ACC116

Introduction to Cost Accounting

CHAPTER 1:
INTRODUCTION
 Learning Outcome:
At the end of this topic, the student should be able to :
Define what is of Cost Accounting
Identify the objective of Cost Accounting
Differentiate between Financial Accounting and Cost Accounting
Differentiate between Cost unit and Cost centre
Identify the element of Costs
Classify cost according to nature, function, behaviour, controllability and
normality
Identify what is Cost statement
Definition of Cost Accounting
Cost accounting is “the application of accounting and
costing principles, methods and techniques in the
ascertainment of costs and the analysis of savings
and/or excesses as compared with previous experience
or with standards”. (CIMA)
 What is Costing?

Defined as the ascertainment of cost

Aims at providing management with information

for purpose of planning and control.

Also helps management make policy decisions.

 Main objective of cost accounting are:

3. To make decision

2. To plan and control cost

1. To determine / ascertain cost

 Definition

Costing System – method of ascertaining costs with the ultimate aim to plan, control and to make
decisions in the operations of a business.

Management accounting – an information system that produces the information required by

managers to create value and manage resources

Financial accounting – the practice of preparing and reporting accounting information for parties
outside organisation
 Costing and Financial Accounting

Costing is an extension of financial accounting.

Financial accounting will give a general indication to management on the performance of the
business, profit or loss being the most important indicator.

Cost accounting, on the other hand, will give a detailed indication of the business performance.

The cost accountant will use the information from the financial accounting system and will also
gather information on the internal operations of the business.

He will ascertain costs and will analyse costs and profits by cost centres, products, jobs or
processes.
 Differences between financial accounting and cost
accounting
Financial Accounting Cost Accounting
Objective It provides information about the financial It provide information of ascertainment of
performance and financial position of the cost to control cost and for decision making
business. about the cost.

Reporting Accounts are prepared to comply with the No legal requirement.

requirement Companies Act, to satisfy the requirements of
the Inland Revenue Board.

Users External users - shareholders, creditors, Internal users -internal management at

financial analysts and government and its different levels
agencies, etc.
Time focus Past oriented Future oriented
 Differences between financial accounting and cost
accounting, con’t..
Financial Accounting Cost Accounting

It provides the details of cost and

Analysis of costs and It shows the profit/loss of the organisation. profit of each product, process, jobs,
profits
contracts, etc.

Report Summary Details of the performance- actual

and expected

Reporting Frequency Annually or semi-annually Depend on the management –

weekly, monthly, quarterly or
annually
 Cost Concepts
1. Cost Unit
◦ Cost unit is a quantitative unit of product or service to which cost can be related.
◦ Selection of suitable cost unit depends upon several factors, such as nature of business, process of
information, requirements of costing system, etc.
◦ Example:
Industry / Product Cost Unit
Automobile Number

Biscuit Kilogram

Chemical Litre, Gallon, Kilogram

Cement Tonne

Gas Cubic Foot, Cubic Metre

Hospital Patient Day

Hotel Guest-day, Guest Room

Power and electricity Kilowatt-hour

Steel Tonne

Transport Passenger Kilometre, Tonne-kilometre

2. Cost Centre
Defined as ‘a location, person or item of equipment (or group of them) in
respect of which costs may be ascertained and relate to the cost units’.
E.g. a person such as salesman; an item of equipment such as delivery van
Cost centre can be classified into:

Production cost centres • Where production take place.

• For furniture manufacturing business, a production cost
centres are the machine department, assembly
department and finishing department.
Process Cost Centres • Where a specific process or a continuous sequences of
operations take place
• Ex: refining process
Service Cost centre • It provide services to other cost centre
• Ex: stores, maintenance, production planning and
personnel.
 Classification of Costs
Costs are classified according to the purpose for which the information is
needed.

Classification of Costs

1. Nature 2. Function 3. Behaviour 4. Controllability 5. Normality

Production Controllable
Materials Fixed costs Normal costs
costs costs

Administration Uncontrollable Abnormal

Labour Variable costs
costs cost costs

Other Marketing Semi-variable

expenses costs costs

Other cost Step costs

1. Nature
* Based on the nature of costs
* classified into materials, labour and other expenses
 Materials

Direct Materials
• All materials that can be physically identified with a specific product.
• Example: for Manufacturers such as Toyota, the direct materials include
steel, tires, engines, etc.
• Example: baking a cake: flour, sugar, eggs etc

Indirect Materials
• Items of material that cannot be physically identified with a specific
product.
• Example: oil and lubricants for the machines, cleaning supplies etc.
• Example: cake: box, candles etc
 1. Nature, con’t..
 Labour

Direct Labour
• Labour costs that can be traced or identified with a particular
product.

• Example: At Toyota, direct labour includes the wages of machine

operators and technicians who assemble the parts and wire the
electronics to build the completed vehicles.

Indirect Labour
• Wages of employees who do not work on the product itself, just
assist in the manufacturing operation.

• Example: salaries, wages and benefits of plant janitors, plant

supervisors, security officer , clerk etc.
1. Nature, con’t..
 Other Expenses
 All costs associated with the manufacture of a product except direct materials
and direct labor
Direct expenses
• Expenses which are incurred specifically to a particular
product

• Example: Cost of design and layout, royalties payable on

use of patents, copyrights, surveyors etc.

Indirect expenses
• All other costs needed to operated a factory which is not
charged directly to the product.
• Example: insurance, electricity, advertising etc.
 2. Function
Cost are classified by function to which they relate.

Costs Function
Production Costs • Incurred from the time of acquisition of materials
until the despatch of completed items to store.
• Examples: Production overhead, direct materials,
direct labour and direct expenses.
Administration • Incurred in the general administration including
Costs directing and controlling the operations of an
organization.
• Examples: Audit fees, office rent, salaries for admin
staff
Marketing Costs • Incurred in selling, publicizing, distributing and
product servicing.
• Examples: Selling costs, publicity cost, distribution
2. Function, con’t..
Costs Function
Finance Costs • Incurred in financing the activity of the business.
• Examples: Interest, Commitment fee, insurance and
dividends.
Research • Incurred in seeking new or improved ideas, materials,
Costs methods and products.
• Examples: Cost of laboratory maintenance, salaries of
research staff.
Development • Incurred in developing the new or improved ideas and
Costs methods so that production can take place.
• Examples: Cost of test or trials runs, obsolescence and
supplies.
3. Behaviour
Costs may or may not vary with the level of activity.

◦ 1. Fixed costs
◦ Will not change (constants) over a given range of activity (volume) and within a
given period of time.
◦ Example: insurance, depreciation, director’s salary, rental
The total fixed
costs do not
increase as
activity
increases.

Fixed cost
2. Variable cost
◦ Costs that vary in direct proportion to changes in the level of activity (volume).
◦ If a factory shut down and stops production completely, no variable cots will
be incurred.
◦ Example: direct materials, direct wages, direct expenses.

The total variable

costs increase as
activity (number of
units) increase.

Variable cost
3. Semi-variable or semi-fixed costs
◦ Costs that contains both fixed and variable costs.
◦ Example: telephone costs

The semi-variable
cost is made up of
a fixed and
variable cost
element.
4. Step cost
◦ Costs are fixed over a range of activity and then rises to a new level as activity
changes.
◦ Example: depreciation on machines may increase with an increase in the level of
activity as more machines are required.

Step costs
remain fixed
over a range
of activity.
4. Controllability

Controllable Uncontrollable

Costs that are not

Costs that are influenced influenced by the
by the decisions or decisions or actions of a
actions of a manager. manager.

Example: increased cost

Example: labour cost which can be of raw materials due to
control by controlling factors such as inflation.
efficiency, overtime, number of
employees etc.
5. Normality

• Costs that have been planned

• Part of cost production.
Normal Costs • Example: loss due to evaporation,
maintenance, salaries paid to employees.

• Costs that have not been plannned for.

• Not charged to the cost of production;
Abnormal Costs transferred to profit or loss account
• Example: lost production due to plant /
machine breakdown, destruction due to fire
 Product Cost vs Period Cost
Product Cost
🞆 Include all costs that are required to make a product “manufacturing costs” :
included as part of inventory and shown on the balance sheet until the product is
sold (cost of goods sold).
🞆 Example: Direct Material, Direct Labor, Manufacturing Overhead

Period Cost
🞆 “Non-manufacturing costs”
🞆 Selling and Administrative costs: reported on the income statement as they are
incurred.
🞆 Examples: Anything at corporate headquarters, anything related to selling the
product, shipping costs, administrative salaries, executive salaries, administrative
office expenses, sales commissions, advertising, research and development, etc.
🞆 Warehouse costs and people who move inventory are period costs
 Cost Statement
Cost statement is a statement showing all the costs that make up a product or
service.
RM
Direct Material Cost 3
Direct Labour Cost 2
Direct expenses 1

Prime Cost 6
Production overhead 3
Production Cost 9
Administration overhead 2
Selling & distribution overhead 1
Total Cost 12

Profit 3
Selling Price 15