Basic Aspects of

Cost Accounting
Why organisations need costing systems
 An organisation’s costing system is the foundation of the
internal financial information system for managers.
 It provides the information that management needs to
plan and control the organisation’s activities and to make
decisions about the future.
 Reasons:
 Actual unit costs for the latest period
 Actual costs of operating a department for the latest period
 The forecast costs to be incurred at different levels of activity
What is cost accounting?
 Cost accounting is a management information system
which analyses past, present and future data to provide
the basis for managerial action.
 The cost accountant:
 Who can provide the answers to the following questions?
 What was the cost of goods produced or services provided last period?
 What was the cost of operating a department last month?
 What revenues were earned last week?
 Knowing about costs incurred or revenues earned enables
management to do the following.
 (a) Assess the profitability of a product, a service, a department,
or the whole organisation.
 (b) Perhaps, set selling prices with some regard for the costs of
sale.
 (c) Put a value on inventory (raw materials, work in progress,
finished goods) that are still held in store at the end of a period,
for preparing a statement of financial position showing of the
company's assets and liabilities.
 Cost accounting is concerned with providing information
to assist the following.
1. Establishing inventory valuations, profits and statement of
financial position items
2. Planning (for example the provision of forecast costs at
different activity levels)
3. Control (such as the provision of actual and standard costs
for comparison purposes)
4. Decision making (for example, the provision of information
about actual unit costs for the period just ended for pricing
decisions).
What is meant by ‘COST’?
 The word ‘cost’ can be used in two contexts.
 It can be used as a noun, for example, when we are referring to
the cost of an item.
 Alternatively, it can be used as a verb, for example, we can say
that we are attempting to cost an activity, when we are
undertaking the tasks necessary to determine the costs of
carrying out the activity.
 The word ‘cost’ can rarely stand alone and should always be
qualified as to its nature and limitations.
Cost units
 The CIMA Terminology defines a cost unit as ‘a unit of
product or service in relation to which costs are
ascertained’.
 This means that a cost unit can be anything for which it is
possible to ascertain the cost.
 The cost unit selected in each situation will depend on a
number of factors, including the purpose of the cost
ascertainment exercise and the amount of information
available.
 Cost units can be developed for all kinds of organisations,
whether manufacturing, commercial or public service
based. Some examples from the CIMA Terminology are as
follows:

INDUSTRY SECTOR COST UNIT

Brick-making 1000 bricks
Electricity Kilowatt-hour (KwH)
Professional services Chargeable hour
Education Enrolled student
ACTIVITY COST UNIT
Credit control Account maintained
Selling Customer call
Composite cost units
 The cost units for services are usually intangible and
they are often composite cost units, that is, they are often
made up of two parts.

BUSINESS COST UNIT

Hotel Bed night
Bus company Passenger mile
Hospital In-patient day
Cost Centres
 A cost centre is a production or service location, a
function, an activity or an item of equipment for which
costs are accumulated.
 A cost centre is used as a ‘collecting place’ for costs.
 The cost of operating the cost centre is determined for the
period, and then which have passed through the cost centre.

When costs are incurred, they are generally allocated to a cost centre. Cost centres may include the
following.
• A department
• A machine or group of machines
• A project (eg the installation of a new computer system)
• A new product (to enable the costs of development and production to be identified)
• A person (eg a marketing director. Costs might include salary, company car and other
expenses incurred by the director)
 For instance, an example of a production cost centre could be
the machine shop in a factory.
 The production overhead cost for the machine shop might be
Rs.100,000 for the period.
 If 1,000 cost units have passed through this cost centre we might say
that the production overhead cost relating to the machine shop was
Rs.100 for each unit.

TYPE OF COST CENTRE EXAMPLES

Service location Stores, canteen
Function Sales representative
Activity Quality control
Item of equipment Packing machine
Cost Objects
 A cost object is anything for which costs can be
ascertained.
 The CIMA Terminology contains the following
description:
 ‘For example a product, service centre, activity, customer or
distribution channel in relation to which costs are ascertained.’

Example, cost objects include:

• Chocolate cakes
• The provision of supply to one of the supermarkets
• The administration department
 Notice that CIMA’s examples of cost objects include a
customer.
 Can you think of costs that might be attributed to a supermarket
which is a customer and is treated as a cost object by a supplier
of processed foods?
 Costs that you might have thought of include the following:
 The cost of the food products supplied to the customer.
 The cost of delivering the food products to the customer.
 The cost of funding the credit taken by the customer.
 The cost of holding any inventories for the supermarket.
 The salary cost of the account manager responsible for the
supermarket’s account.
 The cost of dealing with the customer’s queries.
Classification of costs
Classification of
costs

Classification of Classification of
costs according costs according
to their nature to their purpose:

Material costs Direct costs and

Labour costs Indirect costs

Expense costs
Cost classification for inventory valuation and profit
measurement
 1. Cost elements
 For the purposes of inventory valuation and profit
measurement, the cost accountant must calculate the cost of one
unit. The total cost of a cost unit is made up of the following
three elements of cost.
 • Materials
 • Labour
 • Other expenses (such as rent and rates, interest charges and so on)

Cost elements are 'constituent parts of costs according to the factors

upon which expenditure is incurred, namely material, labour and
expenses'. CIMA Official Terminology
Cost elements can be classified as direct costs or indirect costs.
 2. Direct cost and prime cost
 A direct cost is a cost that can be traced in full to the
product, service, or department that is being costed.

A direct cost is 'expenditure that can be

attributed to a specific cost unit, for example
material that forms part of a
product'.

PRIME COST = DIRECT MATERIAL

COST + DIRECT LABOUR COST +
DIRECT EXPENSES
Prime cost is the 'total of direct material,
direct labour and direct expenses'.
CIMA Official Terminology
 3. Indirect cost/overhead
 An indirect cost (or overhead) is a cost that is incurred in the
course of making a product, providing a service or running a
department, but which cannot be traced directly and in full to
the product, service or department.

An indirect cost or overhead is 'expenditure on labour,

materials or services that cannot be economically identified
with a specific saleable cost unit'.
CIMA Official Terminology
Examples of indirect costs might be the cost of supervisors'
wages on a production line, cleaning materials and
buildings insurance for a factory.
 Total expenditure may therefore be analysed as
follows.

Materials cost = Direct materials cost + Indirect materials cost

+ +
Labour cost = Direct labour cost
+ +
Expenses = Direct expenses
Total cost = Direct cost/prime cost
+
+ Indirect labour cost
+
+ Indirect expenses
+ Overhead cost
 Which of the following costs would be charged to the
product as a prime cost?
 A Component parts
 B Part-finished work
 C Primary packing materials
 D Supervisor wages

A, B and C
A, B and C are all examples of direct material
costs. The prime cost includes direct material,
direct labour and direct
expenses. D is an indirect labour cost.
 4. Product costs and period costs
 For the preparation of financial statements, costs are often
classified as either product costs or period costs. Product
costs are costs identified with goods produced or
purchased for resale. Period costs are costs deducted as
expenses during the current period.

A product cost is a 'cost of a finished product built up from its cost elements'.
A period cost is a 'cost relating to a time period rather than to the output of
products or services'.
CIMA Official Terminology
 5. Functional costs
 Classification by function involves classifying costs as
production/manufacturing costs, administration costs or
marketing/selling and distribution costs.
 This way of classifying costs involves relating the costs to
the activity causing the cost. In a 'traditional' costing
system for a manufacturing organisation, costs are
classified by function as follows.
 • Production or manufacturing costs
 • Administration costs
 • Marketing, or selling and distribution costs
Cost classification for decision making
 A different way of classifying costs is into fixed costs and
variable costs.
 Many costs are part fixed and part variable and so are
called semi-fixed, semi-variable or mixed costs.
 A knowledge of how costs vary at different levels of
activity (or volume) is essential to decision making.

Decision making is concerned with future events and so

managers require information on expected future costs and
revenues. Although cost accounting systems are designed to
accumulate past costs and revenues this historical
information may provide a starting point for forecasting
future events.
 1. Fixed costs and variable costs
 A fixed cost is a 'cost incurred for an accounting period, that,
within certain output or turnover limits, tends to be unaffected
by fluctuations in the levels of activity (output or turnover)'.
 A variable cost is a 'cost that varies with a measure of activity'.
 A semi-variable cost is a 'cost containing both fixed and
variable components and thus partly affected by a change in the
level of activity'.
 2. Relevant costs
 Relevant costs are future cash flows arising as a direct
consequence of a decision.
 Relevant costs are future costs
 Relevant costs are cash flows
 Relevant costs are incremental costs

Relevant costs are future costs.

A decision is about the future and it cannot alter what has been done already.
Costs that have been incurred in the past are totally irrelevant to any decision that is
being made 'now'. Such costs are past costs or sunk costs.
 A relevant cost is a cost that will change as a result of some
decision. Suppose you are thinking about going to a concert this
evening.
 You purchased the $100 ticket several weeks ago. If you go to the
concert, you will likely spend $50 on transportation and parking and
$70 on snacks and refreshments.
 You are thinking you really cannot afford the $120 that you will
spend this evening but you don’t want to “waste” the $100 you
already spent. The total cost if you go to the concert is $220 ($100,
$50, $70).
 However, the $100 ticket price is sunk and not relevant in the
decision you are making today about whether or not to go tonight.
The relevant cost is $120 (which is also called the incremental cost).
 Richard Thaler, an economist who studies decision-making
behavior, provides an interesting example on the other side of
this concert story.
 Suppose in this case there are only immaterial costs of
attending the concert and you have lost the ticket; would you
buy another ticket to go to the concert?
 You have already signaled that you get more than $100 of pleasure
from the concert, so you should be willing to repurchase the ticket
(the loss of the ticket is a sunk cost),
 But many people would choose not to go to the concert.
 Relevant costs are incremental costs.
 For example, if an employee is expected to have no other work
to do during the next week, but will be paid his basic wage (of,
say, $100 per week) for attending work and doing nothing, his
manager might decide to give him a job which earns the
organisation $40.
 The net gain is $40 and the $100 is irrelevant to the decision because
although it is a future cash flow, it will be incurred anyway whether
the employee is given work or not.
 4. Differential costs and opportunity costs
 Relevant costs are also differential costs and opportunity
costs.
 • Differential cost is the difference in total cost between
alternatives.
 • An opportunity cost is the value of the benefit sacrificed
when one course of action is chosen in preference to an
alternative.
 5. Sunk costs: A sunk cost is a past cost which is not
directly relevant in decision making.
 Which of the following options describes the value of a
benefit sacrificed when one course of action is chosen in
preference to an alternative?
 A Relevant cost
 B Differential cost
 C Opportunity cost
 D Sunk cost

Ans is C Opportunity cost

Elements of cost
 The elements of cost are the constituent parts of cost
which make up the TOTAL COST OF A COST
OBJECT.
Cost Behaviour
 Many factors affect the level of costs incurred; for
instance inflation will cause costs to increase over a period
of time.
 In management accounting, when we talk about cost
behaviour we are referring to the way in which costs are
affected by fluctuations in the LEVEL OF ACTIVITY.
 The level of activity can be measured in many different
ways.
 For example, we can record the:
 Number of units produced,
 Miles travelled,
 Hours worked,
 Meals served,
 Percentage of capacity utilised
 1. Fixed cost: The CIMA Terminology defines a fixed
cost as a ‘cost incurred for an accounting period, that,
within certain output or turnover limits, tends to be
unaffected by fluctuations in the levels of activity (output
or turnover)’.
 Another term that can be used to refer to a fixed cost is a
PERIOD COST. This highlights the fact that a fixed cost
is incurred according to the time elapsed, rather than
according to the level of activity.
 The fixed cost per unit reduces as the activity level is
increased. This is because the same amount of fixed cost
is being spread over an increasing number of units.
 2. Variable cost: The CIMA Terminology defines a
variable cost as a ‘cost that varies with a measure of
activity’.
 Examples of variable costs are direct material, direct
labour and variable overheads.
 3. Semi-variable cost: A semi-variable cost is also
referred to as a semi-fixed or mixed cost.
 The CIMA Terminology defines it as a ‘cost containing
both fixed and variable components and thus partly
affected by a change in the level of activity’.
 Examples of semi-variable costs are gas and electricity.
Both of these expenditures consist of a fixed amount
payable for the period, with a further variable amount
which is related to the consumption of gas or electricity.
Quick Tests
 In general terms, financial accounting is for internal reporting
whereas cost accounting is for external reporting.(T/F)
 Choose the correct words from those highlighted.
 In practice, most cost accounting systems use historical
cost/economic cost/economic value/cost value as a measurement
basis.
 Classification of expenditure into material, labour and
expenses, say, is an example of:
 A subjective classification
 B objective classification
 C classification by responsibility
 D classification by behaviour
 A fixed cost is a cost which tends to vary with the level of activity. (T/F)
 Categorise these costs:
 Sales commission
 Functional cost
 Rent ?
 Fixed cost
 Research and development costs
 Fixed cost

 Which of the following would be classified as indirect labour?

 A Assembly workers in a company manufacturing televisions
 B A stores assistant in a factory store
 C Plasterers in a construction company
 D An audit clerk in a firm of auditors
 The following information is available for product M for the month of
December.
 Production costs:
 Variable $4 per unit
 Fixed $6,000
 The total production cost of producing 4,000 units of product M in December is $ _____________?

 Which of the following options describes the value of a benefit

sacrificed when one course of action is chosen in preference to an
alternative?
 A Relevant cost
 B Differential cost
 C Opportunity cost
 D Sunk cost