School Of Management

MBA second trimester

202 - Management Accounting & Cost Accounting

An Assignment on

(Cost Accounting)

SUBMITTED TO: Submitted By:

Faisal Hakimzad
Dr. Rakhi Shukla
MBAN1MG20065
Cost Accounting

Cost accounting is the reporting and analysis of a company's cost structure. Cost
accounting is a process of assigning costs to cost objects that typically include a
company's products, services, and any other activities that involve the company.

Cost accounting is helpful because it can identify where a company is spending its
money, how much it earns, and where money is being lost. Cost accounting aims to
report, analyze, and lead to the improvement of internal cost controls and efficiency.
In short, cost accounting is a system of operational analysis for management.

Even though cost accounting is commonly referred to as a costing method, the scope
of cost accounting is far broader than mere cost. Cost accounting has elements of
traditional bookkeeping, system development, creating measurable information, and
input analysis.

Modern methods of cost accounting first emerged in the manufacturing industries,

though its advantages helped it spread quickly to other sectors. For many firms, cost
accounting helps create and measure business strategy in a more organic way.
Companies that are looking to expand their product line would need to understand the
cost structure. Cost accounting helps management plan for future capital
expenditures, which are large purchases of plant and equipment.

Types of Costs in Cost Accounting

Although there are many types of costs that businesses can incur depending on their
industry, below are a few of the most common costs involved in cost accounting.

 Direct Costs
A direct cost is a cost that's directly tied to the production of a product and typically
includes direct materials, labor, and distribution costs. Inventory, raw materials, and
employee wages for factory workers are all examples of direct costs.

 Indirect Costs
Indirect costs can't be directly tied to the production of a product and might include
the electricity for a factory.
  Variable Costs
Costs that increase or decrease with production volumes tend to be classified
as variable costs. A company that produces cars might have the steel involved in
production as a variable cost.

 Fixed Costs
Fixed costs are the costs that exist to keep the company running and don't fluctuate
with sales and production volumes. The lease on a factory building or equipment
would be classified as fixed costs.

 Operating Costs
Operating costs are the costs to run the day-to-day operations of the company.
However, operating costs—or operating expenses—are not usually traced back to the
product being manufactured and can be fixed or variable.

Objectives of Cost Accounting

Often, the simplest and most important objective of cost accounting is to determine
selling prices. A business that sells sandwiches, for example, would need to track the
cost of bread, lettuce, sandwich meats, mustard, and other ingredients. Otherwise, it
would be difficult to calculate how much to charge for a sandwich.

Cost accounting is also used to help with cost controls. Firms want to be able to spend
less on their inputs and charge more for their outputs. Cost accounting can be used to
identify inefficiencies and apply the necessary improvements needed to control costs.
These controls can include budgetary controls, standard costing, and inventory
management.

Cost accounting can help with internal costs such as transfer prices for companies that
transfer goods and services between divisions and subsidiaries. For example, a parent
company overseas might be the supplier for its U.S. subsidiary, meaning the U.S.
company would be charged by the parent for any purchases of materials.

Cost accounting can contribute to the preparation of the required financial statements,
an area otherwise reserved for financial accounting. The prices and information
developed and studied through cost accounting are likely to make it easier to gather
information for financial accounting purposes. For example, raw material costs and
inventory prices are shared between both accounting methods.

Entrepreneurs and business managers rely on actionable information before making

allocation decisions. Cost accounting buoys decision-making because it can be
tailored to the specific needs of each separate firm. This is different than financial
accounting, in which GAAP and International Financial Reporting Standards (IFRS)
regulate method and presentation.21

Importance of cost accounting

Cost accounting has many advantages. Here are some of the ways it can help a
business:

1. Controlling costs: Cost accounting helps the management foresee the cost price
and selling price of a product or a service, which helps them formulate business
policies. With cost value as a reference, the management can come up with techniques
to control costs with an aim to achieve maximum profitability.
2. Determining the total per-unit cost: Cost accounting techniques help in
determining the total per-unit cost of a product or a service, so that the business can
fix the selling price for it.
3. Showing profitable and non-profitable activities: This information helps the
management put an end to non-profitable activities while developing and expanding
the profitable ones.
4. Comparing costs over time: The data in the cost sheets prepared for various time
periods helps in comparing the cost for the same product or a service over a period of
time.

Elements of cost in cost accounting

The elements of cost are broadly classified into material, labor, and expenses. Each of
them is further divided into direct and indirect costs. The indirect material, labor and
expenses can be categorized as overhead costs.

Let’s take a detailed look at these elements.

 1. Material cost: This is the cost of the basic substances that are used to produce
an item. It can be further classified into direct material and indirect material.
 Direct material: Materials which are directly involved in the manufacturing of a
product and are present in the finished product constitute direct material. For
example, wood used to make furniture, or cloth used to make a shirt.
 Indirect material: Materials which are instrumental in the production of finished
goods but cannot be assigned to specific physical units. For example, a pair of
scissors to cut the cloth for the shirt, or a saw to cut the wood for furniture.
2. Labor cost: These are the human resources required to convert materials into
finished goods. They can be further classified into direct and indirect labor.
 Direct labor: People who are involved actively during the manufacturing of
products. For example, production or manufacturing labor.
 Indirect labor: Employees who are not directly involved in the manufacturing
process and whose labor cannot be assigned to one particular product. For
example, sales representatives and directors.
3. Expenses: Costs incurred by a business, other than material and labor costs,
generally fall under this category. They are further divided into direct and
indirect expenses.
 Direct expenses: These are also called chargeable expenses and are usually
associated with specific cost units. For example, direct labor, cost of raw
materials, utilities, and rent.
 Indirect expenses: All expenses that do not fall under direct expenses are
considered indirect expenses. For example, printing costs, utility bills, and legal
consultation.
4. Overhead costs: The general understanding is that overhead costs are similar
to indirect expenses. But overhead actually has a wider meaning, which includes
indirect labor, indirect material, and indirect expenses.

Overhead costs can be classified into the following three categories:

1. Factory overhead: This includes overhead cost incurred due to

manufacturing, production, or any other type of cost that is responsible for the
smooth functioning of a factory. For example, factory rent, insurance, and
utilities.
2. Office and administrative overhead: These are expenses connected to the
management and administration of a business. For example, office rent,
printers, and stationery.
 3. Selling and distribution overhead: These are expenses related to marketing a
product, acquiring orders, and dispatching goods and services.

Methods of cost accounting

There are four main types of cost accounting techniques.

1. Standard cost accounting: This type of cost accounting uses ratios to check
the utilization of labor and goods to produce goods in a standard environment.
This assessment is called a variance analysis. However, this method is
somewhat dated. When it was introduced a century ago, it made sense to use
labor as the only cost measurement, as it was an important cost driver. With
time, overhead costs have increased compared to labor.

2. 2. Activity-based cost accounting: In this method, the cost of each activity

performed in an organization is allocated to a specific product or service. The
way in which these costs are assigned to cost objects is first decided by
performing activity analysis. This improves the costing accuracy of products
and services.

3. Lean accounting: This is a compilation of principles and processes that

provides numerical feedback to manufacturers applying lean manufacturing and
inventory practices. Lean manufacturing helps management accelerate
processes, eradicate errors, and free up production capacity.
Lean accounting does not rely on activity-based costing or standard costing;
instead, it uses visual and lean-focused performance measurements.

4. Marginal costing: Marginal cost is defined as the additional cost involved in

manufacturing an extra unit of output. This method is also called the cost-profit-
volume analysis. Marginal cost analysis looks at the relationship between
production volume, selling price, costs, expenses and profits. It is calculated by
subtracting variable cost from revenue, then dividing by revenue.
ESSENTIALS OF A GOOD COSTING SYSTEM
A high-quality cost accounting system in one that achieves the objectives of costing in
the best possible way and brings benefits to the business. An ideal system of costing
should possess the following characteristics:

1. Simplicity
The costing system should be simple to operate and easy to understand. The facts,
figures, and other information revealed by cost accounts should be presented in a way
that makes them easy to grasp. As such, the needless elaboration of costing records
should be avoided.

2. Suitability to the Business

The costing system should be devised so as to suit the conditions, requirements, nature,
and size of the business. A costing system that serves the enterprise’s purposes and
supplies necessary information for running the business is an ideal system for that
business.

3. Economy
For the costing system to become a profitable investment for the business, the cost of
installing and operating the system must be within the organization’s financial
capacity.

4. Elasticity
The costing system should be elastic and capable of adapting to changing conditions.
As such, it must not be rigid. It should, in particular, be capable of handling a large
volume of work and also dealing with changes in the nature of business.

5. Accuracy
The costing system should ensure the accuracy of the records that are maintained. If
the costing records maintained are not correct or accurate, the results or conclusions
drawn from them are bound to be inaccurate and misleading.

6. Comparability
Costing records must be presented in a standardized form, enabling a comparative
study of costing results across different periods.
7. Promptness
An ideal system of costing is one in which information necessary for its functioning
are promptly, easily, and punctually available.

Promptness can be ensured if arrangements are made for the timely supply of records
from different business units (e.g., records concerning materials, labor, or overheads)
to the costing office.

Once the costing office receives the information, the obtained data should also be
analyzed and recorded in a timely way to ensure promptness.

8. Reconciliation of Results
The costing system should be maintained so as to make the task of reconciling cost
accounts with financial accounts easy and simple. This reconciliation is essential for
checking the accuracy of cost accounts and also for measuring the efficiency of the
costing system.

Classification of Costs
Classification of Costs essentially means the grouping of costs according to their similar
characteristics. Now, in costing there are a dozen ways to classify costs as per their
nature, functions, traceability etc. Here we will be focussing on five such classifications.
Let us learn this in detail.

1. Classification by Nature
This is the analytical classification of costs. Let us divide as per their natures. So basically
there are three broad categories as per this classification, namely Labor Cost, Materials
Cost and Expenses. These heads make it easier to classify the costs in a cost sheet. They
help ascertain the total cost and determine the cost of the work-in-progress.

 Material Costs: Material costs are the costs of any materials we use in the
production of goods. We divide these costs further. For example, let’s divide
material costs into raw material costs, spare parts, costs of packaging material
etc.
  Labor Costs: Labor costs consists of the salary and wages paid to permanent and
temporary employees in the pursuit of the manufacturing of the goods

 Expenses: All other expenses associated with making and selling the goods or
services.

2. Classification by Functions
This is the functional classification of costs. So the classification follows the pattern of
basic managerial activities of the organization. The grouping of costs is according to the
broad divisions of functions such as production, administration, selling etc.

 Production Costs: All costs concerned with actual manufacturing or construction

of the goods
 Commercial Costs: Total costs of the operation of an enterprise other than the
manufacturing costs. It includes the admin costs, selling and distribution costs
etc.

3. Classification by Traceability
This aspect one of the most important classification of costs, into direct costs and indirect
costs. This classification is based on the degree of traceability to the final product of the
firm.

 Direct Costs: So these are the costs which are easily identified with a specific cost
unit or cost centers. Some of the most basic examples are the materials used in the
manufacturing of a product or the labor involved with the production process.

 Indirect Costs: These costs are incurred for many purposes, i.e. between many cost
centers or units. So we cannot easily identify them to one particular cost center.
Take for example the rent of the building or the salary of the manager. We will not
be able to accurately determine how to ascertain such costs to a particular cost unit.

4. Classification by Normality
This classification determines the costs as normal costs and abnormal costs. The norms
of normal costs are the costs that usually occur at a given level of output, under the same
set of conditions in which this level of output happens.
 Normal Costs: This is a part of the cost of production and a part of the costing profit
and loss. These are the costs that the firm incurs at the normal level of output in
standard conditions.

 Abnormal Costs: These costs are not normally incurred at a given level of output
in conditions in which normal levels of output occur. These costs are charged to the
profit and loss account, they are not a part of the cost of production.

Difference Between Cost Accounting and Financial Accounting

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.
BASIS FOR COST ACCOUNTING FINANCIAL
COMPARISON ACCOUNTING

Cost Accounting is an Financial Accounting is an

accounting system, through
which an organization keeps
Meaning the track of various costs
incurred in the business in
production activities.
Records the information
related to material, labor and
Information type overhead, which are used in
the production process.
Both historical and pre-
Which type of cost is used determined cost
for recording?
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.
Records the information which
are in monetary terms.
Only historical cost.
 Information provided by the
cost accounting is used only
by the internal management of
Users the organization like
employees, directors,
managers, supervisors etc.
Users of information provided
by the financial accounting are
internal and external parties
like creditors, shareholders,
customers etc.

At cost Cost or Net Realizable Value,

Valuation of Stock whichever is less.

No, except for manufacturing Yes for all firms.

Mandatory firms it is mandatory.

Details provided by cost Financial statements are

accounting are frequently reported at the end of the
Time of Reporting prepared and reported to the accounting period, which is
management. normally 1 year.

Generally, the profit is Income, expenditure and profit

analyzed for a particular are analyzed together for a
product, job, batch or process. particular period of the whole
Profit Analysis
entity.

Reducing and controlling Keeping complete record of

Purpose costs. the financial transactions.

Forecasting is possible Forecasting is not at all

through budgeting techniques. possible.
Forecasting

Key Differences Between Cost Accounting and Financial Accounting

The following are the major differences between cost accounting and financial
accounting:
 Cost Accounting aims at maintaining cost records of an organisation. Financial
Accounting aims at maintaining all the financial data of an organisation.
 Cost Accounting Records both historical and per-determined costs. Conversely,
Financial Accounting records only historical costs.
 Users of Cost Accounting is limited to internal management of the entity,
whereas users of Financial Accounting are internal as well as external parties.
 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 realisable value.
 Cost Accounting is mandatory only for the organisation which is engaged in
manufacturing and production activities. On the other hand, Financial
Accounting is mandatory for all the organisations, as well as compliance with the
provisions of Companies Act and Income Tax Act is also a must.
 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.
 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 organisation made during a particular period.
 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.

Economic Order Quantity (EOQ)

conomic order quantity (EOQ) is a calculation companies perform that represents their
ideal order size, allowing them to meet demand without overspending. Inventory
managers calculate EOQ to minimize holding costs and excess inventory.
It doesn’t matter if your business sells jelly beans, appliances, furniture or airplanes.
Finding the economic order quantity for every product you purchase is almost certain
to impact the bottom line. Every business that manages inventory can benefit from
measuring and following the EOQ.
Economic order quantity is a useful metric for businesses that buy and hold inventory
for manufacturing, resale, internal use or any other purpose. Businesses that follow
EOQ look at all costs related to purchasing and delivery while also factoring in demand
for the product, purchase discounts and holding costs.
Experienced business owners and managers understand that purchasing and finding
the ideal inventory levels can be complex. When your vendors offer volume discounts
and other incentives to purchase more, EOQ can help you decide on the right place to
draw the line.
EOQ relies on the economic order quantity formula (found below). That gives you a
data-driven result to help optimize business profitability.
The economic order quantity formula
Calculating Economic Order Quantity (EOQ)
Calculating economic order quantity requires high school-level algebra. Once you
get the variables from your inventory management system, it’s easy to plug in the
numbers and calculate EOQ. When you use a robust ERP, these calculations may all
be handled for you, including order costs like inventory ordering costs, holding costs
and stock out costs.
Three Variables (or Inputs) Used to Calculate EOQ
There are several variations of the formula used to calculate EOQ. One popular EOQ
formula is based on these variables, also called inputs:
D = Demand in units (annual)
S = Order cost
H = Holding costs (per unit, per year)
Economic Order Quantity (EOQ) Formula
EOQ = √ [2DS/H]
EOQ Examples
To best understand how economic order quantity works, here’s an example. Let’s say
a business uses its ERP platform to determine demand, order cost and holding costs
per unit, per year over the last year and expects similar demand next year.
Demand from last year was 10,000 units. The average order cost was $5,000. The
holding cost is $3 per unit, per year.
EOQ = √ [2 x D x S / H]

= √ [ (2 x 10,000 x $5,000) / $3]

= √ [33,333,333.33]
= 5,774 units
Based on this company’s results, the economic order quantity is 5,774 units per order,
roughly twice per year. The EOQ model assumes that demand is constant, and that
inventory is depleted at a fixed rate until it reaches zero. At that point, a specific
number of items arrive to return the inventory to its beginning level. Since the model
assumes instantaneous replenishment, there are no inventory shortages or associated
costs. Therefore, the cost of inventory under the EOQ model involves a tradeoff
between inventory holding costs (the cost of storage, as well as the cost of tying up
capital in inventory rather than investing it or using it for other purposes) and order
costs (any fees associated with placing orders, such as delivery charges). Ordering a
large amount at one time will increase a small business's holding costs, while making
more frequent orders of fewer items will reduce holding costs but increase order costs.
The EOQ model finds the quantity that minimizes the sum of these costs.
The basic EOQ relationship is shown below. Let us look at it assuming we have a
painter using 3,500 gallons of paint per year, paying $5 a gallon, a $15 fixed charge
every time he/she orders, and an inventory cost per gallon held averaging $3 per gallon
per year.

Prepared By:

Faisal Hakimzad
MBAN1MG20065