CHAPTER 6

Introduction to accounting ,costing and

investment evaluation
ACCOUNTING
 It is an information system that reports on the economic
activities and financial condition of a business or other
organization.
 Accounting information can be used to assess past
financial performance of a company and help predict
its future performance.
 All kinds of organizations—government agencies,
nonprofit organizations, and others —rely on
accounting to gauge their progress
THE NEED FOR ACCOUNTING
 Managers, investors, and other internal
groups
 want the answers to two important
questions:

How well did

the organization
perform? Where does
the organization
stand?
FIELDS IN ACCOUNTING
 Financial accounting – recording of transaction for a
business enterprise.
 Cost accounting – determination and control of cost of
manufacturing processes and manufactured proudacts.
 Management accounting – uses historical and estimated
data, deals with specific problems at various levels
 Tax accounting – deals with the preparation of tax
returns.
 International accounting- concerned with problems the
international trade of multi natioinal trade organization.
CONT…
 Accounts
 The elements are divided into classifications called
accounts.
 For instance there are different kinds of assets. A
business would have a cash account like a checking
account and they might also own a building.
CHART OF ACCOUNTS
 Every company has a chart of accounts, sort of like a
table of contents in a book.

 Each account is assigned a number

 Usually assets start with 1, liabilities 2, stockholder’s

equity 3, income 4, cost of goods sold 5, other expenses
6.
BALANCE SHEET
 Highlights the relative strength of a company at a point
in time.

 Terms related to the balance sheet: assets, liabilities,

owner’s equity.
ASSETS
 Assets are things you own or resources a business owns.

 The assets of a business belong to its creditors and

investors.

 Tangible assets-this you can touch like machinery,

buildings, land, computers, etc.

 Intangible assets-things you cannot tough such as right to

patents, rights to payments from customers, copyrights
or trademarks.
CONT…
 Current assets
 Assets that reasonably be converted into cash or used up
in a normal operation of a firm in one year. E.g. cash,
notes receivable

 Fixed assets
 Tangible assets which are of a permanent or relatively of
a fixed nature. E.g. equipment, machinery, land…etc
LIABILITIES
 Things you owe, future obligations of the business

 Creditor claims

 Examples include a bank loan or car loan, or buying

supplies for your business on credit
CONT…
 Current liabilities : financial obligations which are due
with in a short time usually a year or less.
 Notes payable, accounts payable, salaries payable,
interests and taxes payable

 Long term liabilities (fixed liabilities)

 To be settled over several years
EQUITY
 Rights of stockholders or their claim on assets

 There are two types of equity

 Common stock is issued by corporations to finance their
operations
 Retained earnings which is the portion of earned assets kept
in the business
 CAPITAL (Equity) = Assets – liabilities
ACCOUNTING STATEMENTS
 Income statements, capital statements, balance sheet
 Income statement – summary of revenue and the expense
of a business entity
 Capital statement – summarizes the change in capital of
a business entity
 Balance sheet – list of assets, liabilities and capital of a
business entity.
 Work sheet is the source of all the data
INCOME STATEMENT
 Also called the P&L (profit and loss statement)

 Shows your revenues and expenses over a period of time

(month, year)

 Revenue is income from the sale of goods

 If revenue is more than expenses, you have net income

 If expenses are more than revenue, you have a net loss
COST CONCEPTS
 Cost refers the amount of expenses spent to generate product or services.
 Cost refers expenditure that may be actual or nominal expenses incurred to
generate output.
 Cost is the value of economic resources used as result of producing or
doing the things.
 Cost has many meaning but in management cost refers the expenditure not
the price.
 As a manager we use cost information for taking decisions and making
plans, programs and policies and strategies.
 OVERVIEW OF COST CATEGORIES FOR
A MANUFACTURING FIRM
 All costs incurred by the firm must be accounted for in its
financial statements
MANUFACTURING COSTS
Direct Labor (DL)
Direct Materials (DM)
Overhead (OH)
Indirect Materials
Indirect Labor
Other
NON-MANUFACTURING COSTS
Marketing or Selling Costs
Administrative Costs
CONT…
 Manufacturing costs are those costs that are directly
involved in manufacturing of products and services.
 Examples of manufacturing costs include raw
materials costs and salary of labor workers.
 Manufacturing cost is divided into three broad categories
by most companies.

DIRECT MATERIALS COST:
 The materials that go into final product are called raw materials.
 This term is somewhat misleading, since it seems to imply
unprocessed natural resources like wood pulp or iron ore.
 Actually raw materials refer to any materials that are used in the
final product; and the finished product of one company can become
raw material of another company.
 For example plastic produced by manufacturers of plastic is a
finished product for them but is a raw material for Compaq
Computers for its personal computers.

DIRECT LABOR COST
 The term direct labor is reserved for those labor costs
that can be essentially traced to individual units of
products.
 Direct labor is sometime called touch labor, since direct
labor workers typically touch the product while it is
being made.
 The labor cost of assembly line workers, for example, is
a direct labor cost, as would the labor cost of carpenter,
bricklayer and machine operator.

CONT…
 Prime Cost = Direct Materials Cost + Direct Labor Cost
 Manufacturing Overhead Cost:
 Manufacturing overhead, the third element of manufacturing
cost, includes all costs of manufacturing Except direct material
and direct labor.
 Examples of manufacturing overhead include items such as indirect
material, indirect labor, maintenance and repairs on production
equipment and heat and light, property taxes, depreciation, and
insurance on manufacturing facilities.
NON-MANUFACTURING COSTS:
 Non-manufacturing costs are those costs that are not
incurred to manufacture a product. Examples of such
costs are salary of sales person and advertising expenses.
 Generally non-manufacturing costs are further classified
into two categories.
 1. Marketing and Selling Costs

 2. Administrative Costs
CONT…
 Marketing or Selling Costs:
 Marketing or selling costs include all costs necessary to
secure customer orders and get the finished product into
the hands of the customers.
 These costs are often called order getting or order filling
costs.
 Examples of marketing or selling costs include
advertising costs, shipping costs, sales commission
and sales salary.
CONT…
 Administrative Costs:
 Administrative costs include all executive,
organizational, and clerical costs associated with general
management of an organization rather than with
manufacturing, marketing, or selling. Examples of
 administrative costs include executive compensation,
general accounting, secretarial, public relations, and
similar costs involved in the overall, general
administration of the organization as a whole.
ESTIMATE THE
MANUFACTURING COSTS
Equipment Information Tooling

Raw Materials

Labor
Manufacturing System Finished Goods
Purchased
Components

Energy Supplies Services Waste

CONT…
MANUFACTURING COSTS DEFINED
 Sum of all the expenditures for the inputs of the system
(i.e. purchased components, energy, raw materials, etc.)
and for disposal of the wastes produced by the system
ELEMENTS OF THE MANUFACTURING
COST OF A PRODUCT
Manufacturing Cost

Components Assembly Overhead

Equipment Indirect
Standard Custom Labor Support
and Tooling Allocation

Raw
Processing Tooling
Material
MANUFACTURING COST OF A PRODUCT
 Component Costs (parts of the product)
 Parts purchased from supplier
 Custom parts made in the manufacturer’s own plant or by
suppliers according to the manufacturer’s design
specifications
 Assembly Costs (labor, equipment, & tooling)
 Overhead Costs (all other costs)
 Support Costs (material handling, quality assurance,
purchasing, shipping, receiving, facilities, etc.)
 Indirect Allocations (not directly linked to a particular
product but must be paid for to be in business)
MANUFACTURING COSTS
1. Direct Materials (DM)
 Materials that are consumed in the manufacturing process and
physically incorporated in the finished product
 Materials whose cost is sufficiently large to justify the record
keeping expenses necessary to trace the costs to individual
products
MANUFACTURING COSTS
2. Direct Labor (DL)
 Labor time that is physically traceable to the products
being manufactured
 Labor time whose cost is sufficiently large to justify the
record keeping expenses necessary to trace the costs to
individual products
Example:
Direct labor for manufacturing Honda Accords
 Line workers, robot operators, painters, assembly
workers
Any labor probably not included in direct labor?
 Factory janitors, factory supervisors, factory secretaries
KEY ISSUES IN DETERMINING DIRECT
LABOR
Is idle time generally considered as direct labor? Why or why
not?
 Usually not. It is not usually due to one product, hence it is
not traceable
What are the typical fringe benefits an assembly line worker
receives?
 Health insurance, pension plan, disability insurance

Is the cost of fringe benefits for the assembly line workers

generally considered direct labor?
 Usually yes, the costs can be traced
 KEY ISSUES IN DETERMINING
DIRECT LABOR
When an assembly line worker works overtime, he/she is paid a
regular wage plus an overtime premium. Would most companies
treat his/her regular wage as a direct labor cost?
 Yes, the amount of time an employee works can be traced to the
products.

What about the overtime premium?

 Treated as OH, cannot be traced to a specific product.
MANUFACTURING COSTS
3. Manufacturing Overhead (OH)
All of costs of manufacturing excluding direct materials and direct
labor

a. Indirect Materials (IM) – Materials, used in the manufacturing

of products, which are difficult to trace to particular products in
an economical way
 Glue, nails, cleaning supplies

b. Indirect Labor (IL) – Labor, used in the manufacturing of

products, which is difficult to trace to particular products in an
economical way
 Wages for maintenance workers, factory supervisor’s salary,
idle time
MANUFACTURING COSTS
C. All other types of manufacturing overhead
 Depreciation on machinery, depreciation on factory
building, factory insurance, utilities for factory
NON-MANUFACTURING COSTS
1. Marketing or Selling Costs – Costs incurred in
securing orders from customers and providing
customers with the finished product
 Sales commissions, costs of shipping products to
customers, storage of finished goods, depreciation of
selling equipment (cash register)

2. Administrative Costs – Executive, organizational, and

clerical costs that are not related to manufacturing or
marketing
 CEO’s salary, cost of controller’s office, depreciation
on administrative building.
CLASSIFICATION
EXERCISE
Classify the following cost items
 Depreciation on factory building
 Depreciation on office equipment
 Property tax on finished goods warehouse
 Wages paid to forklift operator in finished
goods warehouse
 Wages paid to forklift operator in factory
 Wages paid to welders when welding
equipment is not working
 Paper used in textbook production
 Paper used in central office computer
 Wages paid to assembly line workers
 Maintenance cost for machines
OTHER COST CONCEPTS
Product Costs or Inventoriable Costs – costs assigned to products
that were either purchased for resale (merchandising firm or
retailer) or manufactured for sale (manufacturing firm)
 When products are sold, product costs are recognized as an
expense (cost of goods sold or COGS). The costs of unsold
products remain in inventory and are not expensed (i.e. not
deducted from revenue in calculating net income)

Period Costs – costs that are not product costs and that are
associated with the period in which they are incurred
 Period costs such as selling and administrative costs are expensed
(i.e. deducted from revenue in calculating net income) in the
period they are incurred
PRODUCT COSTS VERSUS PERIOD
COSTS
Product costs include Period costs are not
direct materials, direct included in product
labor, and costs. They are
manufacturing expensed on the
overhead. income statement.
Cost of
Inventory Goods Sold
Expense

Sale

Balance Income Income

Sheet Statement Statement
COSTS RELATED TO DECISION
MAKING
Opportunity Costs - costs when taking one action requires giving
up the opportunity to earn profits from a different action
Incremental Costs or Differential Costs – additional costs
incurred when choosing a certain course of action over another
(Note that incremental costs can include opportunity costs
Sunk Costs – Costs that have been incurred and that are not
affected by any current/future action
 COST FLOWS IN A MANUFACTURING
COMPANY
3. Inputs such as labor and capital equipment are also
incurred to make the product. The costs of all the
inputs used in the manufacturing facilities are recorded
in WORK IN PROCESS INVENTORY
4. As products are finished, they are moved to finished
goods warehouse and their costs are recorded in
FINISHED GOODS (FG) INVENTORY
COST FLOWS IN A MANUFACTURING
COMPANY
RAW MATERIALS INVENTORY
Beg. Bal. - RM Materials used in Production (DM)
Materials Purchased

End. Bal. - RM

WORK IN PROCESS INVENTORY

Beg. Bal. - WIP Cost of Goods Manufactured
DM (COGM)
DL
OH

End. Bal. - WIP

FINISHED GOODS INVENTORY

Beg. Bal. - FG Cost of Goods Sold (COGS)
COGM

End. Bal. - FG
THE INVENTORY EQUATION

Beginning Inventory Ending Inventory

+ = +
Additions to Inventory Items Removed from Inventory

 The inventory equation allows us to put together the following schedules:

Schedule of Total Manufacturing Costs Schedule of Cost of Goods Manufactured

(of the period)
VARIABLE AND FIXED COSTS
Activity – a quantitative measure of a firm’s output of goods or services
 Number of Chrysler vans
 Pairs of Nike shoes
 Tons of cement produced
Variable Costs – costs that change proportionately (in total) with the
activity level within a relevant range of activity
Fixed Costs – costs that do not change in total as activity level changes
within a relevant range of activity
Example: Publishing a magazine
Variable costs Fixed Costs
Cost of paper Rent on building
Cost of ink Salaries to reporters
Sales Commissions Depreciation on printing equipment
Cost of lubricants for machine
Cost of operating press
CONT…
CONT…
 Fixed Cost
 A cost that remains constant within a given period of
time and range of activity in spite of fluctuations in
production.
 Per unit fixed cost with the change in the volume of
production. If the production increases, fixed cost per
unit decreases and as there is decrease in production, the
fixed cost per unit increases.
 Rent and insurance of building, depreciation on plant
and machinery, salary of employees etc., are some
examples of fixed costs.
CONT…
 Variable cost
 Variable costs are those cost which vary directly in
proportion to change in volume of production/output.
 The cost which increases or decreases in the same
proportion in which the units produced is termed as
variable cost.
 Direct material, direct labor , direct expenses, variable
overheads are some examples of variable cost.
TOTAL VARIABLE AND FIXED COSTS

Total Variable Cost Total Fixed Cost

Number of units Number of units

VARIABLE AND FIXED COSTS PER UNIT

Per Unit Variable Cost Per Unit Fixed Cost

Number of units Number of units

 RELEVANT RANGE
The range of activity within which the firm’s cost structure (i.e. variable
cost per unit and total fixed cost) remains unchanged
 Publishing a small number of magazines (cost structure of a small
publisher)

Total Variable Cost Total Fixed Cost

Relevant Range Number of units Relevant Range Number of units

 TOTAL COSTS
To get total costs you need to add variable costs and fixed
costs

Total Cost

Fixed costs
The Slope is the
variable cost per
unit

Number of units
 COST ESTIMATING
 Cost estimating is the estimation of the expected cost of
producing a job or executing a manufacturing order
before the actual production is taken up or
 predicting what new products will cost, before they are
made.
 The expected expenditure on all the items used to make a
product is added to give the estimated cost of final
product.
CONT…
COST ACCOUNTING
 Costing or cost accounting means classifying, recording
and allocating the appropriate
 expenditure for determining the cost of production and
achieved by keeping a continuous record of all
 the costs involved in manufacturing.
CONT…
 Costing or cost accounting gives the actual expenditure
incurred on the production of the
 component based on the records of expenditure on
various activities involved, when the product has already
been manufactured
CONT…
 estimating is a type of forecasting and gives the expected
expenditure to be incurred on the manufacture of the
product before the actual manufacturing is taken up.
 Also, cost estimating is done by qualified engineers,
whereas costing is done by accountants or cost
accountants.
BASIC STEPS IN COST ESTIMATION
 1. Make thorough study of cost estimation request to
understand it fully
 2. Make an analysis of the product and prepare a bill of
materials.
 3. Make separate lists of parts to be purchased from the
market and parts to be manufactured in plant.
CONT…
 4. Determine the cost of parts to be purchased from outside.
 5. Estimate the material cost for the parts/components to be
manufactured in plant.
 6. Make manufacturing process plan for the parts to be
manufactured in plant.
 7. Estimate the machining time for each operation listed in the
manufacturing process plan.
 8. Multiply each operation time by the labour wage rate and add
them up to find direct labour
 cost.
 9. Add the estimate of step 4, 5, and 8 to get prime cost of
component.
 10. Apply overhead costs to get the total cost of the component.
 The selling price of the component is estimated by adding profit to
the total cost obtained in step 10
COST OF PRODUCT (LADDER OF
COSTS)
 1. Prime cost = Direct material cost + Direct labour cost
+ Direct expenses
 2. Factory cost = Prime cost + Factory expenses

 3. Production cost = Factory cost + Administrative

expenses
 4. Total or Ultimate cost = Production cost + Selling and
distribution expenses.
 5. Selling price = Ultimate cost + Profit
CONT…
CONT…
 Example 1 : Calculate prime cost, factory cost,
production cost, total cost and selling price per
 item from the data given below for the year 2003-04.
 Rs.
 Cost of raw material in stock as on 1-04-2003 25,000
 Raw material purchased 40,000
 Direct labour cost 14,000
 Direct expenses 1,000
 Factory/Works overhead 9,750
CONT…
 Administrative expenditure 6,500
 Selling and distribution expenses 3,250

 No. of items produced 650

 Cost of raw material in stock as on 31-03-2004 15,000

 Net profit/item is 10 percent of total cost of the product.

CONT…
 Solution : For 650 units produced during 2003-04
 (i) Direct material used = Stock of raw material on 1-04-2003 + raw
material purchased – stock of raw material on 31-03-2004
 = 25,000 + 40,000 – 15,000
 = Rs. 50,000
 (ii) Direct labour = Rs. 14,000
 (iii) Direct expenses = Rs. 1,000
 Prime cost = 50,000 + 14,000 + 1,000
 = Rs. 65,000
 Factory cost = Prime cost + Factory expenses
 = 65,000 + 9,750
 = Rs. 74,750
 Production cost = Factory cost + Administrative expenses
 = 74,750 + 6,500
 = Rs. 81,250
CONT…
 Total cost = Production cost + Selling expenses
 = 81,250 + 3,250

 = Rs. 84,500

 Selling price = 84,500 + 10 percent of 84,500

 = Rs. 92,950

 Prime cost/item =

 65, 000/650 = 100

 Factory cost/item =

 74, 750/650 = 115

CONT…
 Production cost/item =
 81, 250/650 = Rs. 125

 Total cost/item =

 84, 500/650= Rs. 130

 Selling price/item =

 92, 950/650 = Rs.143

BREAK EVEN POINT, BREAK EVEN CHART AND
BREAK EVEN ANALYSIS

 Fixed costs : The fixed costs are the items of

expenditure which remain more or less constant
irrespective of the volume of production
 Variable costs : Variable costs are those items of
expenditure which vary with the volume of
production.
CONT…
Fixed Costs Variable costs
 Depreciation  direct material cost,

 Interest on capital  cost of power/fuel

amount consumed,
 Supervisory charges  cost of tools used,

 Operator charges  cost of consumable

 Rent of building stores, repair and

maintenance charges,
storage charges
CONT…
 Break-even point (BEP) represents the production
quantity for which the total cost of producing the
goods equals the total sales price.
 At break-even point there will be neither any profit nor
any loss to the manufacturer.
CONT…
 Q = Quantity at BEP
 F = Fixed costs

 V = Variable cost per unit produced

 S = Selling price per unit

 Then F + (Q × V ) = S × Q

 Q= F/S – V
CONT…
 Break-even chart is a graphical representation of
inter-relationship between quantity produced, cost of
producing and sales return.
 The total cost of production (fixed cost + variable cost)
and total sales return are plotted against quantity
produced.
 The intersection of the total cost and total sales return
lines gives the break-even point.
CONT…
INVESTMENT EVALUATION
 Total investment costs: Defined as the sum of fixed
capital (fixed investments plus production capital costs)
and net working capital

 Fixed Assets: It comprises of fixed investments and pre-

production capital costs.
CONT…
 1) Fixed Investments: Land & site preparation, Building
& civil works, Plant machinery & equipment including
auxiliary equipment, Certain incorporate fixed assets
such as industrial property rights.
 2) Pre- production capital expenditure:

 A) Expenditures incurred during the registration &

formation of the company like legal fees for preparation
memorandum, articles of association & similar
documents.
CONT…
 B)Consultant fees for preparing studies, engineering
services & supervision of erection & construction.
 C) Other expenditures for planning the project.

 D) Salaries , Travel expenses, social security contributions

of personnel engaged during the pre-production period.
 E) Preparatory installations such as camps, temporary
offices, stores etc.
 F) Training costs, including fees, travel and living
expenses, salaries and stipends of the trainees
 G) Interest on loan during construction
 WORKING CAPITAL
 Defined as the current assets minus current liabilities. It
indicates the financial means required to operate the
project according to its production program.
 Current assets- Receivables, inventories(raw material,
auxiliary material, supplies packaging materials, spares
and small tools), work in progress, finished products and
cash.
 Current liabilities- Accounts payable (creditors) and are
free of interest.
CONT…
Working Capital= Current Assets - Current Liabilities
Or Working Capital= Permanent Capital - Fixed Capital
Types of Capital:
Three types- Equity, Debt and Mezzanine.
SOURCES OF FINANCING
 Equity capital providers,
 commercial banks,

 Export credit agencies,

 Bilateral and Multilateral aid agencies,

 Industrial investors,

 National and regional development banks, Capital

markets and
 Local currency funding.
CONT…
 Interest is the excess amount which one earns over one’s
money lent to someone else (individual, banks,
organizations etc.)
 Interest may arise from one of the following reasons:

 Interest is a compensation for a current income

foregoing. Ex: If a farmer lends his money, he forgoes
some income, which he could have earned by using that
money for some productive purpose such as using
increased quantities of fertilizer.
 Interest is a reward somebody is entitled to, for his
sacrifice of present pleasure by lending his money to
somebody else.