Chapter 1

The fundamentals of
costing
Phuong Thao NGUYEN
NEU-SAA
 What is cost accounting?
01
Topic list
02 Basic cost accounting concepts

Cost classification for inventory

03 valuation and profit measurement

Cost classification for

04 planning and decision making

05 Cost classification for control

06 Ethics and professional

scepticism
1. What is cost
accounting
 1.1. The cost accountant
1. Access to historical cost information
• Assess the Profitability
• Determine selling prices
• Valuate inventory

2. Estimate the future

• Future costs
• Information to make decision
• Financial resources
 1.2. Cost accounting and management accounting
WAYS OF

Accumulating
Historical costs
Charging Provision of
Historical costs to units information
of output/ department

• Planning
Establish • Control
• Inventory valuation • Decision making
• Profits or losses
• Balance sheet items
 1.3. Cost accounting systems
Provide internal financial Scope
information:
• Service industries,
• Establish inventory valuations,
government departments,
profits or losses and balance
not-for-profit organisations
sheet items
(including charity)
• Planning
• Within a manufacturing
• Control
organization: manufacturing,
• Decision making
administration, S&D, R&D…
1.4. Financial Accounting vs Cost accounting
Using the same basic data/ different purpose
External Internal
Shareholders
Banks
Customers
FA MA
Managers of
Suppliers organisation
HMRC
Employees
1.4. Financial Accounting vs Cost accounting
. Financial Accounts
• . Details the performance
• Prepare financial accounts: by law
• Format: law and FRS
• Concentrate on the business
as a whole
• Information: Monetary
nature
• Past operations
. Management accounts
• No legal requirement
• Format: No strict rules
• Aid a decision (NOT end
product of a decision)
• Focus on specific areas of an
organization’s activities
• Monetary measures
• Non – monetary measures
• Historical record
• Future planning tool
2. Basic cost
accounting concepts
2.1. Functions and departments

Organisation

Function A Function B Function C

Department 3
Department 1 Department 2
2.1. Functions and departments
Manufacturing
Board of organisation
directors structure

Marketing Administration Production

Mixing Baking Stores

 2.2. Cost objects
Anything for which we are trying to ascertain the cost

EXAMPLES
✓A unit of product
✓A unit of service
✓A department
✓A function
✓A project
✓A new product
 2.2. Cost objects
EXAMPLES Which of the following are cost objects?

• A parking machine • Business rates paid on a factory

• The factory canteen
• Direct materials for production
• Annual salary of the chief
accountant
• A telephone bill
• An operating theatre in a hospital
• Labour used in cleaning offices
• A branch of a high street bank
• Glue used in making a chair
• A meal in a restaurant
 2.3. Cost unit
Basic measure of product or service (one particular cost object)

➔ Cost unit:
meal served

➔ Cost per cost unit:

£12/ meal
- material: £8/ meal
- labour: £2/ meal
- other expense: £2/meal
 2.4. Composite cost units
Composite cost units: two-part cost units
Often in service organisations

Monitoring cost

Controlling cost
 2.4. Composite cost units
Example:

Which of the following cost objects would be suitable cost units

for a hotel?
• Bar
• Restaurant
• Room/night
• Meal served
• Conference delegate
• Fitness suite
• Conference room/day
 2.5. The concept of cost

Amount of money incurred in producing a

product

Act of determining the amount of money

incurred in operating a department
2.6. Direct v indirect costs and cost objects

Direct cost Indirect cost

Identified with a Cannot be identified with
cost object a particular cost object

Depend on a cost object

 3. Cost classification
for inventory valuation and profit measurement
 3.1. Cost elements
✓ Inventory ✓ Profit
For the purpose of valuation measurement

✓Materials
Direct Production
✓Labour costs
Indirect Period
costs
✓Other expenses
 3.2. Direct cost and prime cost
Direct costs

Material Labour Other expenses

Prime cost = Total direct cost

= direct material cost + direct labour cost + direct expenses
 3.3. Indirect cost and overhead
Indirect costs

Material Labour Other expenses

Overhead = indirect cost

Total cost = Direct cost (Prime cost) + Indirect cost (overhead)

 3.3. Indirect cost and overhead
Overhead: indirect (materials cost + wages + expenses)
• Production ✓ factory
overhead

• Administration ✓direction, control and administration

overhead
• Selling ✓promoting sales and retaining
overhead customers

• Distribution ✓making the packed product ready for

overhead dispatch and delivering
3.4. Productions costs and period costs
Production costs

• Costs: identified with goods

• Costs: deducted from revenue

Allocated to the value of goods

NOT included in the value of

inventory

Period costs
 4. Cost classification
for planning and decision making
 4.1. Cost behavior patterns
Cost behavior: how cost vary in relation to the level of activity

Fixed cost

Variable cost

Semi-variable cost

Level of activity:
• The volume of production • The number of invoices issued
• The number of item sold • The number of units consumed
 4.1. Cost behavior patterns
Fixed cost
Within a relevant range of activity
=> Not affected by the variation of
level of activity

Variable cost
Affected by the variation of level • Cost behavior:
of activity
how cost vary in relation to the
Semi variable cost
level of activity

Part-fixed and Part-variable • Level of activity

Partly affected by changes in ✓ Volume of production/ output
the level of activity ✓ Sales
 4.1. Cost behavior patterns

Total cost
increases

Constant
In a relevant range

Semivariable
Semi fixed
Mixed cost
 4.2. Cost behavior and total and unit costs

Example:
Find correct type of each cost:
• Telephone bill
• Annual salary of the chief accountant
• Cost of materials used to pack 20 units of product X into a box
4.3. The relevant range Step Fixed cost
• Fixed for a certain range of activity
• Increase: once a critical level of
activity is reached
Fixed cost

Relevant range presents

The activity level:
• Experience of operating in the
Relevant range
past
Range of activity level • Cost information is available
Cost behavior patterns occur
Extrapolation
Fixed cost Extrapolation
Activity level outside the relevant
Fixed for levels of activity within range
the relevant range => Dangerous to predict cost
 4.3. The relevant range
Example:
Graphs the following expenses
• Electricity bill: a standing charge for each period plus a charge for each
unit of electricity consumed
• Supervisory labour, which is paid as a monthly salary
• Sales commission, which amounts to 2% of sales revenue
• Machine rental cost of a single item of equipment. The rental
agreement is that £10 should be paid for every machine hour worked
each month, subject to a maximum monthly charge of £480
5. Cost classification
for control
 5.1. Responsibility accounting
Cost allocated to products:
Not always useful for the purpose of control
Cost allocated to the individuals responsibility
Provide link between:
costs - Area of responsibility
Allocating
cost
Responsibility
A responsibility centre
Accounting
A system of accounting A Department
– segregate A function
revenue/cost into => Direct responsibility
managers most capable Controllable costs
of controlling them Uncontrollable costs
5.2. Controllable and uncontrollable costs

Controllable Be influenced by
cost manager decisions and
action

Uncontrollable Cannot be affected by

cost manager within a given
time span

Most efficient classified of costs for control purpose

5.2. Controllable and uncontrollable costs
Most variable costs
Controllable in short term

Non-controllable cost by junior manager

Can be controllable by a senior
manager

Non-controllable cost by one department’s

manager
Can be controllable by another
department’s manager
Some non-controllable costs
• Due to inflation, or
• In long term rather than the short
term
6. Ethics and
professional
scepticism
 6.1. Ethics
Help manager
• Planning
• Control
• Decision making
Cost
accounting

Forecasts Budgets Variance analysis

Preparation and reporting Information

 Fundamental principles

1 2 3 4 5

Integrity Objectivity Professional competence

Confidentiality Professional
and due care behaviour

Ensure
ICAEW
• Prepare and report information fairly, honestly, in accordance with relevant
ethical professional standards
guidance • Take reasonable steps to maintain information:
• Describes clearly the true nature: transactions, assets, liabilities
• Classifies and records information: timely and proper
• Represents the facts: accurately and completely
 6.3. Threats & Safeguard
To compliance with fundamental principles Take steps to ensure not associated with information
• Self – interest
• Self – review • Contains a materially false/ misleading
statement
• Advocacy • Contains statements/ information furnished
• Familiarity recklessly
• Intimidation • Omits/ obscures information => misleading

Necessary safeguards to

The significant of threats depends on
• Source of the pressure
• The degree to which the information is
misleading
• Eliminate threats
• Reduce them to an acceptable level
Not possible to reduce threats
• Refuse to be associated with any misleading
information
 6.3. Professional scepticism

Definition:
• Assess information/ estimates/
explanations critically
• Questioning mind
• Alert to possible misstatement
(error/ fraud)
Practice