which determines the profit for the whole organization
made during a particular period.
8. The purpose of Cost Accounting is to control costs, but the purpose of financial accounting is
to keep complete records of the financial information, on the basis of which reporting can be
done at the end of the accounting period.
Conclusion

So, above are the most important differences between the Cost Accounting and Financial
Accounting. The information provided by the Cost Accounting is helpful in the decision making of the
managers to control costs, but it lacks comparability. The information provided by the financial
accounting is capable of making comparisons, but future forecasting cannot be done through this
information. That is why they both go side by side, in fact, cost accounting data is helpful for financial
accounting.

COST CONCEPTS:

Cost is "a foregoing, measured in monetary terms, incurred or potentially to be incurred to achieve a
specific objective".
Cost refers the monetary measure of the amount of resources given up or used for some specified
purpose. It is the value the goods or services expended to obtain current or future benefits.
Costs can be classified in different ways. There are manufacturing costs and non-manufacturing
costs, direct and indirect costs, product and period costs, controllable and uncontrollable costs, fixed
and variable, etc.
Management accountants need to understand cost concepts because they are vital in many areas of
planning, control, and decision-making. In this unit, we will learn about the different types of costs
and product costing systems.
 
1. TYPES OF COSTS: COST CLASSIFICATIONS:
Costs can be classified into different categories for different purposes.
Costs may be categorized according to their: (1) management function, (2) ease of traceability, (3)
timing of charge against revenue, (4) behavior in accordance with activity, and (5) relevance to
decision making.

According to Management Function

1. Manufacturing costs - incurred in the factory to convert raw materials into finished goods. It
includes cost of raw materials used (direct materials), direct labor, and factory overhead.
2. Nonmanufacturing costs - not incurred in transforming materials to finished goods. These
include selling expenses (such as advertising costs, delivery expense, salaries and commission of
salesmen) and administrative expenses (such as salaries of executives and legal expenses).

According to Ease of Traceability

1. Direct costs - those that can be traced directly to a particular object of costing such as a
particular product, department, or branch. Examples include materials and direct labor. Some
operating expenses can also be classified as direct costs, such as advertising cost for a particular
product.
2. Indirect costs - those that cannot be traced to a particular object of costing. They are also called
common costs or joint costs. Indirect costs include factory overhead and operating costs that benefit
more than one product, department, or branch.

According to Timing of Charge against Revenue

1. Product costs - are inventoriable costs. They form part of inventory and are charged against
revenue, i.e. cost of sales, only when sold. All manufacturing costs (direct materials, direct labor, and
factory overhead) are product costs.
2. Period costs - are not inventoriable and are charged against revenue immediately. Period costs
include non-manufacturing costs, i.e. selling expenses and administrative expenses.

According to Behavior in Accordance with Activity

1. Variable costs - vary in total in proportion to changes in activity. Examples include direct
materials, direct labor, and sales commission based on sales.
2. Fixed costs - costs that remain constant regardless of the level of activity. Examples include rent,
insurance, and depreciation using the straight line method.
3. Mixed costs - costs that vary in total but not in proportion to changes in activity. It basically
includes a fixed cost portion plus additional variable costs. An example would be electricity expense
that consists of a fixed amount plus variable charges based on usage.

According to Relevance to Decision Making

1. Relevant cost - cost that will differ under alternative courses of action. In other words, these costs
refer to those that will affect a decision.
2. Standard cost - predetermined cost based on some reasonable basis such as past experiences,
budgeted amounts, industry standards, etc. The actual costs incurred are compared to standard
costs.
3. Opportunity cost - benefit forgone or given up when an alternative is chosen over the other/s.
Example: If a business chooses to use its building for production rather than rent it out to tenants, the
opportunity cost would be the rent income that would be earned had the business chose to rent out.
4. Sunk costs - historical costs that will not make any difference in making a decision. Unlike
relevant costs, they do not have an impact on the matter at hand.
5. Controllable costs - refer to costs that can be influenced or controlled by the manager. Segment
managers should be evaluated based on costs that they can control.

2. MANUFACTURING AND NON-MANUFACTURING COSTS:

Costs, when categorized according to function, can be classified into: (1) manufacturing costs and
(2) non-manufacturing costs.
Manufacturing Costs
Manufacturing costs refer to those that are spent to transform materials into finished goods.
Manufacturing costs include direct materials, direct labor, and factory overhead.
Direct materials - cost of items that form an integral part of the finished product. They refer to the
major parts or ingredients. Examples include wood in furniture, steel in automobile, water in bottled
drink, fabric in shirt, etc.
Direct labor - cost of labor expended directly upon the materials to transform them into finished
goods. Direct labor refers to salaries and wages of employees who work to convert the raw materials
to finished goods.
Factory overhead - also called manufacturing overhead, refers to all costs other than direct
materials and direct labor spent in the production of finished goods. Factory overhead
includes indirect materials such as cost of nails, thread, glue, etc.; indirect labor such as salary of the
supervisor; and factory expenses such as rent of the factory space, depreciation of factory
equipment, utilities expense of the factory, factory supplies, etc.
Manufacturing costs are also known as factory costs or production costs.

Non-manufacturing Costs
Non-manufacturing costs refer to those incurred outside the factory or production department. These
are costs are not needed in transforming materials into finished goods. Non-manufacturing costs
include: selling expenses and general expenses.
Selling Expenses - also called Selling and Distribution Expenses. Examples include advertising
costs, salaries and commission of sales personnel, storage costs, shipping and delivery, and
customer service.
General Expenses - also called General and Administrative Expenses. Examples are: executive
salaries, salaries of administrative staff, accounting expenses, legal expenses, research and
development, and other costs related to general administration of the organization.

3. DIRECT COSTS and INDIRECT COSTS:

Costs, when categorized according to traceability to the product or cost object, can be classified into:
(1) direct costs and (2) indirect costs.

Direct Costs
Direct costs are those that can be easily traced to or associated directly with a specific cost object. A
cost object is something for which cost is measured such as a specific product, a specific department
or a specific branch.
For example, ABC Company produces plastic food containers. The cost of plastic used in production
can be easily traced to the food containers. However, the cost spent for electricity is not directly
traceable to the food containers since such cost was not used solely for the production of the
product.
Examples of direct costs include direct materials, direct labor, and other costs incurred for a
particular product such as advertising and promotion costs for, say "Product A".
If the cost object is a department or a branch, all costs that can be associated directly to a particular
department or branch are direct costs. For example, salaries of sales personnel are directly
traceable to the selling department of the organization. Also, the salaries of the sales personnel of
"Branch A" can be traced directly to that branch.

Indirect Costs
Indirect costs are difficult to trace directly to a specific cost object. These costs are commonly shared
by multiple products, different departments, or branches; hence, such costs cannot practically be
traced to a cost object.
Examples of indirect costs include factory overhead costs, organization-wide advertising, taxes, and
other common or joint costs.

4. PRODUCT COSTS and PERIOD COSTS:

Costs, when categorized according to the timing of charge against revenue, can be classified into:
(1) product costs and (2) period costs.
Product Costs
Product costs refer to inventoriable costs. These costs are included as part of inventory and are
charged against revenues as cost of sales only when sold. In other words they are initially
classified as assets and are transferred to expense when they are sold.
All manufacturing expenses (i.e., direct materials, direct labor, and factory overhead) are product
costs. Direct materials, direct labor, and factory overhead are combined to form the products to be
sold, hence the term "product costs".
In the accounting records, the cost of finished products is accumulated in an inventory account -
usually "Finished Goods Inventory". When goods are sold, the cost is transferred from "Finished
Goods Inventory" in the balance sheet to "Cost of Sales" (or Cost of Goods Sold) in the income
statement.

Period Costs
Period costs are charged immediately against revenue. Unlike product costs, they are classified as
expenses right away. They are not included in inventory.
Period costs include selling and distribution expenses, and general and administrative expenses.
These costs are presented directly as deductions against revenues in the income statement.

5. CONTROLLABLE COSTS and UNCONTROLLABLE COSTS:

Costs, when categorized in relation to persons regulating them, can be classified into: (1)
controllable costs and (2) uncontrollable costs.
Controllable Costs
Controllable costs are costs that can be influenced or regulated by the manager or head responsible
for it.
For example: direct materials, direct labor, and certain factory overhead costs are controlled by the
production manager. Another example: the sales manager has control over the salary and
commission of sales personnel.
Uncontrollable Costs

From the term itself, uncontrollable costs are those that are not under the control of a specified
manager. These cannot be influenced by decisions or actions of the manager. These costs are
imposed by the top management or allocated to several departments. For example, a company-wide
advertising cost that is allocated by the central office to different departments is not under the control
of the department heads.
Other examples include depreciation, insurance, share in rent, share in organization-wide security
costs, etc.
6. PRIME COSTS and CONVERSION COSTS:
Manufacturing costs (direct materials, direct labor, and factory overhead) can be classified further
into: (1) prime costs and (2) conversion costs.
Prime Costs
Prime costs refer to the total cost of direct materials and direct labor.
Direct materials pertain to cost of items that form an integral or major part of the finished product.
Examples are steel in automobiles, rubber in tires, fabric in clothing, etc. Direct labor refers to the
salaries and wages of workers who transform the materials into finished goods.
Conversion Costs
Conversion costs refer to those that are spent to transform raw materials into finished goods, i.e.
direct labor and factory overhead.
Direct labor, as mentioned above, refers to the salaries of production workers. Factory overhead
refers to costs incurred in production other than direct materials and direct labor. Factory overhead
includes indirect materials (such as nails, staples, adhesives, etc.), indirect labor (such supervisor's
salary), and factory expenses (factory supplies, utilities, depreciation, and all other expenses
incurred in the factory).
Example
During the month of December, MGM Company used materials costing $360,000. Direct labor cost
amounted to $200,000 and factory overhead is estimated at $250,000 based on direct labor hours.
Compute for the prime costs and conversion costs.
Solution:
Prime costs = Direct materials + Direct labor
$360,000 + $200,000 = $560,000
Conversion costs = Direct labor + Factory overhead
$200,000 + 250,000 = $450,000

Example
ABC Company's prime costs amount to $650,000 while conversion costs amount to $600,000. Total
factory overhead is equal to $320,000. Compute for the cost of direct materials.

Solution:
Conversion costs = Direct labor + Factory overhead
$600,000 = Direct labor + $320,000
Direct labor = $280,000
Prime costs = Direct materials + Direct labor
$650,000 = Direct materials + $280,000 (from above)
Direct materials = $370,000

Prepared by: Maria Corazon S. Guintu, CPA MBA

College Instructor - BSA