Cost & Mgt. Acct - I, INSTR - Chapter 1 & 2

Addis Ababa University, College of Business & Economics, Department of Accounting & Finance
COST AND MANAGEMENT ACCOUNTING I

CHAPTER I & II
PART ONE
FUNDAMENTALS OF COST ACCOUNTING
1.1 The Major Purposes of Accounting Systems

 Accounting is a major means of helping managers
a. To administer each of the activity or functional areas for which they are
responsible, and
b. To coordinate those functions within the framework of the organization as a
whole.
 Accounting provides information for three major purposes:

1. Routine internal reporting for the decisions of managers-Information that provided
for decisions that occur with some regularity, for example „weekly labour cost
report‟.
2. Non routine internal reporting for decisions of managers-Information that affects
decisions that occur irregularly or without precedent, for example analysis of cost
data that specifically collected for special purpose.
3. External reporting to investors, government authorities, and other outside parties
on the organization‟s financial position, operations, and related activities, for
example providing financial statements for potential investors.
1.2 The Role of an Accountant in an Organization

Any organization has its own organizational structure, which gives an insight
into informational needs of management and the interrelationship between
managers and accountants (particularly management accountant). Moreover,
the organizational structure identifies two basic areas of functions. These are
line functions and staff functions.
Line Functions: These are directly related to the achievement of the basic
objectives of an organization. Workers in this function are called line people
and perform the primary business tasks for which the company is organized.
Cost & Management Accounting I; Instructor: Kassaye Tuji, 2023GC (2015EC) Page 1
For example, in a merchandising firm, line people are engaged in jobs related
to buying and selling of merchandises.
In a manufacturing firm, people in line departments (departments which are
in line functions) perform tasks related to manufacture and sale of products.
Staff Functions: These are indirectly related to the achievement of basic

objectives of the organization. These functions are supportive in nature in
that they provide services or assistances to the line functions, or sometimes
other parts of the organization. Therefore, people in this line perform
activities, which support and facilitate the functions of line departments.
Departments, which give these supporting services, are called staff
departments. For example, in merchandising firms, and manufacturing firms,
activities such as accounting and finance, repair and maintenance, and legal
services are supporting functions and the units (departments) are staff
departments.
Accountants Role:
The above two divisions of functions in an organization can tell what role an
accountant plays. Accordingly, accounting activity is a staff function. Since
the role of staff persons is basically advisory in nature, they have no authority
over line departments. However, their advice is an important input in policy
formulations and other decision-making processes. The accountant, hence, is
a key person in facilitating such decisions. Moreover, the accountant does
have a delegated authority from top management to set policy in accounting
and financial reporting matters, and is therefore, responsible to prescribe and
maintain uniform accounting procedures and to require reports and other
information from line units. In most organizations, the person responsible for
these activities is called a controller.
Accountants have major role for special decision making. As stated above,
cost data play an important role in many decisions made by managers. The
cost data are the output of a cost accounting system, which is operated by an
accountant.
Thus, an accountant has an important role in decision-making process not as a

decision maker but as collector and reporter of relevant cost data.
The accountant serves as a technical expert to operating personnel
responsible for decision-making. The accountant‟s reports must provide valid
data, which are pertinent [useful] to the decision at hand. Many managers
want accountants to offer their recommendations about the proper decision.
The accountant should be able to guide the decision maker to make good
decision.
A good decision is a decision, which is consistent with the objectives of the

decision maker and with the information available. Making a good decision
does not necessarily lead to a good result; the future may bring events, both
favorable and unfavorable, that could not have been predicted by the decision
maker. The quantifiable data are usually predictable. However, there are
qualitative factors that must be considered by the decision maker. The
accountant does not provide these qualitative factors. It is the responsibility
of the decision maker to consider them. It is important to note that the
objectives of the decision maker might lead to selection of an action that is
not the most profitable.
For example, the action that the decision maker expects to give the best
economic results might require doing something that conflict with the policy
of the firm. If the firm is quality conscious, its manager may refuse to take
action that reduce quality and selling price to increase sales volume.
Therefore, qualitative factors could outweigh the quantitative factors
including cost data. Since qualitative factors are usually affected by attitudes
of individual decision maker, managers try to express these factors as much
as possible in quantitative terms.
1.3 Accounting and the Management Process

In the management process accountants involve in the processes and
techniques that focus on the effective use of organizational resources, to
support manager in their tasks of enhancing both customer value and
shareholder value.
 Accounting helps the management process in;

1. Formulating Strategies and Plans
 E.g. New Product Development, Investment Decision, etc.
2. Resource Allocation Decision
 E.g. Product or Customer emphasis
3. Cost Control
 E.g. Planning of Operation and Activities
4. Performance Measurement
 E.g. Evaluation of People and Operation
5. Meeting Legal Requirements
 E.g. External Regulation, Reporting Requirement, etc.
1.4 Accounting Discipline Overview (Financial Accounting, Management Accounting

and Cost Accounting)
 Financial Accounting
 Concerned with providing information to stockholders, creditors and other who are
outside the organization
 Focuses on reporting to external parties.
 It measures and records business transactions and provides financial statements
that are based on GAAPs.
 Management Accounting
 Measures and reports financial and non-financial information that helps managers
to fulfil the goals of the organization.
 Concerned with providing information to mangers, i.e. people inside the
organization who direct and control its operations.
 Focuses on internal reporting.
 Cost Accounting
 Provides information for both management accounting and financial accounting.
 It measures and reports financial and non-financial information that relates to the
cost of acquiring or consuming resources by an organization.
 Includes those parts of both management accounting and financial accounting
where cost information is collected or analysed
 Relationship of Cost Accounting with Financial Accounting and Management

Accounting
Cost Accountancy is an essential part of accountancy, which has been developed to meet
the managerial needs of business. Starting off as a branch of financial accounting, cost
accountancy has developed so fast in the last few decades that it is difficult to give suitable
definition, which fully covers its scope.
Further, cost accountancy is regarded as the science, art and practice of cost accountant.
 It is a science in the sense it is body of systematic knowledge having certain
principles, which a cost accountant should follow for the proper discharge of his
duties.
 It is an art, as it requires the ability and skill on the part of a cost accountant in
applying the principles of cost accountancy to various managerial problems.
 Cost Accounting primarily deals with collection, analysis of relevant cost data for
interpretation and presentation for various problems of management.
 Cost accounting is a management information system, which analyses past, present,
and future data to provide the basis for managerial decision making.
 According to Charles T. Horngren Cost Accounting is “a quantitative method
that accumulates, classifies, summarizes, and interprets information for three major
purposes:
(i) Operational planning and control
(ii) Special decisions and
(iii) Regular decisions.
 In general, cost accounting is thus concerned with recording, classifying and

summarizing costs for determination of costs of products or services, planning,
controlling and reducing such costs and furnishing of information to management for
decision making.
Thus Cost Accounting is concerned with
 Accounting the costs
 Controlling the costs
 Reducing the costs
 Purpose of Cost Accounting

Cost accounting has developed as a specialty within the field of accounting at the same
time that business enterprises become more complex. In simpler times, when individual
artisans provided goods and services, elaborate accounting records were unnecessary. An
individual producer could evaluate the viability of the operation simply by comparing
cash receipts to cash disbursements.
With the rise of multiply owned enterprises, owners saw a need to develop objective and
equitable procedures (financial accounting) to determine net income so that they could
calculate their fair share of proceeds from the enterprise. But it was the rise of the large
firm producing numerous products and services that need for cost accounting.
Firm wide net income no longer provided sufficient information for owners to make
operating decisions. The use of common labor and facilities to produce a wide range of
products made it extremely difficult for them to determine profitability of each product.
In turn, decisions concerning the expansion or contraction of product lines became
difficult.
Traditional cost accountants concentrated on developing reporting systems that would

yield costs so that they could evaluate the profitability of individual product lines.
Fortunately, the discipline is changing, and cost accountants are becoming much more
concerned with providing information that will help management meet the firm's goals.
In a nutshell, for many years ago cost accounting systems emphasized one purpose, i.e.,
product costing for inventory valuation and income determination. As a result many
systems failed to collect the data in a form suitable for other purposes such as evaluating
departmental efficiency.
Modern cost accounting systems are incorporating other purposes that may be
characterized as planning and controlling. This includes getting a reliable data for
predicting the economic consequences of management decision. The cost accounting
department, under the direction of the controller (the higher officer of accounting
department), is responsible for keeping records of a company's manufacturing and non-
manufacturing activities.
In general, the role (or purpose) of cost accounting may be summarized as follows:
 Planning: The cost accounting system provides vital information needed to plan
future operations. Cost data help to resolve questions relating to proposed projects or
policies, such as the following:
-Should we build a new plant or modernize the old one?
-How far can we go in lowering prices to increase our volume of sales?
-What will be the effect on costs of automating part of our factory operations?
 Budgeting: Cost accounting is also used in preparing a company's budget. A budget

is the overall financial plan for the future activities. All levels of the management
should be involved in the development of budget.
 Controlling Costs: Cost accounting is one of the most valuable management tools to
control operations. Comparing actual costs with budgeted costs are helpful in
evaluating the results of operations. The differences between the two sets of cost
figures can be noted and investigated while there is still time to take remedial
(corrective) actions.
 Determining Profits: One of the objectives of cost accounting is the consistent

allocation of manufacturing costs to units in the ending inventory and to units sold
during the period. At the end of the fiscal year, the matching of costs with
revenues determines profits for the period.
 Product Pricing: Management's pricing policy should assure not only the
recovery of all costs but also the securing of a profit even under adverse
conditions.
 Choosing Among Alternatives: Managers are constantly faced with the
existence of not just one or two alternatives, but numerous alternative choices of
action, that might be taken in any given situation facing a firm. The cost and
management accounting system assists the managers in arriving at a correct
decision by presenting suitable analysis of the costs associated with the
alternatives at hand. Cost accounting, for example, is a source of information
concerning different alternative course of action such as make or buy, continue or
discontinue production, developing new product or not, etc.
 Estimating and Bidding: In certain trades, knowledge of the costs of doing business
is needed to estimate a job or to bid for other jobs or contracts. The order generally
goes to the lowest bidder. Under competitive pressure, the decisive difference in a bid
may be as little as a fraction of a cent per unit. Attempting to bid without detailed cost
information can means losing the job or it can mean winning the job but having to
perform the work at a loss. Either result is undesirable.
 The Role of Cost Accountant

A cost accountant is a specialist who analyzed the cost recording and reporting needs of a
business and devises a system of records and procedures that will meet these needs. This
system will include the necessary forms and other records; record keeping procedures,
controls, summarizing techniques, and formal reporting methods. In addition, the cost
accountant provides up-to-date analyses of the operations of the business to help
management make rational and meaningful decision.
A processor of perishable goods has different needs than an automobile manufacturer.

Likewise, a large company with several departments manufacturing many products has
different concerns than a small plant making one product. A cost accountant must be
able to adopt systems and procedures in order to meet these varying needs.
 Cost, Expense and Loss

 Costs are not necessarily the same as expenses. Expenses are reported in the
income statement. They can represent costs for which benefits have already been
received in the current fiscal period.
 Expenses in its broadest sense defined as "all expired costs, which are
deductible from revenue.”
 Expenses in a narrowed sense "the term 'expenses' refers to such items as

operating selling or administrating expenses, interest and taxes."
 Losses are not costs but reductions in firm liquidity other than from withdrawal of
capital for which no compensatory value has been received, e.g. destruction of
plant, furniture or inventories by fire or some natural calamity.
 Cost represents as a resource sacrificed, or foregone or a release of something

of value to achieve a specific objective.
 Put differently Cost is the price of economic resources used as a result of

producing or doing the thing.
1.5 Cost Benefit Philosophy and Behavioural Considerations in Management

Accounting System
Management accounting deals with the provision of accounting and non-accounting
information to internal users for the purpose of facilitating their decision making. While
technical in nature, management accounting still functions in a behavioral environment
shaped by the behaviors of management accountants as producers of information and
managers as internal users, as they react to the information produced or received, the
context created, the attitudes and perceptions generated, and the outcomes desired.
Accordingly, we will try to see the concept of “Behavioral Management Accounting” in

relation to the “Cost Benefit Philosophy” as the study of the behaviors and behavioral
contexts created by the production of management accounting information to be used by
internal decision makers. Knowledge and appreciation of these behaviors and behavioral
contexts contribute to the success and efficiency of management accounting in serving
the goals of the firm.
Cost-benefit analysis is the exercise of evaluating an action's consequences by weighing

the pluses, or benefits, against the minuses, or costs. It is the fundamental assessment
behind virtually every business decision, due to the simple fact that business managers do
not want to spend money unless the resulting benefits are expected to exceed the costs.
As companies increasingly seek to cut costs and improve productivity, cost-benefit

analysis has become a valuable tool for evaluating a wide range of business opportunities,
such as major purchases, organizational changes, and expansions.
Some examples of the types of business decisions that may be facilitated by cost-benefit
analysis include whether or not to add employees, introduce a new technology, purchase
equipment, change vendors, implement new procedures, and remodel or relocate
facilities.
In evaluating such opportunities, managers can justify their decisions by applying cost-
benefit analysis. From these examples let‟s take the employee case. If we want to
improve the operation or productivity of our firm in aggregate level, we may think of
increasing the number of employees or appreciation of the salary of the existing workers
so as to achieve our purpose.
Here, there is often a degree of complexity, and subjectivity, to the actual implementation
of cost-benefit analysis. This is because not all costs or benefits are obvious at first.
Fortunately, management accounting is built on behavioral foundations. Its explicit aim is
to affect the behavior of individuals in a desirable direction. To accomplish this purpose,
management accounting has to be adapted to the different characteristics that shape the
“cognitive makeup” of individuals within an organization and affect their performance. In
general, these characteristics pertain to three factors:
(1) The perception by the individual of what should be the objective function or
goals in the firm;
(2) The various factors likely to motivate the individual to perform; and
(3) The decision-making model most relevant to particular contexts and most
preferred by the individual.
Although these factors do not constitute an exhaustive list of the behavioral concepts
likely to affect the performance of an individual within an organization, they have been
identified in the literature of various disciplines as essential factors to be considered for
an understanding of an individual behavior within an organization and the design of any
information system.
Thus, management accounting requires a good grasp of the behavioral concepts, namely,
the objective function in management accounting, motivation theories, and models of
decision making.
Each of these concepts identifies factors and situations that influence individual behavior
and indicates avenues for management accounting to adapt its services. Behavioral
considerations ought to figure prominently in analyses concerning the perceptions and
actions of victims, perpetrators, law enforcement agents, or policy planners.
One important factor that distinguishes genuine behavioral analyses from standard
normative accounts, and makes life significantly more difficult as a result, is that true
behavioral analyses will often depend on the specific details and nuances of the
particular case. Whereas standard analysis may rely, say, on observed probabilities and
on tangible costs and benefits, a good behavioral account would need to consider not only
a variety of intangible factors but also the manner in which these are perceived by
individual actors in particular contexts.
1.6 Management Accounting in Service Organization

Management accounting, which is a more elaborate version of cost accounting, needs to
take a multidimensional focus in order to better serve the various and complex needs
facing the management accountant. As a result, management accounting rests not only in
accounting but also on organizational, behavioral, decisional, strategic, and other
foundations and dimensions. An understanding of these dimensions is vital to a better
understanding of the management accountant‟s new role.
Prior to the 1970s, most innovations in management accounting techniques, and the most
sophisticated management accounting systems, were found in manufacturing firms. As
the service sector became a larger part of the overall economy, and as competitive
pressures within service sector industries increased (in some cases brought about by
deregulation), many service companies invested substantial resources in management
accounting systems tailored to meet their needs.
Service sector industries noted for significant developments in their management
accounting systems include transportation, financial institutions, and health care.
Customer costing (determining the cost of servicing an individual customer), and
improving the timeliness of accounting information, are very common issues of particular
importance to many service sector companies.
Nowadays, management accounting involves consideration of the ways in which

accounting information may be accumulated, synthesized, analyzed, and presented in
relation to specific problems, decisions, and day-to-day tasks of business management.
An appreciation of management accounting requires a good understanding of the

different facets of accounting organizations. Equivalent to its tremendous roll in relation
to the production activities, currently management accounting deals with the provision of
information that allows an efficient management of the different parts of the value chain,
namely;
(1) Research and development,
(2) Design of projects, services, or processes,
(4) Marketing,
(5) Distribution,
(6) Customer service and the like
1.7 Ethical Consideration in Management Accounting

Practitioners of management accounting have an obligation to the public, their profession, the
organization they serve, and themselves, to maintain the highest standards of ethical conduct.
In recognition of this obligation, the Institute of Management Accountants (IMA) has
promulgated the following standards of ethical conduct for practitioners of management
accounting and. Adherence to these standards internationally is integral to achieving the
objective of management accounting.
 Practitioners of management accounting have a responsibility to:

 Competence
 Maintain an appropriate level of professional competence by ongoing development of
their knowledge and skills.
 Perform their professional duties in accordance with relevant laws, regulations, and
technical standards.
 Prepare complete and clear reports and recommendations after appropriate analysis of
relevant and reliable information
 Confidentiality
 Practitioners of management accounting have a responsibility to: Refrain from
disclosing confidential information acquired in the course of their work except when
authorized, unless legally obligated to do so.
 Inform subordinates as appropriate regarding the confidentiality of information

acquired in the course of their work and monitor their activities to assure the
maintenance of that confidentiality.
 Refrain from using or appearing to use confidential information acquired in the
course of their work for unethical or illegal advantage either personally or through
third parties.
 Integrity
 Avoid actual or apparent conflicts of interest and advise all appropriate parties of any
potential conflict.
 Refrain from engaging in any activity that would prejudice their ability to carry out
their duties ethically.
 Refuse any gift, favor, or hospitality that would influence or would appear to influ-
ence their actions.
 Refrain from either activity or passively subverting the attainment of the organiza-
tion‟s legitimate and ethical objectives.
 Recognize and communicate professional limitations or other constraints that would
preclude responsible judgment or successful performance of an activity.
 Communicate unfavorable as well as favorable information and professional judg-
ment or opinion.
 Refrain from engaging [in] or supporting any activity that would discredit the
profession.
 Objectivity
 Communicate information fairly and objectively.
 Disclose fully all relevant information that could reasonably be expected to influence
an intended user‟s understanding of the reports, comments, and recommendations
presented.
PART TWO
INTRODUCTION TO COST TERMS & COST CLASSIFICATION
2.1. Cost in General (Basic Cost Concepts)
The term cost is frequently used in everyday conversation among different persons. As a
result, cost may have many different meanings to different people. From accounting
point of view, cost may be defined as a sacrifice or giving up of economic resources for
particular purposes, usually in an exchange for some goods or services. The economic
resource given up is measured in monetary units. It can be cash payment, usage of
existing non-monetary assets, or assuming a liability.
Cost is distinguished from expense, which is the value of assets given up to generate
revenue. Clearly, most costs eventually become expenses. In fact, some become
expenses virtually at the same time as the costs are incurred. When this is true, the terms
cost and expenses are interchangeably used. For example, if a firm buys supplies only as
the supplies are needed and if the supplies are used immediately to help generate sales,
the outlay for supplies is usually called an expense.
To aid decisions, managers want the cost of something. This “Something” is called a
cost objective or a cost object. A cost object is defined as any activity for which a
separate measurement of costs is desired. Examples of cost objectives include
departments, products, sales territories, kilometers driven, patients seen, and student
hours taught and so on.
2.2. Cost Accumulation and Cost Assignment

 The cost accounting system typically includes two processes:
i. Cost Accumulation. It involves collection of cost data in an organized way by
some “natural” classification such as materials or labor.
ii. Cost Assignment. It is a general term that encompasses both cost tracing and cost
allocation.
 Cost tracing is the assigning of direct costs to the chosen cost object.
 Cost allocation is the assigning of indirect costs to the chosen cost object.
Direct Cost tracing

Costs Cost
Cost Assignment Object
Indirect Cost allocation
Costs
Direct costs are costs that are related to the particular cost object and that can be traced to
it in an economically feasible (cost – effective) way.
In contrast, indirect costs are costs that are related to the particular cost object but cannot
be traced to it in an economically feasible way. Indirect costs are allocated to the cost
object using cost allocation. Classification of costs as direct and indirect costs will be
discussed later.
2.3. Identification, Classification, Work-Flow and Characteristics of Costs

Cost objectives are defined as the different ways. Costs may be classified and grouped on
the different purposes for which costs are measured. There is several standard cost
classification and each classification has its own unique terminology. We will provide a
rather comprehensive list of ways costs may be grouped, the concepts underlying each
and the terminology commonly used. (Remember that the same cost may be included in
several or in all of the following classifications).
 Based on Time period

Time can be broadly classified into past and future. Cost can also be classified according
to time periods. Historical costs are those that were incurred in a past period. Future
costs, generally called budgeted costs, are those that are expected to be incurred in future
period. Generally no adjustment is made in accounting for the change in the purchasing
power of the dollar when comparing historical costs with budgeted costs. High rate of
inflation in recent years have created some problems in the comparability of these
number. But as yet there has not been any comprehensive adjustment. Several methods to
adjust for inflation are currently being considered, but the accepted method simply has
not been decided on.
 Management Function
An organization may be separated into functional areas. A manufacturing company's
functional areas generally include manufacturing, marketing and general administration.
i) Manufacturing costs: include costs from the acquisition of Raw Materials through
production until the product can be turned over to the marketing division to be sold.
Manufacturing cost include the cost of the raw materials, payroll costs for people
working on the product and incidental costs such as taxes, power, depreciation and
repairs associated with the manufacturing equipment.
ii) Selling cost: are all cost associated with marketing and selling a product. They include
all costs incurred by the marketing division form the time the manufacturing process
in complete until the product is delivered to the customer. These costs include
advertising, promotional offers, Fright to deliver the product and warehouse costs
while the product is waiting to be sold.
iii Administrative cost: are all costs associated with the management of the company
and include expenditures for accounting, legal and administrative activities. Interest
costs are also includes among administrative costs.
 By Accounting Treatment
The alternatives in accounting for costs are to expense it or to capitalize it.
i. Period costs; Cost that are expensed in the period in which they are incurred. Period
costs possess no future benefits and are generally associated with non- manufacturing
area of the business. Examples of period costs include advertising, interest,
president‟s salary and sales commission.
ii. Product costs: consists of all costs associated with manufacturing function of the
business. They include material, labour, and other factory costs associated with
assembling and processing the units. Because the company still holds the product and
its usefulness has not yet expired. It is not appropriate to expense these costs. They
are capitalized as inventory and held as un-expired costs until they are sold.
iii.Capital costs; are similar to product costs in that they are also capitalized as assets.
However, capital cost is the term used to describe the acquisition of plant and
equipment. These items are capitalized as tangible fixed assets and are depreciated
over their useful lives. Products costs are reserved for inventorable costs associated
with the manufacturing process.
 Traceability to Products
A direct cost is one that can be economically traced to a single cost object. In
manufacturing, the cost object is a unit of finished product.
An indirect cost is one that is not directly traceable to the manufactured product, is
associated with the manufacture of two or more units of finished product. The economics
of tracing a cost to a particular unit of finished product is an important distinction
between direct cost and indirect cost. However most of the time costs are classified as
indirect costs if their dollar amounts are immaterial when compared to the other
materials going into the product. Also the cost involved in tracing and recording the items
as direct costs would be much greater than the benefit of having that information.
 Cost Behavior
Cost behavior describes how a cost changes with time or with changes in volume.
i Variable costs are cost that changes proportionately in total as the volume of
production or sale changes. The total variable cost increases proportionately with the
number of units produced, but the cost of each unit remains the same.
ii Fixed costs remain constant in dollar amount as volume of production or sales
changes. Straight - line depreciation on a piece of equipment is an example of a fixed
costs. The amount of depreciation is the same regardless of the number of units produced.
iii. Mixed costs
 Mixed costs are costs made up of fixed and variable elements. They are the combination
of variable costs and fixed costs. Mixed costs are also known as semi-fixed or semi-
variable. Semi- fixed costs are those which remain constant up to a certain level of
output after which they become variable. A semi-variable cost is the cost which
basically variable but remains constant when a certain level of output is reached.
 Because of the variable component mixed costs fluctuate with volume. And because of
fixed component they do not change in direct proportion to output. For example, a
worker who is paid 150 birr per week (fixed) plus bonus of 10 birr for each unit
completed (variable).
Behaviour of the Cost (within the relevant range)

Cost In Total Per Unit
Variable Cost Total variable cost increases and Variable cost remains constant per
decreases in proportion to changes unit.
in the activity level.
Fixed Cost Total fixed cost is not affected by Fixed costs decrease per unit as the
changes in the activity level within activity level rises and increase per
the relevant range. unit as the activity level falls.
 Decision Significance
A decision involves making choices among alternative courses of action the decision
maker generally collects cost information to assist in making the decision.
I) Relevant costs are future costs that differ with the various decision alternatives. They
are costs that make a difference in a decision making process.
II) Irrelevant costs do not relate to any of the decision alternatives, are historical in
nature, or are the same under all decision alternatives
 Irrelevant costs are generally excluded from the cost analysis.
 Managerial Influence
Managerial influence refers to the ability of manager to control a particular cost.
Remember that, all costs are controlled by some on at some level in the organization, if
the time period is long enough. However, when we focus on a particular manager at a
particular level in the organization and for a short period of time, there are some costs
that can be influenced and some that cannot.
I) Controllable costs are subject to significant influence by a particular manger with in
the time period under consideration.
II) Uncontrollable cost is those costs over which a given manager does not have a
significant influence.
 Commitment to Cost Expenditure

Commitment to a cost expenditure focuses on fixed costs as opposed to variable costs
and on budgeted costs as opposed to historical costs.
 Budgeted fixed costs can be broadly classified as committed costs and
discretionary costs.
i) A committed costs: is one that is an inevitable consequence of a previous
commitment. Property tax budgeted for the coming year is an example of a committed
cost.
ii) A discretionary costs; also called a programmed costs or a Managed cost, is one for
which the amount or the time of incurrence is a matter of choice. There are some non-
recurring costs for which a final commitment has not yet been made and that can be
postponed until a future period or canceled entirely.
Replacing the carpet in the administrative offices and repainting the walls of the factory
are examples of discretionary costs where the right timing is a matter of judgment. Other
types of discretionary cost is one that is part of normal recurring operations and fills a
function that is necessary for the operation and maintenance of facilities, but it can be
changed in amount by management decision.
Advertising, employee training or outside consulting services are examples of
discretionary costs where the right amount is a matter of judgment.
 Other Cost Classifications

Several other cost classifications are frequently used in discussing cost accounting and
management decision but generally are excluded from the record keeping process. Their
primary usefulness is in helping to place in correct perspective the potential benefits of a
possible course of action. This classification includes managerial costs, out-of pocket
costs, sunk costs and opportunity costs.
i Marginal costs: also called incremental costs, are the costs
associated with the next unit or the next project. The term marginal cost is widely
used in economics to refer to the added cost associated with the production of an
additional unit of output. The accounting use is an adoption of the economics
concept.
ii Out -of - pocket costs; are cost that must be related with a current expenditure.
Generally, an out - of - pocket cost is a cash expenditure associated with a particular
decision alternative.
iii Sunk Costs: are defined as past costs that have already been incurred. Because sunk
costs are historical costs, they are generally irrelevant to decisions affecting the
current or future use of the asset.
iv Opportunity cost: is defined as the cost or value of an opportunity

forgone when one course of action is chosen over another. Opportunity cost is non an
out- of- pocket cost, or even a future cost associated with the selected alternative, but
represents the lost opportunity associated with each of the alternatives that are
rejected.
 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 they 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 in to a salable finished product. In
other words, the incurrence of conversion costs causes direct materials to changed or
converted in to finished goods.
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
 Summary of Cost Classification and Sub-Classification

Cost Classification Sub- classifications
Historical costs
Time period Budgeted Costs
Manufacturing cost
Management
Selling Costs
Function
Administrative costs
Period costs
Accounting Product costs
treatment
Capital costs
Direct costs
Cost Traceability
Data to product Indirect costs
Variable costs
Cost behavior
Fixed costs
Mixed costs
Decision Relevant Costs
Significance Irrelevant costs
Managerial Controllable costs

Control Uncontrollable costs
Commitment to Committed costs

Cost expenditure Discretionary costs
Marginal costs
Other Out - of pocket costs
Sunk costs
Opportunity costs
2.4. Cost Object Versus Cost Driver

 Cost Object
Accountant usually defines cost as a resource sacrificed or forgone to achieve a specific
objective. For now, consider cost as being measured in the conventional accounting
way, as monetary unit (for example birr) that must be paid for goods and services.
To guide decisions, managers want data pertaining to a verity of purpose. They want the
cost of something. We call this something a cost object and define it as any activity or
item for which a separate measurement of costs is desired.
The cost object is a key feature of management accounting.
 It may be an activity or operation in which resources are consumed or received
(repairing automobiles, responding in inquires for information, reconciling bank
statement).
 The cost object may be a product or service e.g. (Renting room, flying passenger
from Addis Ababa to Metu).
 The cost object may be project e.g. constructing a house.
 The cost objects maybe a department e.g. (producing department, procurement
department.
 The cost object may be a program e.g. (HIV/AIDS control program, athletic
program).
 To summarize the following are example of cost object.
Cost-Object
Activity or Product or Project Departments Program

operation services
By itself, the term cost is meaningless. Cost measurement must be tied to at least one
cost object. The same cost may pertain to many cost objects simultaneously. For
instance, the cost of materials may become part of the cost of a product and part of the
cost of running the department.
 Cost Drivers
A cost driver is any factor whose change causes a change in the total cost of a related
cost object. Drivers are casual factors whose effects are increases in total costs. There
are many possible cost drivers. Example, In factory setting, the total cost of material
used may be driven not only by the production volume but also by the quality of the
material, the skills of the worker, and the number of parts in a finished product, and the
condition of the applicable machines.
Cost drive is an intuitively appealing term. It encompasses any underling factor that
causes, or drives, costs. It facilitates the subsequent explanation that factors in addition
to production volume.
Example of cost drivers
Total Costs of Activity Cost Driver
Product design Number of products, number of parts
Distribution Type of transportation, miles driven
Weight number of stops, speed
Manufacturing Production volume, in unit of Products,
number of setups, number of parts
2.5. Correlation of Cost Accumulation and Cost Object

A cost system typically accounts for costs in two broad stages:
1. It accumulates costs by some “natural” classification such as raw materials used,
fuel consumed, or advertising placed, and then
2. It allocate (trace) these costs to cost object.
Cost Accumulation is the collection of cost data in some organized way through an
accounting system. Cost allocation is a general term that refers to identifying
accumulated cost with or tracing accumulated cost-to-cost object such as department,
activities, or products.
Cost object are chosen not for their own sake but to help decision-making. The most
economically feasible approach to the design of a cost system is typically to assume
some common classes of decision e.g. (inventory control, labour control) and to choose
cost object (for example, product and departments) that relate to those decisions. Nearly
all systems at least accumulate actual cost, which are amounts determined on the basis
of costs incurred as distinguished from predicated or forecasted costs.
 Relationship of Cost Accumulation to Cost Object

Cost Accumulation Cost Object
Product 1
o
Actual Raw Production
Product 2
Department
Material Cost Product 3
Purpose – to Purpose – to
compute costs compute costs of
for evaluating various products
departmental for decisions such
efficiency and as product pricing
managerial and product
performance emphasis
2.6. Identifying Cost Accounting System with matching of Cost-flow and Work-flow
2.6.1. Costs on Financial Statements
Financial statements of a Manufacturing company are more complex as compared to
financial statements of Merchandising and Service companies. Particularly, the Statement
of Financial Position, and Profit & Loss Statement of a Manufacturing Enterprise are
somewhat different from their Merchandising and Service counterpart. All costs
mentioned above should be properly accounted for and reported in the financial
statements of a manufacturing firm, which is more complex than that of the
Merchandising and Service complements.
2.6.2. Statement of Financial Position of Manufacturing Firm

The Statement of Financial Position of a manufacturing firm differs from the Statement
of Financial Position of a merchandising firm principally by the types of inventories
reported. A manufacturing firm carries three types of inventories namely, Direct
Materials, Work-In-Process, and Finished good.
Inventory of Direct Material represents the costs of materials that are not yet entered into
a manufacturing process. Such materials may be purely raw materials that have not
received any processing before, such as agricultural outputs, or they may be semi
processed or fully processed products of another firm like wheat flour directly going into
Biscuit in Food Complex Industries.
Inventories of Work-In-Process represent all goods that are undergoing some
manufacturing process but yet not finished to be dispatched for use by customers. The
costs of work in process inventory include all the manufacturing costs incurred so far in
the manufacturing process; the cost of direct materials, the costs of labour, and applied
manufacturing overhead. The Finished Good Inventory embodies the final product that is
not yet sold. The cost of finished goods inventory includes all manufacturing costs, direct
material, direct labour, and manufacturing overhead incurred to produce that product.
 The following partial Statement of Financial Position may show the presentation
of inventories in a Manufacturing firm.
OLYAD FURNITURE FACTORY
STATEMENT OF FINANCIAL POSITION
AS AT JUNE 30, 2021
Current assets:
Cash on Hand 12,669.00

Cash in Bank 245,980.00
Account receivables 125,468.00
Allowance for doubtful account 4,578.00 120,890.00
Inventories:
Direct material 117,450.00
Work in process 131,600.00
Finished good 182,000.00
Total inventories 431,050.00
2.6.3. Profit & Loss Statement of a Manufacturing Firm
Profit & Loss Statement of a manufacturing firm differs from Profit & Loss Statement of
a merchandising firm by the Cost of Goods Manufactured caption.
A merchandising firm sells goods after buying it from a manufacturing firm. But a
manufacturing firm sells goods that are internally produced. Hence, the costs of goods
sold caption contains cost of goods manufactured instead of purchase.
The amount of purchase can easily be found from the ledger, but cost of goods
manufactured cannot. Cost of goods manufactured must first be computed before the
Profit & Loss Statement is prepared.
A merchandising business can monitor operational performance more easily than a

manufacturing business, because they easily know their selling price and buying price.
However a Manufacturing firm cannot easily identify the cost of production.
Further, there are rooms in a manufacturing business to make operations more efficient.
Therefore, many manufacturing businesses prepare their Profit & Loss Statements more
frequently than merchandising businesses.
Frequent preparation allows them to know the results of operation and thereby alter
operational strategies if the results are not satisfactory.
 For comparison purposes, here below you will find Profit & Loss Statement of a
merchandising and manufacturing business (a hypothetical example).
 Profit & Loss Statement of a Merchandising Business

TAJUDIN IMPORT PLC
PROFIT & LOSS STATEMENT
FOR THE YEAR ENDED JUNE 30, 2021
Sales 1,200,000.00
Cost of goods sold:
Merchandise inventory, July 1, 2020 120,000.00
Purchase 960,000.00
Merchandise available for sale 1,080,000.00
Less Merchandise inventory June 30, 2021 240,000.00
Cost of merchandise sold 840,000.00
Gross profit 360,000.00
Operating expenses:
Selling expenses 85,000.00
Administrative expenses 75,000.00
Total operating expenses 160,000.00
Net income 200,000.00
 Profit & Loss Statement of a Manufacturing Business

ABC FURNITURE FACTORY
FOR THE YEAR ENDED JUNE 30, 2021
Sales 1,831,600.00
Cost of goods sold:
Finished good inventory, July 1, 2020 157,000.00
Cost of goods Manufactured 1,101,750.00
Cost of finished goods available for sale 1,258,750.00
Less finished goods inventory June 30, 2021 182,000.00
Cost of merchandise sold 1,076,750.00
Operating expenses:
A comparison of the two statements shows the following facts. Purchase in a

merchandising firm represents goods that are bought over a definite specified period, a
year in the above example. The total purchase made in that period is added to the
beginning inventory balance and yield the total cost of goods available for sale in that
period. The manufacturing equivalent is the cost of goods manufactured, which represent
the total manufacturing cost of goods produced in that period or year.
The cost of goods manufactured by itself needs a computation that presents the cost of
direct material used, cost of direct labour incurred, and factory overhead costs. The
direct material used alone is a separate schedule that shows the direct material placed in
production in that period.
 Steps to be followed in preparation of Profit & Loss Statement of a Manufacturing Firm

In general the following four steps are required to prepare Profit & Loss Statement of a
manufacturing firm.
Step 1 – The schedule of Direct Materials used in production

The cost of direct material used is equivalent to the beginning inventory of direct material
plus purchases made during that period less the direct material left at the end of the
period. For illustration purposes, the above Profit & Loss Statement of ABC Furniture
Factory will be used.
Direct Materials Used = Beginning Direct Materials Inventory + Direct Materials

Purchased – Ending Direct Materials Inventory
 Assume that the direct materials inventory of ABC Furniture Factory amounts to
Birr 124,000.00 at the beginning of the year i.e., as of July 1, 2020, purchases of
Birr 440,000.00 and freight costs Birr 1,600.00 is made during the year, and the
amount of direct materials inventory at the end of the year is Birr 117,450.00. The
direct material used is therefore will be shown in the schedule below.
Schedule 1- Schedule of direct material used

Beginning direct material inventory 124,000.00
Add: Total cost of direct materials purchased
Direct materials purchased 440,000.00
Freight in 1,600.00 441,600.00
Direct materials available for use 565,600.00
Deduct: Ending direct materials inventory 117,450.00
Direct materials used in production 448,150.00
 This schedule can be presented either separately or can be incorporated
to the cost of goods manufactured schedule.
Step 2 – The schedule of cost of goods manufactured

To determine the cost of goods manufactured, three factors are necessary: cost of direct
materials used, cost of direct labour, and manufacturing overhead.
Extending the same example, let say the cost of direct labour employed is Birr 437,500,
and the following overhead costs are incurred:
 OH Cost of the Period
Indirect labour 98,600.00
Depreciation on factory equipment 44,600.00
Light and power 43,600.00
Depreciation of Factory building 12,000.00
Insurance expense on factory properties 9,500.00
Property tax 19,500.00
Factory supplies expense 5,800.00
Miscellaneous factory costs 4,100.00
Total overhead 237,700.00
Cost of goods manufactured = Beginning Work In Process Inventory + (DM Used +

DL Incurred + MOH) – Ending Work In Process Inventory.
Assume that Beg. WIP= 110,000 and End. WIP= 131,600
Schedule 2- Schedule of cost of goods manufactured

Work in process inventory July 1, 2020 110,000.00
Add: Direct Materials used* (previous schedule) 448,150.00
Direct labour 437,500.00
Factory overhead 237,700.00
Manufacturing cost incurred during the year 1,123,350.00
Total Manufacturing Costs to Account for 1,233,350.00
Deduct: Work in process inventory June 30, 2021 131,600.00
Cost of goods manufactured 1,101,750.00
Step 3 – The schedule of cost of goods sold

The cost of goods sold represents the cost of goods that are sold during a given year. The
cost of goods sold is computed using the following formula:
Cost of goods sold = Beg. FG Inventory + CoG Manufactured – End. FG Inventory.
Example:
 Assume that the finished good inventory as of the beginning of the year is Birr
157,000.00, and the ending inventory of finished goods inventory is Birr
182,000.00. The cost of goods sold is then prepared as follows:
Schedule 3 – schedule of cost of goods sold

Finished goods inventory, July 1, 2020 157,000.00
Add: Cost of goods manufactured* 1,101,750.00
Cost of goods available for sale 1,258,750.00
Deduct: finished good inventory June 30, 2021 182,000.00
Cost of goods sold 1,076,750.00
* The cost of goods manufactured is obtained from the previous schedule.
Step 4 – The Profit & Loss Statement

All the above schedules are inputs one to the other. The ultimate goal of making all the
schedules is to prepare the Profit & Loss Statement. The Profit & Loss Statement
contains three main elements, and these are: Sales, Cost of goods sold, and Operational
expenses.
The cost of goods sold is deducted from sales to arrive at gross profit or gross margin.
From the gross margin, operational expenses are deducted to determine net income
assuming no income tax.
Assume that sales of the period are 1,831,600. Selling Expense is 330,000 &
Administrative Expense is 168,850.
Schedule 4 – schedule of the Profit & Loss Statement

 The Single Step Profit & Loss Statement of ABC Furniture Factory looks the
following:
Sales 1,831,600.00
Cost of goods sold 1,076,750.00
Operating expenses:
Net Income 256,000.00
The above Profit & Loss Statement is called a Single Step or Condensed Profit & Loss
Statement, as it does not show how each element is constructed. The separate schedules
are inputs to the Profit & Loss Statement.
It is also possible to include all the schedules at a time to prepare the Profit & Loss
Statement. Such a statement contains detailed information about each item. Such a
statement is called multiple step Profit & Loss Statement.
The next statement is a Multiple Step Profit & Loss Statement of ABC Furniture
Factory.
ABC FURNITURE FACTORY
FOR THE YEAR ENDED, JUNE 30, 2021
Sales (a)1,831,600.00
Less cost of goods sold:
Finished goods inventory, July 1, 2020 157,000.00(b)
Work in process inventory, July 1, 2020 110,000.00©
Work in process during the year:
Direct materials used:
Direct materials, July 1, 2020 124,000.00
Direct materials purchased (including freight in) 441,600.00
Direct materials available for use 565,600.00
Direct materials, June 30, 2021 117,450.00
Direct material used 448,150.00(d)
Direct labour 437,500.00(e)
Factory overhead:
Indirect labour 98,600.00
Depreciation on factory equipment 44,600.00
Light and power 43,600.00
Depreciation of Factory building 12,000.00
Insurance expense on factory properties 9,500.00
Property tax 19,500.00
Factory supplies expense 5,800.00
Miscellaneous factory costs 4,100.00
Total Factory Overhead 237,700.00(f)
Total manufacturing cost during the year 1,123,350.00(g//d+e+f)
Total manufacturing cost to account for 1,233,350.00(h//g+c)
Deduct: Work in process, June 30, 2021 131,600.00
Cost of goods manufactured 1,101,750.00(i)
Cost of goods available for sale 1,258,750.00(j//b+i)
(Including beg. finished goods inventory)
Deduct: Finished good inventory, June 30, 2021 182,000.00
Cost of goods sold (k)1,076,750.00
Gross profit (l//a-k)754,850.00
Deduct: Operational expenses:
Total operational expenses 498,850.00
ILLUSTRATION QUESTIONS – 1 & 2
 The following data is related to the operations of Action Company

Jan 1, 2021 Dec 31, 2021
Inventories
Finished goods Br. 43,000 Br. 52,000
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 2,500
Repair and maintenance- factory 4,000
Sales 500,000
Selling expense 85,000
Sales return and allowance 2,500
Instructions:-
A. Prepare:
1. Statement of Cost of Goods Manufactured, and
2. Cost of Goods Sold for the year ended December 31,2021
B. Prepare the Profit & Loss Statement for the year ended December 31,2021
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:-
A. Prepare a schedule of cost of goods sold for July
B. Prepare the July‟s cost of goods manufactured schedule
C. What was the amount of prime and conversion costs incurred in July?

Cost & Mgt. Acct - I, INSTR - Chapter 1 & 2

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Cost & Mgt. Acct - I, INSTR - Chapter 1 & 2

Uploaded by

Copyright:

Available Formats

Addis Ababa University, College of Business & Economics, Department of Accounting & Finance

COST AND MANAGEMENT ACCOUNTING I

1.1 The Major Purposes of Accounting Systems

 Accounting provides information for three major purposes:

1.2 The Role of an Accountant in an Organization

Staff Functions: These are indirectly related to the achievement of basic

Thus, an accountant has an important role in decision-making process not as a

A good decision is a decision, which is consistent with the objectives of the

1.3 Accounting and the Management Process

 Accounting helps the management process in;

1.4 Accounting Discipline Overview (Financial Accounting, Management Accounting

 Relationship of Cost Accounting with Financial Accounting and Management

 In general, cost accounting is thus concerned with recording, classifying and

 Purpose of Cost Accounting

Traditional cost accountants concentrated on developing reporting systems that would

 Budgeting: Cost accounting is also used in preparing a company's budget. A budget

 Determining Profits: One of the objectives of cost accounting is the consistent

 The Role of Cost Accountant

A processor of perishable goods has different needs than an automobile manufacturer.

 Cost, Expense and Loss

 Expenses in a narrowed sense "the term 'expenses' refers to such items as

 Cost represents as a resource sacrificed, or foregone or a release of something

 Put differently Cost is the price of economic resources used as a result of

1.5 Cost Benefit Philosophy and Behavioural Considerations in Management

Accordingly, we will try to see the concept of “Behavioral Management Accounting” in

Cost-benefit analysis is the exercise of evaluating an action's consequences by weighing

As companies increasingly seek to cut costs and improve productivity, cost-benefit

1.6 Management Accounting in Service Organization

Nowadays, management accounting involves consideration of the ways in which

An appreciation of management accounting requires a good understanding of the

1.7 Ethical Consideration in Management Accounting

 Practitioners of management accounting have a responsibility to:

 Inform subordinates as appropriate regarding the confidentiality of information

2.2. Cost Accumulation and Cost Assignment

Direct Cost tracing

2.3. Identification, Classification, Work-Flow and Characteristics of Costs

 Based on Time period

Behaviour of the Cost (within the relevant range)

 Commitment to Cost Expenditure

 Other Cost Classifications

iv Opportunity cost: is defined as the cost or value of an opportunity

 Prime and Conversion Costs

 Summary of Cost Classification and Sub-Classification

Managerial Controllable costs

Commitment to Committed costs

2.4. Cost Object Versus Cost Driver

Activity or Product or Project Departments Program

2.5. Correlation of Cost Accumulation and Cost Object

 Relationship of Cost Accumulation to Cost Object

2.6.2. Statement of Financial Position of Manufacturing Firm

Cash on Hand 12,669.00

2.6.3. Profit & Loss Statement of a Manufacturing Firm

A merchandising business can monitor operational performance more easily than a

 Profit & Loss Statement of a Merchandising Business

 Profit & Loss Statement of a Manufacturing Business

A comparison of the two statements shows the following facts. Purchase in a

 Steps to be followed in preparation of Profit & Loss Statement of a Manufacturing Firm

Step 1 – The schedule of Direct Materials used in production

Direct Materials Used = Beginning Direct Materials Inventory + Direct Materials

Schedule 1- Schedule of direct material used

Step 2 – The schedule of cost of goods manufactured

Cost of goods manufactured = Beginning Work In Process Inventory + (DM Used +

Schedule 2- Schedule of cost of goods manufactured