Cost Accounting

Definition

Chartered Institute Of Management Accountants ( CIMA London )

Costing is the technique and process of ascertaining cost

Cost Accounting
Cost accounting measures and reports information relating to the cost of acquiring and utilizing resources Cost accounting provides information for management and financial accounting
Cost management describes the approaches and activities of managers in short-run and long-run planning and control decisions These decisions increase value of customers and lower costs of products and services Cost management is an integral part of a companys strategy
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Cost Accounting

It provides information for both management accounting and financial accounting. It measures and reports from financial and non financial data.

Financial Accounting
Financial accounting measures and records business transactions and provides financial statements that are based on generally accepted accounting principles (GAAP) Managers are responsible for the financial statements issued to investors, government regulators, and other parties outside the organization

Financial accounting focuses on external parties

Financial accounting reports on what happened in the past

An Introduction to Cost Terms

Costs and Cost Objects

Cost a resource sacrificed or foregone to achieve a specific objective Cost Object any product, machine, service or process for which cost information is accumulated cost objects can vary in size from an entire company, to a division or program within the company, or down to a single product or service

Direct and Indirect Costs

Direct Cost a cost which is related to a particular cost objective and can be traced to it in an economically feasible way

Indirect Cost a cost which is related a particular cost objective but cannot be traced to it in an economically feasible way indirect costs are allocated to cost objectives
Direct Cost Indirect Cost Trace

Cost Object
Allocate
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Cost Drivers and Cost Management

Cost driver (cost generator or cost determinant) a factor which causes the amount of cost incurred to change production costs are driven by the number of products produced, labour costs, number of setups required, and the number of change orders Cost Reduction Programs focus on two things: 1. Doing only value-added activities 2. Efficiently manage the use of cost drivers in those value-added activities
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Variable and Fixed Costs

Variable Cost a cost which is constant per unit but changes in total in proportion to changes in the output materials (parts), fuel costs for a trucking company Fixed Cost a cost which does not change in total as volume changes but changes on a per-unit basis as the cost driver increases and decreases amortization, insurance
R s

Volume

R s

Volume
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Total Costs and Unit Costs

Unit Cost (or Average Cost) Total cost / some number of units Average cost = Total manufacturing costs / Number of units produced = Rs980,000 / 10,000 = Rs98 per unit Unit or average costs must be interpreted with caution As volume increases, the unit or average cost falls as the fixed costs are spread over a larger number of units
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Types of Inventory

Direct material inventory (stock awaiting use in the manufacturing process) Work-in process inventory (partially completed goods on the shop floor) Finished goods inventory (goods completed but not yet sold)

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Period and Product Costs

Period Costs are expensed on the income statement as they are incurred also called operating costs (excluding cost of goods sold) examples: selling, general and administrative costs Product Costs are inventoried on the balance sheet and expensed only when the product or service is sold also called inventoriable costs Examples: materials and labour (manufacturing)
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Costing System Terminology

Cost Object anything for which a separate measurement of costs is desired Cost Pool a grouping of individual cost items

Cost Allocation Base a factor that is the common denominator for systematically linking an indirect cost or group of indirect costs to a cost object
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Alternative Classifications of Costs

1. Business function a. R&D b. Design c. Production d. Marketing e. Distribution f. Customer service 2. Assignment to a cost object a. Direct costs b. Indirect costs 3. Behaviour pattern a. Variable costs b. Fixed costs 4. Aggregate or average a. Total costs b. Unit costs 5. Assets or expenses a. Inventoriable costs b. Period costs

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Costs in a Manufacturing Company

Balance Sheet
Direct Material Purchases Direct Labour Materials Inventory Work in Process Inventory Finished Goods Inventory

Income Statement
Revenue
Cost of Goods Sold Gross Margin Period Costs Marketing and Administrative Costs Operating Income
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Indirect Manufacturing Costs Inventoriable (Product) Costs

Costing Systems

Job-Costing System
Costs are assigned to a distinct unit or batch Resources are expended to bring a distinct product or service to market for a specific customer advertising campaign, audit, aircraft assembly

Process-Costing System Costs are assigned to a mass of similar units Resources are used to mass-produce a product or service and not for any specific customer Postal delivery, oil refining
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Job Costing Approach

1. Identify the cost object(s) 2. Identify the direct costs for the cost object(s) 3. Select cost-allocation bases to use in allocating the indirect costs to the cost object(s) 4. Identify the indirect costs associated with each cost-allocation base

5. Compute the rate per unit of each cost-allocation base to allocate indirect costs to the cost object(s)
6. Compute the indirect costs allocated to the cost object(s) 7. Determine the cost of the cost object(s) by adding the direct and indirect costs 18

Job Costing Overview

Indirect Cost Pool Manufacturing Overhead Rs1,215,000 27,000 Direct Manufacturing Labour-Hours

Cost Allocation Base

Rs45 per direct Manufacturing Labour Hours

Direct Material Direct Labour

Cost Object: Direct + Indirect Costs

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Job Costing System in Manufacturing

Buy Materials Materials Inventory Work-In-Process Inventory Use Materials Finished Goods Inventory Sell Goods

Cost of Goods Sold

Complete Production

Incur Labour Costs Incur Overhead Costs

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Cost Sheet

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Cost Sheet
It is a statement designed to show the output of a particular accounting period along with breakup of cost. It is a memorandum statement It does not form part of double entry cost accounting records. It discloses the total cost and cost per unit. It helps

To fix Selling Price.

To submit quotation price. To Control cost.
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 COST SHEET
Total Cost Cost Per unit

Direct Materials Direct Labour Prime Cost Add: Works Overheads Works Cost Add: Administration overheads Cost of Production Add: Selling & Distribution Overheads Total Cost or Cost of Sales

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Elements of Cost
Direct Material :Identify in the product Easily measure & directly charge to the product e.g. Timber in furniture making Categories raw material Specifically purchased for specific job or process Parts or components purchased. e.g. tyres for cycles Primary Packing material to protect finished product for easy handling inside the factory. 24

Direct Labour :Labour engaged in converting raw material into finished goods Altering the construction Actual Production Composition of Product i.e labour which can be attributed to a particular job,product or process Exception :- Where the cost is not significant like wages of trainees- their labour though directly spent on product is not treated as direct Labour Test: Easily Identify Feasible to Identify 25

Overheads :- It may be defined as the aggregate of the cost of indirect materials, indirect labour and such other expenses including services as cant conveniently be charged direct to specific cost unit. Categories: Manufacturing Overheads Administration of machines Selling & distribution of machines

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Standard Costing

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Why is Standard Costing Used?

A standard is a preestablished benchmark for desirable performance. A standard cost system is one in which a company sets cost standards and then uses them to evaluate actual performance. A variance is the difference between actual performance and the standard.
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Favorable versus Unfavorable

A standard is a preestablished benchmark for desirable performance.

An unfavorable variance occurs when actual performance falls below the standard.

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. Standard cost is the Predetermined cost based on a technical estimate for material, labor and overhead for a selected period of time and for a specified set of working conditions.

Standard costing is the preparation of standard cost and applying them to measure the variations from actual

costs and analyzing the causes of variations with a view

to maintain maximum efficiency in production
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Quantity and Price Standards

Quantity used

Price paid

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Ideal versus Practical Standards

A standard that allows for no inefficiencies of any kind is an ideal standard.

A standard that allows for the normal inefficiencies of production is called a practical standard.

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The Standard Costing Process

Gather information and set standards. Investigate the cause of variances.

Compare actual performance to standard and prepare performance reports.

Determine if corrective action is needed.

Determine which variances to investigate.

Take corrective action.

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Problems With Standard Costing

Employees may try to set low standards to make them easier to achieve. Using historical data to set standards may build in past inefficiencies. Managers might focus on the numbers to the exclusion of other important factors.
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Problems With Standard Costing

Focus on unfavorable variances may result in ignoring the favorable variances. Managers may lose sight of the big picture.

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Comparison of Cost Systems

Cost Classification

Actual Cost System Actual Actual Actual

Normal Cost System Actual Actual

Standard Cost System Estimated Estimated

Direct Material
Direct Labor Manufacturing Overhead

Estimated Estimated
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Analysis of variance

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Analysis of Variance
Analysis of Variance may be done in respect of each element of cost and sales: 1.Direct Material Variance

2.Direct Labor Variance

3.Overhead Variance

4.Sales Variance
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Material Variances

(Standard Price x Standard Rate) - ( Actual quantity x Actual Rate )

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Direct Materials Variances

There are two variances calculated for material cost variance. The material quantity variance (also called the usage variance) is a measure of the amount of materials used. The material price variance is a measure of the cost to buy the various materials that were purchased.
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Material Variances

( Standard material price Actual material price) Actual material quantity

( Standard material quantity Actual material quantity) Standard unit price

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Direct Materials Variances

Again Material Qt variances can be divided into two varainces

The material mix variance .

The material Yield variance

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Material Mix Variances

Actual weight do not differ

Standard Cost of Standard Mix Standard Cost of Actual Mix Std. Unit cost (SQ AQ)

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Material Mix Variances Actual weight differ

Total wt. Of actual mix X Std. Cost Total wt. Of standard of Std. Mix mix

Std. Cost of actual mix

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Material Variances

Standard Rate (Actual Yield Standard Yield ) {If std. & actual mix are same}

Standard Rate = Std. Cost of Std. Mix Net Std. Output (Gross output Standard loss)
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Material yield Variances

{Standard Rate (Actual Yield Revised Standard Yield ) If std. & actual mix are not same}

Standard Rate = Std. Cost of Revised Std. Mix Net Std. Output (Gross output Standard loss)
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Labor Variances

The labor cost variance is the difference between actual cost of hour worked and the standard cost allowed.

The labor rate variance is the difference between the actual direct labor cost incurred and the standard cost for the actual hours worked.
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Labor Cost Variance

St. Cost of labor Actual cost of labor

Labor Rate Variance

Rate variance =Actual Time Taken (Standard Rate Actual Rate)
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Total Labor Efficiency Variance

Standard Rate (Standard time for actual Output - Actual time Paid for)

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Labor Variances

Total Labor efficiency variance are of two types

Labor Efficiency Variance

Labor Idle Time variance

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Labor Variances

Labor Efficiency Variance

Labor Efficiency Variance = Standard rate(Standard time for actual output - Actual time worked)

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Labor Variances

Labor Idle Time variance

Labor Idle Time variance = Abnormal Idle Time x Standard Rate

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Labor Variances

Labor Mix Variance

St. Cost of St Composition (Actual time taken) Standard cost of actual Composition ( Actual time worked)

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Labor Variances

Labor Yield Variance

Standard Rate (Actual Yield Revised Standard Yield)

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Overhead cost variance can be defined as the difference between the Standard cost allowed for the actual output achieved and the actual overhead cost incurred.

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Overhead :- According to terminology of cost Accountancy (ICWA London) Overhead is defined as The aggregate of indirect material cost, indirect wages (indirect Labor Cost) and indirect expenses.

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Overhead Costs
Overhead costs are significant for most organizations Variable Overhead Recall that variable overhead is allocated to products and services using a budgeted variable overhead rate

Fixed Overhead Recall that fixed overhead is allocated to products and services using a budgeted fixed overhead rate

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Overhead Cost Variances

Variable Overhead
How the Cost is Planned and Controlled
Rs Rs

Fixed Overhead

Volume

Volume
Rs

How Costs are Allocated to Products

Rs

Volume

Volume
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Overhead cost Variance:-

Overhead Cost Variance

Variable overhead variance Fixed overhead variance

Expenditure variance

Efficiency variance

Expenditure Volume variance variance

Capacity variance

Calendar variance

Efficiency variance
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Overhead Cost Variance :Overhead Cost Variance ( Actual output x Standard overhead Rate per unit ) Actual overhead cost

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Overhead Cost Variances

Overhead Cost variances can be

divided into two varainces
1. Variable Overhead variance

.
2. Fixed Overhead variance

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Variable Overhead Variance

1. Variable Overhead variance (Actual output x Standard variable overhead rate) (Actual variable overheads)

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Variable Overhead Variances

Variable Overhead variances can be

divided into two variances
1. Variable Overhead Expenditure variance

.
2. Variable Overhead Efficiency variance

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(A) Variable overhead (spending) expenditure

variance = (Actual hours worked x standard variable overhead rate) Actual variable overheads (B) Variable overhead efficiency variance = Standard variable overhead rate(standard Hours for Actual output Actual Hours)

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2. Fixed overhead variance

Fixed overhead variance (Actual output x standard fixed overhead rate) Actual fixed overheads Fixed overhead variance can be categorized into:a) Expenditure variance = Budgeted Fixed overheads Actual fixed overheads

b)

Volume variance = actual output x Standard rate Budgeted fixed overheads

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b) Capacity variance= standard rate( Revised Budgeted units Budgeted units)

c) Calendar variance = (Decrease or increase in number of units produced due to the difference of budgeted and actual days x standard rate per unit)
e) Efficiency Variance = Standard Rate (Actual Production Standard Production)

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Using Standard Cost Variances

A performance report should be prepared on a periodic basis for the managers who are responsible for the standard cost variances. The management by exception concept would then be used by the managers to focus their attention on the most significant cost variances.
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Marginal Costing

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Marginal Costing:Chartered Institute of Management Accountant, EnglandMarginal costing is the ascertainment of

marginal cost and of the effect on profit of changes in volume or type of output by differentiating between fixed cost and variable costs.

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Features of Marginal Costing:

Cost is classified into : Fixed Cost Variable Cost Variable cost is only charged to production Fixed cost is recovered from contribution Valuation of stock of WIP and F.G. is done on the basis of marginal cost. Selling price is based on marginal cost and contribution It is technique used to ascertain the marginal cost & to know the impact of V.C. on volume of output Profit is calculated by deducting marginal cost and fixed cost from sales C-V-P analysis is one of integral part of marginal costing 70

Costs
Fixed (Indirect/Overheads) are not influenced by the quantity produced but can change in the long run e.g., insurance costs, administration, rent, some types of labour costs (salaries), some types of energy costs, equipment and machinery, buildings, advertising and promotion costs. Variable (Direct) vary directly with the quantity produced, e.g., raw material costs, some direct labour costs, some direct energy costs. Semi-fixed Where costs not directly attributable to either of the above, for example some types of energy and labour costs.
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Costs
Total Costs (TC) = Fixed Costs (FC)+ Variable Costs (VC) Average Costs = TC/Output (Q) AC (unit costs) show the amount it costs to produce one unit of output on average Marginal Costs (MC) the cost of producing one extra or one fewer units of production MC = TCn TCn-1
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Revenue

Total Revenue also known as turnover, sales revenue or sales = Price x Quantity Sold TR = P x Q Price may be a variety of different prices for different products in the portfolio Quantity Units sold
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Profit Profit = TR TC Normal Profit the minimum amount required to keep a business in a particular line of production Abnormal/Supernormal Profit the amount over and above the amount needed to keep a business in its current line of production
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Marginal Cost Equation Sales = Variable Cost + Fixed Cost + Profit/Loss Sales - Variable Cost = Fixed Cost + Profit/Loss Sales - Variable Cost = Contribution Therefore, Contribution = S.P. V.C. or Contribution = Fixed Cost + Profit
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Cost-Volume-Profit (CVP) Analysis

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Cost volume Profit Analysis Cost volume Profit Analysis is a logical extension of marginal costing C.V.P. analysis examines the relationship of cost & profit to the volume of business to maximize profits Indicates direct relationship between volume & profit Indicates Indirect relationship between volume & cost per unit (Inverse)
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Cost-Volume-Profit Assumptions and Terminology

1. Changes in the level of revenues and costs arise only because of changes in the number of product (or service) units produced and sold. 2. Total costs can be divided into a fixed component and a component that is variable with respect to the level of output.
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Cost-Volume-Profit Assumptions and Terminology

3. When graphed, the behavior of total revenues and total costs is linear (straight-line) in relation to output units within the relevant range (and time period).

4. The unit selling price, unit variable costs, and fixed costs are known and constant.
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Abbreviations

SP = Selling price VCU = Variable cost per unit

CMU = Contribution margin per unit

CM% = Contribution margin percentage FC = Fixed costs
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Abbreviations

Q = Quantity of output units sold (and manufactured) OI = Operating income TOI = Target operating income TNI = Target net income

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Breakeven Point

Sales

Variable expenses

Fixed expenses

Total revenues = Total costs

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Break Even
Point of No Profit and No Loss Occurs where Total Costs = Total Revenue

Fixed Costs Break-Even Point = --------------Contribution

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Cost-Volume-Profit Assumptions and Terminology

Break even point ( Rs ) =Fixed Cost / P/V ratio

Break Even point (Units) = Fixed Cost (Total) ----------------------------(S.P per unit M.C per unit) or( Contribution per Unit)

P/V Ratio = Profit / Sales P/V Ratio = Contribution / Sales

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Cost-Volume-Profit Assumptions and Terminology

Value of sales to earn desired amount of profit:(Fixed Cost + Desired Profit) -----------------------------------------P/ V ratio

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Cost-Volume-Profit Assumptions and Terminology

Variable Cost = Sales (sales x P/V ratio)
Profit= (sales x P/V ratio) Fixed Cost Fixed Cost= (sales x P/v ratio) Profit

Margin of safety = (Rs) = Profit/ P/V ratio or = Actual sales Break Even Sales (Units) = Profit / Contribution per unit
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Essentials of Cost-Volume-Profit (CVP) Analysis Example

Assume that the Furniture Shop can purchase Chairs for Rs32 from a local factory; other variable costs amount to Rs10 per unit. The local factory allows the Furniture Shop to return all unsold Chairs and receive a full Rs32 refund per pair of Chairs within one year. The average selling price per pair of Chairs is Rs70 and total fixed costs amount to Rs84,000.
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Essentials of Cost-Volume-Profit (CVP) Analysis Example

How much revenue will the business receive if 2,500 units are sold? 2,500 Rs70 = Rs175,000 How much variable costs will the business incur? 2,500 Rs42 = Rs105,000

Rs175,000 105,000 84,000 = (Rs14,000)

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Essentials of Cost-Volume-Profit (CVP) Analysis Example

What is the contribution margin per unit?

Rs 70 Rs 42 = Rs 28 contribution margin per unit

What is the total contribution margin when 2,500 pairs of Chairs are sold? 2,500 Rs 28 = Rs70,000

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Essentials of Cost-Volume-Profit (CVP) Analysis Example

Contribution margin percentage (contribution margin ratio) is the contribution margin per unit divided by the selling price. What is the contribution margin percentage? Rs28 Rs70 = 40%

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Essentials of Cost-Volume-Profit (CVP) Analysis Example

If the business sells 3,000 pairs of Chairs, revenues will be Rs 210,000 and contribution margin would equal 40% Rs 210,000 = Rs 84,000.

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Equation Method

(Selling price Quantity sold) (Variable unit cost Quantity sold) Fixed costs = Operating income Let Q = number of units to be sold to break even Rs70Q Rs42Q Rs84,000 = 0 Rs28Q = Rs 84,000 Q = Rs84,000 Rs28 = 3,000 units
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Contribution Margin Method

Rs84,000 Rs28 = 3,000 units

Rs84,000 40% = Rs210,000

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Graph Method

378 336 294 252 210 168 126 84 42 0 0

Breakeven

$(000)

Fixed costs

1000

2000

3000

4000

5000
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Units

Target Operating Income

(Fixed costs + Target operating income) divided either by Contribution margin percentage or Contribution margin per unit

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Target Operating Income

Assume that management wants to have an operating income of Rs 14,000. How many pairs of Chairs must be sold? (Rs84,000 + Rs14,000) Rs 28 = 3,500 What sales are needed to achieve this income?

(Rs84,000 + Rs14,000) 40% = Rs245,000

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Target Net Income and Income Taxes Example

Proof: Revenues: 4,822 Rs70 Variable costs: 4,822 Rs42 Contribution margin Fixed costs Operating income Income taxes: Rs51,016 30% Net income

Rs337,540 202,524 Rs135,016 84,000 51,016 15,305 Rs 35,711

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Alternative Fixed/Variable Cost Structures Example

Suppose that the factory the Chairs Shop is using to obtain the merchandise offers the following: Decrease the price they charge from Rs32 to Rs25 and charge an annual administrative fee of Rs30,000. What is the new contribution margin?

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Alternative Fixed/Variable Cost Structures Example

Rs70 (Rs25 + Rs10) = Rs35

Contribution margin increases from Rs28 to Rs35.

What is the contribution margin percentage?

Rs35 Rs70 = 50% What are the new fixed costs?

Rs84,000 + Rs30,000 = Rs114,000

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Alternative Fixed/Variable Cost Structures Example

Management questions what sales volume would yield an identical operating income regardless of the arrangement. 28x 84,000 = 35x 114,000
114,000 84,000 = 35x 28x 7x = 30,000 x = 4,286 pairs of Chairs
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Alternative Fixed/Variable Cost Structures Example

Cost with existing arrangement = Cost with new arrangement .60x + 84,000 = .50x + 114,000 .10x = Rs30,000 x = Rs300,000 (Rs300,000 .40) Rs 84,000 = Rs36,000

(Rs300,000 .50) Rs114,000 = Rs36,000

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Contribution income statement emphasizes . contribution margin. Financial accounting income statement emphasizes gross margin.

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Application Of Marginal Costing

1. 2. 3. 4.

Cost Control Profit planning Evaluation of performance Decision Making Fixation of selling Price Key or limiting factors Make or Buy Decision
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Application Of Marginal Costing

Selection of suitable product mix Effect of change in price Maintained a desired level of Profit Alternative methods of Production Diversification of Products Closing down of activities Alternative course of action Level of activity planning
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Typical Relevant Costing Decisions

One-Time-Only Special Order (Pricing) Make or Buy Decisions (Outsourcing) Opportunity Costs Product Mix Decisions under Capacity Constraints Add or Drop a Product Line or Customer Equipment Replacement Decisions

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One-Time-Only Special Order

Without Order Volume Relevant revenues 30,000 With Order 35,000

Difference 5,000

Rs600,000 Rs655,000 Rs55,000

Relevant costs: Variable manufacturing Incremental income

(225,000)

(262,500)

(37,500)

Rs17,500
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Outsourcing and Make/Buy Decisions

Make Relevant costs: Outside cost of parts Direct materials Direct labour Variable overhead Fixed purchasing, receiving and setup overhead Rs160,000 Rs80,000 10,000 40,000 Buy Difference

Rs160,000

(80,000) (10,000) (40,000)

20,000

(20,000)

Incremental difference In favour of making

Rs10,000
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Outsourcing and Opportunity Costs

Make Relevant cost to make Relevant cost to buy Opportunity cost: Profit forgone because Capacity cannot be used to make another product Total relevant costs Rs150,000 Buy

Rs 160,000

25,000 Rs175,000 Rs160,000

Opportunity cost considers the profits lost by not following the next best alternative course of action
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Product Mix Decisions Under Constraint

Snowmobile Engine Contribution margin per unit Machine hours required per unit Contribution margin per machine hour Rs240 2 Rs120 Boat Engine Rs375 5 Rs75

If machine hours are constrained, maximize income by first producing as many snowmobile engines as can be sold and then shift production to boat engines

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Customer Profitability Analysis

Keep Account Drop Account Difference

Relevant revenue Rs1,200,000 Rs800,000 Rs(400,000) Relevant costs: Cost of goods sold 920,000 590,000 330,000 Material-handling labour 92,000 59,000 33,000 Marketing support 30,000 20,000 10,000 Order/delivery 32,000 20,000 12,000 Decline in operating income if drop account
Rs(15,000)
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