UNIT-1: INTRODUCTION

An Overview of Cost and Management Accounting

 Cost accounting is a specialized branch of
accounting.
 It has been developed because of limitations of
financial accounting.
 The costing data needs to be arranged, re-
analyzed and processed further for playing more
effective role in the managerial process.

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Management accounting provides all
possible information required for
managerial purposes.
Management uses cost data to
minimize the costs and evaluate the
performance as a basis for decision
making.
It is for this reason that most of the cost
accounting concepts are also used in
management accounting. 2
Management accounting connotes a
much wider field than cost
accounting.
The function of management
accounting is much more than simply
the accumulation of cost data.
However, both cost and management
accounting systems are
complementary in nature.
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Cost terms, concepts and classification
Cost classifications for preparing external financial
statements.
Purpose: Preparing an income statement and balance
sheet.
Cost classification based on cost behavior or cost
classification as to variability.
 Purpose: Predicting changes in cost due to changes in
activity.
Cost classification based on cost objects.
 Purpose: Assign costs to different objects.
Cost classification for decision making.
 Purpose: For pricing, product planning, budgeting and
controlling. 4
Cost classifications for preparing external
financial statements.
This cost classification focuses on the
problem of valuing inventories and
determining cost of goods sold for
external financial reports.
Before beginning this discussion, you
may want to explain the difference
between a manufacturing and a
merchandising company. 5
 Manufacturing companies convert raw materials
into a product. The company then sells that
product either to other companies or, less
commonly, directly to individuals.
 Merchandising companies, by contrast, buy
finished products and resell the products to
customers.
 Valuing inventories and determining cost of
goods sold is simple in a merchandising company,
but is difficult in a manufacturing company.
 For that reason, we concentrate on
manufacturing in this section of the unit.
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 Manufacturing costs
 These costs are incurred to make a product.
 Manufacturing costs are usually grouped into three
main categories: direct materials, direct labor, and
manufacturing overhead.
 Direct material + Direct labor = Prime cost.
 Direct labor + Manufacturing overhead = Conversion
cost.
 Most manufacturing companies divide manufacturing
costs into above three broad categories.
 There is no any manufacturing costs for merchandise
companies.
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Non-manufacturing costs
 A manufacturing company incurs many other
costs in addition to manufacturing costs.
 For financial reporting purposes most of these
other costs are typically classified as selling
(marketing) costs and administrative costs.
 Marketing and administrative costs are incurred in
both manufacturing and merchandising firms.

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 Product costs versus Period costs
 In addition to the distinction between
manufacturing and nonmanufacturing costs, there
are other way to look at costs.
 For instance, they can also be classified as either
Product costs or period costs.

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 Product costs:
 For financial reporting purposes, product costs
include all the costs that are involved in acquiring
or making a product.
 These product costs are assigned to inventories
and are considered assets until the products are
sold.
 At the point of sale, product costs become cost of
goods sold on the income statement.
 For manufacturing-sector companies, all
manufacturing costs (DM, DL & MOH) are product
or inventoriable costs.
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 For merchandising-sector companies , product
or inventoriable costs are the costs of
purchasing the goods that are resold in their
same form.
 These costs comprise the costs of the goods
themselves plus any incoming freight,
insurance, and handling costs for those goods.
 Service-sector companies provide only services
or intangible products.
 The absence of inventories of tangible products
for sale means there are no product or
inventoriable costs.
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 For merchandising-sector companies , product
or inventoriable costs are the costs of
purchasing the goods that are resold in their
same form.
 These costs comprise the costs of the goods
themselves plus any incoming freight,
insurance, and handling costs for those goods.
 Service-sector companies provide only services
or intangible products.
 The absence of inventories of tangible products
for sale means there are no product or
inventoriable costs.
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 Period costs:
 Period costs are all the costs that are not included
in product costs.
 Period costs are expensed on the income
statement in the time period in which they are
incurred.
 All nonmanufacturing (selling and administrative)
costs are typically considered to be period costs.
 Therefore, for manufacturing-sector companies,
period costs in the income statement are all
nonmanufacturing costs.
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 For merchandising-sector companies, period
costs in the income statement are all costs not
related to the cost of goods purchased for resale.
 Examples of these period costs are labor costs of
sales personnel and advertising costs.
 Because there are no inventoriable costs for
service-sector companies, all costs in the income
statement are period costs.

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Cost classification based on cost behavior or cost classification
as to variability.
 Managers often need to be able to predict how costs will
change in response to changes in activity.
 The activity can be expressed in many ways, such as units
produced, units sold, miles driven, hours worked, and so forth.
 Accordingly costs can be classified into variable and fixed costs.
 A variable cost is constant per unit of activity but changes in
total as the activity level rises and falls.
 A fixed cost is constant in total for changes in activity within
the “relevant range”.
 When expressed on a per unit basis, a fixed cost is inversely
related to activity—the per unit cost decreases when activity
rises and increases when activity falls.
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 The relevant range is the range of activity within
which the assumptions about variable and fixed
costs are valid.
 For example, the assumption that the rent for
diagnostic machines is Birr 8,000 per month is
valid with in the relevant rage of 0 to 2,000 tests
per month.

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 Cost classification based on cost objects.
 Managers often want costs to be assigned to “cost objects”
 such as products, product lines, jobs customers, departments,
etc.
 for a variety of purposes including for pricing, profitability
studies and control of spending.
 For purposes of assigning costs to cost objects, costs are
classified as either direct or indirect.
 Direct Costs: (DM & DL)
 A direct cost can be easily and conveniently traced directly
to a cost object.
 For example, the cost of materials required for a particular
product is a direct cost because it can be traced directly to
the product.
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 Indirect Costs:
 An indirect cost is a cost that cannot be easily and conveniently
traced to the particular cost object.
 For example, administrative wages & salaries, office equipment
depreciation, selling expenses such costs that generally cannot be
directly traced to individual products and therefore are
considered indirect costs.
 Therefore, these costs are called common costs of producing the
various products of the factory.
 The assignment of indirect costs to cost objects is called cost
allocation, a form of cost assignment in which direct tracing is not
economically feasible, so cost drivers are used instead.
 A cost driver is any factor that has the effect of changing the
amount of total cost. or
 Drivers are casual factors whose effects are increases in total
costs. 18
Cost classification for decision making.
 Costs are an important feature of many business
decisions.
 In making decisions, it is essential to have a firm grasp of
the concepts differential cost, opportunity cost and sunk
cost.
Differential cost:
 Decisions involve choosing between alternatives.
 In business decision, each alternative will have certain
costs and benefits that must be compared to the costs
and benefits of the other available alternatives.
 A difference in costs between any two alternatives is
known as a differential cost or incremental cost.
 For example consider the following case. 19
 ABC Company is thinking about changing its marketing
method from distribution through retailers to distribution
by door-to-door direct sale. Present costs and revenues,
and projected costs and revenues are as follows.
Retailer Direct Sale Differential costs
(Present) (Proposed) and revenues
Revenue $700,000 $800,000 $100,000
CGS 350,000 400,000 50,000
Advertising 80,000 45,000 (35,000)
Commissions 0 40,000 40,000
Warehouse dep. 50,000 80,000 30,000
Other expenses 60,000 60,000 0
Total 540,000 625,000 85,000
Net Income 160,000 175,000 15,000 20
 Opportunity cost:
 It is the potential benefit that is given up when
one alternative is selected over another.
 To illustrate this important concept, consider the
following examples.
 Example-1: Mr. X is employed with a company
that pays him a salary of $20,000 per year. He is
thinking about leaving the company and returning
to school. Since returning to school would require
that he give up his $20,000 salary, the forgone
salary would be an opportunity cost of seeking
further education.
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 Sunk cost:
 A sunk cost is a cost that has already been
incurred and that cannot be changed by any
decision made now or in the future.
 Since sunk costs cannot be changed by any
decision, they are not differential costs.
 Therefore, they should be ignored in decision
making.
 For example: $500 spent to replace brakes for
Motor car last year—not relevant in making a
selling decision in the future
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Cost behavior analysis and use
 Cost behavior analysis is the study of how specific
costs respond to changes in the level of business
activity.
 With an appropriate activity index costs can be
classified as variable, fixed and mixed costs.
Variable costs:
 As we discussed earlier that variable costs are
costs that vary in total directly and
proportionately with changes in the activity level.
 But variable cost that remains the same per unit
at every level of activity.
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 The variable cost may true variable cost or step variable cost.
(True variable versus step variable costs).
 Not all variable cost have exactly the same behavior pattern.
 Some variable costs behave in a true or proportionately
variable pattern.
 Other variable costs behave in a step variable pattern.
True variable costs:
 Direct materials is true or proportionately variable cost
because the amount used during a period will vary in direct
proportion to the level of production activity.
Step variable costs:
 A cost that is obtainable only in large chunks (such as the labor
cost of maintenance workers) and that increase or decrease
only in response to fairly wide changes in the activity level is
known as step variable cost. 24
 Fixed costs:
 Fixed costs are costs that remain the same in total
regardless of changes in the activity level.
 But fixed costs per unit vary inversely with activity;
as volume increases, unit cost declines and vice
versa.
 Fixed costs are sometimes referred to as a capacity
costs. This is because they result from outlays made
for buildings, equipment, skilled professional
employees, and other items needed to provide the
basic capacity for sustained operations.
 For planning purposes, fixed costs can be viewed as
being either committed or discretionary. 25
Committed fixed costs:
 These costs relate to the investment in facilities,
equipment, and the basic organizational structure of a
firm.
 For example, costs include depreciation of buildings and
equipment, taxes on real estate, insurance, and salaries
of top management and operating personnel.
Discretionary fixed costs:
 These costs are often referred to as managed fixed costs.
 Usually arise from annual decisions by management to
spend in certain fixed cost areas.
 For example, research, public relations, management
development programs, and internships for students.
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 Mixed costs:
 Mixed cost sometime referred as semi variable cost.
 Mixed costs contain both a variable element and a fixed element; they
increase in total as the activity level increases but not proportionately.
 For purpose of planning, mixed costs must be classified into their fixed
and variable elements.
 Suppose that ABC Computers has 10 sales representatives, each earning a
salary of $30,000 per year plus a commission of $50 per computer sold.
 If 10,000 computers are sold, then the total cost (associated with the
sales representatives) is $800,000 that is the sum of the fixed salary cost
of $300,000 (10 × $30,000) and the variable cost of $500,000 ($50 ×
10,000).
 The linear equation for a mixed cost is given by:
 Y = a + bX (Y = Total mixed costs; a = Total fixed costs; b = Variable cost per unit; X =
Level of activity).
 Y = $300,000 (10 × $30,000) + ($50 × 10,000).
 Y = $800,00
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 Analysis of mixed costs:
 There are three major methods of analyzing
mixed costs that rely on past records of cost and
activity data.
 High-low method
 Scattergraph method
 Least-squares regression method.

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High-low method
 To analyze mixed costs with this method, you begin by
identifying the period with the lowest level of activity
and the period with the highest level of activity.
 The difference in cost observed at the two extremes is
divided by the change in activity between the
extremes in order to estimate the variable cost per
unit of activity.
 i.e., Variable cost per unit = Change in total costs/High
minus low activity level.
 Then determine the fixed cost by subtracting the total
variable cost at either the high or the low activity level
from the total cost at that activity level.
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Case-1: Assume that the following information gathered from records of
maintenance costs and patient days for the seven months of the Adama
Hospital.
Month Activity Level: Maintenance costs
Patient Days incurred
January 5,600 $7,900
February 7,100 8,500
March 5,000 7,400
April 6,500 8,200
May 7,300 9,100
June 8,000 9,800
July 6,200 7,800

 Required: 1. Use the high-low method to estimate variable and fixed

components of maintenance costs incurred.
2. Express the fixed and variable components of maintenance costs
incurred as a cost formula in the linear equation form. 30
 Scatteredgraph method
 The above high-low method is very simple to apply, but it suffers
from a major defect in that it utilizes only two data points.
 Generally, two points are not enough to produce accurate results
in cost analysis work.
 Additionally, periods in which the activity level is unusually low
or unusually high will tend to produce inaccurate results.
 And also sometimes the high and low levels of activity don’t
coincide with the high and low amounts of cost.
 For these reasons, other methods of cost analysis that utilize a
greater number of points will generally be more accurate than
the high-low method.
 If a manager chooses to use the high-low method, he or she
should do so with a full awareness of the high-low method’s
limitations.
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 A more accurate way of analyzing mixed costs is
to use the scatter graph method.
 Under this method to analyze mixed costs, the
cost and its activity base should be plotted on a
scatter graph.
 A regression line is fitted to an array of plotted
points by drawing a line with a straight edge.
 This helps to quickly diagnose the nature of the
relation between the cost and the activity base.

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 Case-2: Refer to the case-1 and use scattergraph
method to estimate fixed cost per month and
variable cost per patient -day.

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Least-squares regression method
There are, two major drawbacks to the scatter graph method.
First, it is subjective.
No two analysts who look at the same scatter graph are likely to draw exactly
the same regression line.
Second, the estimates of fixed costs are not as precise as they are with other
methods, since it is difficult to precisely measure the dollar amount where the
regression line intersects the vertical cost axis.
Therefore, least-square method is more objective and precise approach to
estimating the regression line than the scatter graph method.
Rather than fitting a regression line through the scatter graph data by visual
inspection, this method uses mathematical formulas to fit the regression line.
Also, unlike the high-low method, this method takes all of the data into
account when estimating the cost formula.
A relatively steep slope indicates a strong relationship between the cost driver
and costs.
A relatively flat regression line indicates a weak relationship between the cost
driver and costs.
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Product costing methods:
Absorption and variable costing:
 Two general approaches are used for costing
products for the purpose of valuating inventories
and cost of goods sold.
 One approach is called absorption costing, it is
generally used for external financial reports.
 The other approach, called variable costing, is
preferred by some managers for internal decision
making and must be used when an income
statement is prepared in the contribution format.
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Absorption costing method
 Absorption costing treats all costs of production as product costs, regardless
of whether they are variable or fixed.
• Absorption costing technique is also termed as Traditional or Full Cost
Method.
• Under this method, the cost of a product is determined, after considering
both fixed and variable costs.
• The cost of a unit of product under this costing method therefore consists of
direct materials, direct labor and both variable and fixed manufacturing OH.
• The fixed costs are apportioned on a suitable basis over different products,
manufactured during a period.
 Thus, this costing allocates a portion of fixed manufacturing OH cost to each
unit of product, along with the variable MOH costs.

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Variable costing method
 Under this method, only those costs of production
that vary with output are treated as product costs.
 This includes direct materials, direct labor, and the
variable portion of manufacturing OH.
 Fixed manufacturing OH is not treated as a product
cost under this method.
 Rather, fixed MOH is treated as a period cost and, like
selling and administrative expenses, it is charged off
in its entirety against revenue each period.
 Consequently, the cost of a unit of product in
inventory or in cost of goods sold under this costing
method contains no element of FMOH cost. 37
Sierra Company produces and sells a single product. The following
costs relate to its production and sale.
Selling price per unit……………………… $20
Variable costs per unit:
Direct materials……………………………… $2
Direct labor …………………………………… 4
Variable MOH………………………………… 1
Variable selling & adm. Exp. ………….. 3
Fixed costs per year:
Fixed MOH ……………………………………………. $30,000
Fixed selling & adm. Exp. …………….. ………. $10,000
Units in beginning inventory ………. 0
Units produced ………………………….. 6,000
Units sold ………………………………….. 5,000
Units in ending inventory …………... 1,000 38
 Required:-
1. Assume that the company uses Absorption costing:
(a). Compute the unit product cost
(b). Prepare an income statement.
2. Assume that the company uses Variable costing:
(a). Compute the unit product cost
(b). Prepare an income statement.
3. Reconcile the variable costing and absorption
costing net income figures?

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