What is Management Accounting?

Posted on 19th Sep 2024 08:48:37 PM Accounting


The term management accounting refers to accounting for the management, i.e. accounting which provides necessary information to the management for discharging its functions. The functions of the management are planning, organizing, directing and controlling. Thus, management accounting provides information to management so that planning, organizing, directing and controlling of business operations can be done in an ordinary manner. 

The institute of cost and management accountants, London defines management accounting as follows-

“The application of professional knowledge and skill in the preparation of accounting information in such a way as to assist management in the formation of policies and in the planning and control of the operations of the undertaking”

“Management accounting is the application of appropriate techniques and concepts in processing historical and projected economics data of an entity to assist management in establishing plans for reasonable economics objectives, in the making of rational decisions with a view towards these objectives”

Objectives of Management Accounting
The important objectives of Management accounting are given in below-
1) To use the information: The statistical data relate to the management for determination of principles and goal.
2) Formulation of Plan:  Short and long term plan for the business enterprise by which amount of production, sales, financing, amount of cost, product price, amount of net profit etc  relating information can be gathered and also analyzed and formulate plan. Too much important for Short term yearly budget and long term capital budget formulation.
3) Control the activities: By this in every level management in business enterprise power and responsibility to perform activities can be distributed and also imposed duty is performed efficiently that are ensured.
4) Analyses and evaluation: Accomplished activities and also to compare with policy so that reason of variance can be known and control.
5) Taking decision: To find out various problems within the organization also to select better alternatives and taking correct decision.

Scope of management accounting: Management accounting is concerned with presentation of accounting information in the most useful way for the management. Its scope is quite vast and includes within its fold almost all aspects of business operations.
1) Financial Accounting
2) Cost accounting
3) Revaluation Accounting
4) Budgetary control
5) Statistics
6) Inventory control
7) Taxation
8) Office service
9) Internal audit

Function of management accounting
1) Provides data
2) Modifies data
3) Analysis and interpret data
4) Serves as a mean of communication
5) Facilitates control
6) Uses also qualitative information

Differences between management accounting, cost accounting and financial accounting

Function of Management Accountant: It is the duty of the management accountant to keep all levels of management informed of their real position. The jobs that are performed by him are as follows-
1) Planning
2) Controlling
3) Coordinating
4) Others functions
a) He administers tax policies and procedures.
b) He supervises and coordinates the preparation of reports to govt. agencies.
c) He ensures fiscal protection for the assets of the business through adequate internal control and proper insurance coverage.
d) He carious out continuous appraisal of economic and social forces and the govt. influences and interests their effect on business.

Limitation of management Accounting
1) Limitation of basic records
2) Persistent efforts
3) Management accounting is only a tool
4) Wide scope
5) Top-heavy structure
6) Opposition to change
7) Evolutionary stage

Utility of management accounting
1) Planning
2) Controlling
3) Coordinating
4) Organizing
5) Motivating
6) Communicating

Installation of management accounting system
1) An appropriate organizational manual should be prepared and adapted.
2) The requisite staff will have to be recruited, trained and developed.
3) Appropriate forms, returns, etc. Should be designed, prepared and made available.
4) Classification and coordination of accounts.
5) Developing a suitable system for the integration of cost and financial data.
6) Setting up a suitable system of budgetary control.
7) Setting up of standards, introducing standard costing techniques.
8) Setting up of cost, budget and profit centers and introduction of operational research techniques.

Tools of management accounting
1) Financial Accounting
2) Financial statement analysis
3) Funds flow analysis
4) Cash flow analysis
5) Costing techniques
6) Budgetary control
7) Management reporting

Cost accounting: Cost accounting, as a tool of management, provides management with detail records of the costs relating to products, operations or functions. Cost accounting refers to the process of determining and accumulating the cost of some particular product or activity. It also covers classification, analysis and interpretation of costs. The cost so determined and accumulated may be the estimated future cost for planning purposes or actual costs for evaluating performance. 

The Institute of Cost and Management Accountants, London, defines cost accounting as “the process of accounting for cost from the point at which expenditure is incurred or committed to the establishment of its ultimate relationship with cost centers and cost units.

Finally we can say that cost accounting is the process which classify record and allocate costs by the determination of costs.

Costing: Cost accounting and costing have distinctly different meanings. The Institute of Cost and Management Accountants, London has defined costing as the ascertainment of costs. Costing includes “techniques and process of ascertaining” costs.

The “technique” refers to principles and rules which are applied for ascertaining costs of products manufactured and service rendered. 

There are mainly methods of costing known as Job costing and Process costing.

The “process” includes the day to day routine of determining costs within the method of costing (either job or process) adopted by a business enterprise. Within such process there could be historical costing, marginal costing, absorption costing, standard costing etc. 

Difference between costing and cost accounting

Objectives of / function of cost accounting:
There is a direct relationship among information needs of management, cost accounting objectives and techniques and tools used for analysis in cost accounting. Cost accounting has the following three important objectives:

1. To determine product cost: the objective of determining the cost of products is of prime importance of in cost accounting. The total product cost and cost per unit of product is important in making inventory valuation, deciding price of the product and managerial decision-making. Product costing covers the entire cycle of accumulating manufacturing and other costs and subsequently assigning them to work –in -progress and finished goods.

2. To facilitate planning and control of regular business activities:  Another important objectives of cost accounting is the creation of useful cost data and information for the purposes of planning and control by management. The different plans are evaluated in terms of respective cost and associated benefits. The management control over business operations aims to establish balance between actual and budgeted performances.

A properly cost accounting system includes the following steps in the controlling process:
I. Comparing actual business performances with budgets and standards.
II. Analyzing the variance between budgets and standards and actual by causes, and management responsibility so that corrective action may be taken.
III. Providing managers with data and reports about their individuals’ performance and performance of subordinates.

3. To supply information for short and long -run decisions: It is another important purpose of cost accounting is to provide important data so that management can take short and long run decision easily.

Other important objectives of cost accounting are describing in below:
1. To determine the cost per unit: Cost accounting determine per unit cost for every job, production process and for per unit of service. In which overall raw materials, labour and other direct and indirect costs are kept in account broadly. By which cost of finished goods and cost of work-in-progress can be determine separately.  
2. To provide a correct analysis of cost: It is another objective of cost accounting. According to this objective it analyzes different cost properly such as fixed, variable and mixed cost.
3. To disclose the sources of wastage:  By knowing the different cost separately it helps to find out the source of wastage and also helps to control the costs.
4. To determine price: it also helps to determine the price of product or service so that every cost associated with can be determined. 
5. To help  in the preparation of budget and implementation of budgetary control:

Advantages of cost accounting
Business enterprise can drive many advantages from the cost accounting system. Some advantages are as follows:
1. Provide data about profitable and un-profit able product and activities.
2. Minimize the losses and wastage:
3. Production/ manufacturing methods can be improved. So that costs can be controlled and profit increased.
4. Cost data can be obtained and compared with standard cost within the firm or industry. 
5. Helps management in avoiding losses due to many factors such as,
a. Low demand
b. Competitive conditions
c. Change in technology
d. Seasonal demand for the product 
6. Provides cost data and information to determine price of the product.
7. Negotiation with Govt. and labour union can be made easily with the information provided by it.
8. Helps management in knowing the costs of different alternatives and selecting most advantageous course of action.
9. More accurate and reliable financial account can be prepared.
10. Maximum utilization of resources such as physical and human resource.
11. Helps management to take appropriate and complex decision.
12. Helps to submit tender and future plan.
13. Helps to compare standard and actual cost and determine variance then helps to take corrective action. 

Relationship between cost accounting and financial accounting

Differences between cost accounting and financial accounting: There are some basic differences between cost and financial accounting which are needed to get a proper perspective. The most important differences between cost and management accounting are discussing in below:
1. Nature: Basically financial accounting classifies, records, presents and interprets, in terms of money, transactions and events that are of a financial character, and provides management with the facts and figures necessary for the preparation of the periodic financial statements-the balance sheet, the income statement and the statement of changes financial position. In contrast to financial accounting, cost accounting classifies records, presents and interprets in a significant manner the material, labour and overhead costs involved in manufacturing and selling each product or each job or rendering a service.
2. Primary users of information: The users of financial accounting information are the owners and the external users of the business enterprise such as shareholders, creditors, financial analyst, government authorities, stock exchange, labour unions etc. The information generated from the cost accounting system is used by members of management at different levels. 
3. Purpose: The purpose of financial accounting is to prepare trading account, profit and loss account and balance sheet. But the purpose of cost accounting is to prepare a cost sheet so that cost can control.
4. Accounting system: financial accounting follows the double entry system for recording, classifying and summarizing business transactions. But cost accounting does not based on double entry system. The data under cost accounting may be gathered for small or large segments or activities of an organization and monetary as well as other measures can be used for different activities in the firm. 
5. Accounting principles: The “generally accepted accounting principles” are important in financial accounting. But there have no specific principles for cost accounting.
6. Unit of measurement: in financial accounting the unit of measurement is must in the form of money. But in cost accounting besides money, labour hour, machine hour and product unit may be used as a unit of measurement for the purpose of analysis and decision making.
7. Time spam: financial accounting data and statements are developed for a definite period, usually yearly, half yearly, quarterly that means at regular time interval. But cost accounting is prepared whenever it is needed. Such report may be prepared on a monthly, weekly or even daily basis.
 
Limitation of cost accounting
Though cost accounting is the accounting system by cost of production or unit can be determined and controlled, some organizations do not look with favour the installation of cost accounting system. Some arguments are advanced against adopting cost accounting are as follows:
1. Costly and time consuming: The system of cost accounting may prove costly and small organization may not find it profitable. The collection, analysis, allocation and maintenance of cost data is a time-consuming and difficult task which requires efficient manpower.
2. Increase work load: all business organizations are required to prepare financial accounts to determine profit and financial position. So installation of cost accounting along with financial accounting system increase work load.
3. Less accuracy and active: cost accounting system itself is not an end but only a means to achieve certain objectives. The system itself will not improve efficiency, control cost and avoid wastage. Sometimes management personnel become inactive with the mere installation of the cost accounting system.
4. Complex to implement the system:  Some of the organization cannot implement the cost accounting system properly which create complexity for the organization. That is not the problem of cost accounting system but also for users of it.

However the above arguments are not valid keeping in view the advantage and contributions of the cost accounting to management as explained earlier, it can be rightly said that cost accounting is necessary for all manufacturing firms. It is necessary to reduce cost, to avoid wastage, to improve efficiency and to provide cost data to management for planning, controlling and decision making. 
Cost center, profit center and 

Difference between cost centre and cost unit
There have some basic differences between cost centre and cost unit that are describing in below-
1. Definition: cost unit is the smallest part of product and service to determine cost. Cost centre is the division, labour, machinery, location, process and responsibility which ascertained cost.
2. Purpose: cost unit are fixed to determine per unit cost of product and service. Cost centre are fixed to collect, distribute and control of the cost of product and service by various centre.
3. Function: cost unit is the  diversification of production. Cost centre is the division of production.
4. Necessity: cost unit is necessary to determine cost. Cost centre is mandatory to control and distribute of cost.
5. Scope: the value of the produced goods and service and profit can be calculated by the cost unit. Cost centre only calculate cost and also distribute and control.  

Cost centre
According to the Chartered Institute of Management Accountants, London, cost center means “a location, person or item of equipment (or group of these) for which costs may be ascertained and used for the purpose of cost control.” Thus, cost center refers to one of the convenient units into which the whole factory or an organization has been appropriately divided for costing purposes. Each such unit consists of a department, a sub-department or an item or equipment or machinery and a person or a group of persons. Sometimes, closely associated departments are combined together and considered as one unit for costing purposes. For example, in a laundry, activities such as collecting, sorting, marking and washing of clothes are performed. Each activity may be considered as a separate cost center and all costs relating to a particular cost center may be found out separately. 

Cost centers may be classified as follows
a. Productive, unproductive and mixed cost centers:  Productive cost centers are those which are actually engaged in making products. Service or unproductive cost centers do not make the products but act as the essential aids for the productive centers. The examples of such service centers are as follows: 
• Administration department 
• Repairs and maintenance department 
• Stores and drawing office department 

Mixed costs centers are those which are engaged sometimes on productive and other times on service works. For example, a tool shop serves as a productive cost center when it manufactures dies and jigs to be charged to specific jobs or orders but serves as servicing cost center when it does repairs for the factory. 

b. Personal and impersonal cost centers: Impersonal cost center is one which consists of a department, a plant or an item of equipment whereas a personal cost center consists of a person or a group of persons.

c. Operation and process cost centers: In case a cost center consists of those machines or persons which carry out the same operation, it is termed as operation cost center. If a cost center consists of a continuous sequence of operations, it is called process cost center. In case of an operation cost center, cost is analyzed and related to a series of operations in sequence such as in chemical industries, oil refineries and other process industries. The objective of such an analysis is to ascertain the cost of each operation irrespective of its location inside the factory.

Cost can be determine, distribute and control by the accumulation of cost by this cost centre. But the specific income or revenue cannot be determined by the cost centre.

Profit centre: profit centre is that department which can determine cost and income. Since income and expenses/cost can be determined so profit can also be determined by this centre. The scope of profit centre is wider than the cost centre. Within a profit centre there may have several cost centre.

Investment centre: Which department can determine the amount of investment along with cost and profit centre is called as investment centre. Rate of return on investment also can be determined by this centre. The efficiency of manager also can be determined through by the investment centre.

Cost and expenses
Differentiate between cost and expenses.

Cost Unit and Cost Center
The technique of costing involves the following: 
• Collection and classification of expenditure according to cost elements 
• Allocation and apportionment of the expenditure to the cost centers or cost units or both 

Cost Unit
While preparing cost accounts, it becomes necessary to select a unit with which expenditure may be identified. The quantity upon which cost can be conveniently allocated is known as a unit of cost or cost unit. The Chartered Institute of Management Accountants, London defines a unit of cost as a unit of quantity of product, service or time in relation to which costs may be ascertained or expressed. 

Unit selected should be unambiguous, simple and commonly used. Following are the examples of units of cost: 
(i) Brick works             per 1000 bricks made
(ii) Collieries                per ton of coal raised
(iii) Textile mills             per yard or per lb. of cloth manufac- tured or yarn spun
(iv) Electrical companies             per unit of electricity generated
(v) Transport companies             per passenger km.
(vi) Steel mills             per ton of steel made

Cost centre: According to the Chartered Institute of Management Accountants, London, cost center means “a location, person or item of equipment (or group of these) for which costs may be ascertained and used for the purpose of cost control.” Thus, cost center refers to one of the convenient units into which the whole factory or an organization has been appropriately divided for costing purposes. Each such unit consists of a department, a sub-department or an item or equipment or machinery and a person or a group of persons. Sometimes, closely associated departments are combined together and considered as one unit for costing purposes. For example, in a laundry, activities such as collecting, sorting, marking and washing of clothes are performed. Each activity may be considered as a separate cost center and all costs relating to a particular cost center may be found out separately. 

Cost centers may be classified as follows:

d. Productive, unproductive and mixed cost centers: Productive cost centers are those which are actually engaged in making products. Service or unproductive cost centers do not make the products but act as the essential aids for the productive centers. The examples of such service centers are as follows: 
• Administration department 
• Repairs and maintenance department 
• Stores and drawing office department 

Mixed costs centers are those which are engaged sometimes on productive and other times on service works. For example, a tool shop serves as a productive cost center when it manufactures dies and jigs to be charged to specific jobs or orders but serves as servicing cost center when it does repairs for the factory. 

e. Personal and impersonal cost centers: Impersonal cost center is one which consists of a department, a plant or an item of equipment whereas a personal cost center consists of a person or a group of persons.

f. Operation and process cost centers: In case a cost center consists of those machines or persons which carry out the same operation, it is termed as operation cost center. If a cost center consists of a continuous sequence of operations, it is called process cost center. In case of an operation cost center, cost is analyzed and related to a series of operations in sequence such as in chemical industries, oil refineries and other process industries. The objective of such an analysis is to ascertain the cost of each operation irrespective of its location inside the factory.

Cost can be determine, distribute and control by the accumulation of cost by this cost centre. But the specific income or revenue cannot be determined by the cost centre.

Difference between cost centre and cost unit
Classification of Cost: Cost may be classified into different categories depending upon the purpose of classification. Some of the important categories in which the costs are classified are as follows: 

1. Fixed, Variable and Semi-Variable Costs: The cost which varies directly in proportion with every increase or decrease in the volume of output or production is known as variable cost. Some of its examples are as follows: 
• Wages of laborers 
• Cost of direct material 
• Power 

The cost which does not vary but remains constant within a given period of time and a range of activity in spite of the fluctuations in production is known as fixed cost. Some of its examples are as follows: 
• Rent or rates 
• Insurance charges 
• Management salary 

The cost which does not vary proportionately but simultaneously does not remain stationary at all times is known as semi-variable cost. It can also be named as semi-fixed cost. Some of its examples are as follows: 
• Depreciation 
• Repairs 

Fixed costs are sometimes referred to as “period costs” and variable costs as “direct costs” in system of direct costing. Fixed costs can be further classified into: 
• Committed fixed costs 
• Discretionary fixed costs 

Committed fixed costs consist largely of those fixed costs that arise from the possession of plant, equipment and a basic organization structure. For example, once a building is erected and a plant is installed, nothing much can be done to reduce the costs such as depreciation, property taxes, insurance and salaries of the key personnel etc. without impairing an organization’s competence to meet the long-term goals. 

Discretionary fixed costs are those which are set at fixed amount for specific time periods by the management in budgeting process. These costs directly reflect the top management policies and have no particular relationship with volume of output. These costs can, therefore, be reduced or entirely eliminated as demanded by the circumstances. Examples of such costs are research and development costs, advertising and sales promotion costs, donations, management consulting fees etc. These costs are also termed as managed or programmed costs. 

In some circumstances, variable costs are classified into the following: 
• Discretionary cost 
• Engineered cost 

The term discretionary costs are generally linked with the class of fixed cost. However, in the circumstances where management has predetermined that the organization would spend a certain percentage of its sales for the items like research, donations, sales promotion etc., discretionary costs will be of a variable character. 

Engineered variable costs are those variable costs which are directly related to the production or sales level. These costs exist in those circumstances where specific relationship exists between input and output. For example, in an automobile Industry there may be exact specifications as one radiator, two fan belts, one battery etc. would be required for one car. In a case where more than one car is to be produced, various inputs will have to be increased in the direct proportion of the output. 

Thus, an increase in discretionary variable costs is due to the authorization of management whereas an increase in engineered variable costs is due to the volume of output or sales. 

2. Product Costs and Period Costs: The costs which are a part of the cost of a product rather than an expense of the period in which they are incurred are called as “product costs.” They are included in inventory values. In financial statements, such costs are treated as assets until the goods they are assigned to be sold. They become an expense at that time. These costs may be fixed as well as variable, e.g., cost of raw materials and direct wages, depreciation on plant and equipment etc.

The costs which are not associated with production are called period costs. They are treated as an expense of the period in which they are incurred. They may also be fixed as well as variable. Such costs include general administration costs, salaries salesmen and commission, depreciation on office facilities etc. They are charged against the revenue of the relevant period. Differences between opinions exist regarding whether certain costs should be considered as product or period costs. Some accountants feel that fixed manufacturing costs are more closely related to the passage of time than to the manufacturing of a product. Thus, according to them variable manufacturing costs are product costs whereas fixed manufacturing and other costs are period costs. However, their view does not seem to have been yet widely accepted. 

3. Direct and Indirect Costs: The expenses incurred on material and labor which are economically and easily traceable for a product, service or job are considered as direct costs. In the process of manufacturing of production of articles, materials are purchased, laborers are employed and the wages are paid to them. Certain other expenses are also incurred directly. All of these take an active and direct part in the manufacture of a particular commodity and hence are called direct costs.

The expenses incurred on those items which are not directly chargeable to production are known as indirect costs. For example, salaries of timekeepers, storekeepers and foremen. Also certain expenses incurred for running the administration are the indirect costs. All of these cannot be conveniently allocated to production and hence are called indirect costs. 

4. Decision-Making Costs and Accounting Costs: Decision-making costs are special purpose costs that are applicable only in the situation in which they are compiled. They have no universal application. They need not tie into routine-financial accounts. They do not and should not conform the accounting rules. Accounting costs are compiled primarily from financial statements. They have to be altered before they can be used for decision-making. Moreover, they are historical costs and show what has happened under an existing set of circumstances. Decision-making costs are future costs. They represent what is expected to happen under an assumed set of conditions. For example, accounting costs may show the cost of a product when the operations are manual whereas decision-making cost might be calculated to show the costs when the operations are mechanized. 

5. Relevant and Irrelevant Costs: Relevant costs are those which change by managerial decision. Irrelevant costs are those which do not get affected by the decision. For example, if a manufacturer is planning to close down an unprofitable retail sales shop, this will affect the wages payable to the workers of a shop. This is relevant in this connection since they will disappear on closing down of a shop. But prepaid rent of a shop or unrecovered costs of any equipment which will have to be scrapped are irrelevant costs which should be ignored. 

6. Shutdown and Sunk Costs: A manufacturer or an organization may have to suspend its operations for a period on account of some temporary difficulties, e.g., shortage of raw material, non-availability of requisite labor etc. During this period, though no work is done yet certain fixed costs, such as rent and insurance of buildings, depreciation, maintenance etc., for the entire plant will have to be incurred. Such costs of the idle plant are known as shutdown costs. 
Sunk costs are historical or past costs. These are the costs which have been created by a decision that was made in the past and cannot be changed by any decision that will be made in the future. Investments in plant and machinery, buildings etc. are prime examples of such costs. Since sunk costs cannot be altered by decisions made at the later stage, they are irrelevant for decision-making.

An individual may regret for purchasing or constructing an asset but this action could not be avoided by taking any subsequent action. Of course, an asset can be sold and the cost of the asset will be matched against the proceeds from sale of the asset for the purpose of determining gain or loss. The person may decide to continue to own the asset. In this case, the cost of asset will be matched against the revenue realized over its effective life. However, he/she cannot avoid the cost which has already been incurred by him/her for the acquisition of the asset. It is, as a matter of fact, sunk cost for all present and future decisions. 

Example: Jolly Ltd. purchased a machine for $. 30,000. The machine has an operating life of five yea$ without any scrap value. Soon after making the purchase, management feels that the machine should not have been purchased since it is not yielding the operating advantage originally contemplated. It is expected to result in savings in operating costs of $. 18,000 over a period of five years. The machine can be sold immediately for $. 22,000.

To take the decision whether the machine should be sold or be used, the relevant amounts to be compared are $. 18,000 in cost savings over five yea$ and $. 22,000 that can be realized in case it is immediately disposed. $. 30,000 invested in the asset is not relevant since it is same in both the cases. The amount is the sunk cost. Jolly Ltd., therefore, sold The machinery for $. 22,000 since it would result in an extra profit of $. 4,000 as compared to keeping and using it. 

7. Controllable and Uncontrollable Costs: Controllable costs are those costs which can be influenced by the ratio or a specified member of the undertaking. The costs that cannot be influenced like this are termed as uncontrollable costs.

A factory is usually divided into a number of responsibility centers, each of which is in charge of a specific level of management. The officer in charge of a particular department can control costs only of those matte$ which come directly under his control, not of other matte$. For example, the expenditure incurred by tool room is controlled by the foreman in charge of that section but the share of the tool room expenditure which is apportioned to a machine shop cannot be controlled by the foreman of that shop. Thus, the difference between controllable and uncontrollable costs is only in relation to a particular individual or level of management. The expenditure which is controllable by an individual may be uncontrollable by another individual. 

8. Avoidable or Escapable Costs and Unavoidable or Inescapable Costs: Avoidable costs are those which will be eliminated if a segment of a business (e.g., a product or department) with which they are directly related is discontinued. Unavoidable costs are those which will not be eliminated with the segment. Such costs are merely reallocated if the segment is discontinued. For example, in case a product is discontinued, the salary of a factory manager or factory rent cannot be eliminated. It will simply mean that certain other products will have to absorb a large amount of such overheads. However, the salary of people attached to a product or the bad debts traceable to a product would be eliminated. Certain costs are partly avoidable and partly unavoidable. For example, closing of one department of a store might result in decrease in delivery expenses but not in their altogether elimination.

It is to be noted that only avoidable costs are relevant for deciding whether to continue or eliminate a segment of a business. 

9. Imputed or Hypothetical Costs: These are the costs which do not involve cash outlay. They are not included in cost accounts but are important for taking into consideration while making management decisions. For example, interest on capital is ignored in cost accounts though it is considered in financial accounts. In case two projects require unequal outlays of cash, the management should take into consideration the capital to judge the relative profitability of the projects. 

10. Differentials, Incremental or Decrement Cost: The difference in total cost between two alternatives is termed as differential cost. In case the choice of an alternative results in an increase in total cost, such increased costs are known as incremental costs. While assessing the profitability of a proposed change, the 
incremental costs are matched with incremental revenue. This is explained with the following example: 

Example
A company is manufacturing 1,000 units of a product. The present costs and sales data are as follows: 
Selling price per unit    $. 10
Variable cost per unit    $. 5
Fixed costs     $. 4,000

The management is considering the following two alternatives
i.  To accept an export order for another 200 units at $. 8 per unit. The expenditure of the export order will increase the fixed costs by $. 500. 
ii. To reduce the production from present 1,000 units to 600 units and buy another 400 units from the market at $. 6 per unit. This will result in reducing the present fixed costs from $. 4,000 to $. 3,000. 
Which alternative the management should accept? 

Solution
Statement showing profitability under different alternatives is as follows: 
Particulars     Present situation
$.              $.          Proposed situations 
Sales.
Less:
Variable purchase costs
Fixed costs Profit     5,000
4,000     10,000
9,000 
________________________________________1,000     6,000
4,500 
________________________________________    11,600
10,500 
________________________________________1,100     5,400
3,000 
________________________________________    10,000
8,400 
________________________________________1,600 

Observations 
i. In the present situation, the company is making a profit of $. 1,000. 
ii. In the proposed situation (i), the company will make a profit of $. 1,100. The incremental costs will be $. 1,500 (i.e. $. 10,500 - $. 9,000) and the incremental revenue (sales) will be $. 1,600. Hence, there is a net gain of $. 100 under the proposed situation as compared to the existing situation. 
iii. In the proposed situation (ii), the detrimental costs are $. 600 (i.e. $. 9,000 to $. 8,400) as there is no decrease in sales revenue as compared to the present situation. Hence, there is a net gain of $. 600 as compared to the present situation. 

Thus, under proposal (ii), the company makes the maximum profit and therefore it should adopt alternative (ii). 

The technique of differential costing which is based on differential cost is useful in planning and decision-making and helps in selecting the best alternative. 

In case the choice results in decrease in total costs, these decreased costs will be known as detrimental costs. 

11. Out-of-Pocket Costs: Out-of-pocket cost means the present or future cash expenditure regarding a certain decision that will vary depending upon the nature of the decision made. For example, a company has its own trucks for transporting raw materials and finished products from one place to another. It seeks to replace these trucks by keeping public carriers. In making this decision, of course, the depreciation of the trucks is not to be considered but the management should take into account the present expenditure on fuel, salary to drive$ and maintenance. Such costs are termed as out-of-pocket costs. 

12. Opportunity Cost: Opportunity cost refers to an advantage in measurable terms that have foregone on account of not using the facilities in the manner originally planned. For example, if a building is proposed to be utilized for housing a new project plant, the likely revenue which the building could fetch, if rented out, is the opportunity cost which should be taken into account while evaluating the profitability of the project. Suppose, a manufacturer is confronted with the problem of selecting anyone of the following alternatives: 
a. Selling a semi-finished product at $. 2 per unit 
b. Introducing it into a further process to make it more refined and valuable 

Alternative (b) will prove to be remunerative only when after paying the cost of further processing, the amount realized by the sale of the product is more than $. 2 per unit. Also, the revenue of $. 2 per unit is foregone in case alternative (b) is adopted. The term “opportunity cost” refers to this alternative revenue foregone. 

13. Traceable, Untraceable or Common Costs: The costs that can be easily identified with a department, process or product are termed as traceable costs. For example, the cost of direct material, direct labor etc. The costs that cannot be identified so are termed as untraceable or common costs. In other words, common costs are the costs incurred collectively for a number of cost centers and are to be suitably apportioned for determining the cost of individual cost centers. For example, overheads incurred for a factory as a whole, combined purchase cost for purchasing several materials in one consignment etc.

Joint cost is a kind of common cost. When two or more products are produced out of one material or process, the cost of such material or process is called joint cost. For example, when cottonseeds and cotton fibers are produced from the same material, the cost incurred till the split-off or separation point will be joint costs. 

14. Production, Administration and Selling and Distribution Costs: A business organization performs a number of functions, e.g., production, illustration, selling and distribution, research and development. Costs are to be curtained for each of these functions. The Chartered Institute of Management accountants, London, has defined each of the above costs as follows:

A. Production Cost: The cost of sequence of operations which begins with supplying materials, labor and services and ends with the primary packing of the product. Thus, it includes the cost of direct material, direct labor, direct expenses and factory overheads.

B. Administration Cost: The cost of formulating the policy, directing the organization and controlling the operations of an undertaking which is not related directly to a production, selling, distribution, research or development activity or function.

C. Selling Cost: It is the cost of selling to create and stimulate demand (sometimes termed as marketing) and of securing orders.

D. Distribution Cost: It is the cost of sequence of operations beginning with making the packed product available for dispatch and ending with making the reconditioned returned empty package, if any, available for reuse.

E. Research Cost: It is the cost of searching for new or improved products, new application of materials, or new or improved methods.

F. Development Cost: The cost of process which begins with the implementation of the decision to produce a new or improved product or employ a new or improved method and ends with the commencement of formal production of that product or by the method.

G. Pre-Production Cost: The part of development cost incurred in making a trial production as preliminary to formal production is called pre-production cost. 

15. Conversion Cost: The cost of transforming direct materials into finished products excluding direct material cost is known as conversion cost. It is usually taken as an aggregate of total cost of direct labor, direct expenses and factory overheads.

Methods of Costing: Costing can be defined as the technique and process of ascertaining costs. The principles in every method of costing are same but the methods of analyzing and presenting the costs differ with the nature of business. The methods of job costing are as follows:

1. Job Costing 
The system of job costing is used where production is not highly repetitive and in addition consists of distinct jobs so that the material and labor costs can be identified by order number. This method of costing is very common in commercial foundries and drop forging shops and in plants making specialized industrial equipments. In all these cases, an account is opened for each job and all appropriate expenditure is charged thereto. 

2. Contract Costing 
Contract costing does not in principle differ from job costing. A contract is a big job whereas a job is a small contract. The term is usually applied where large-scale contracts are carried out. In case of ship-builders, printers, building contractors etc., this system of costing is used. Job or contract is also termed as terminal costing. 

3. Cost plus Costing 
In contracts where in addition to cost, an agreed sum or percentage to cover overheads and fit is paid to a contractor, the system is termed as cost plus costing. The term cost here includes materials, labor and expenses incurred directly in the process of production. The system is used generally in cases where government happens to be the party to give contract. 

4. Batch Costing 
This method is employed where orders or jobs are arranged in different batches after taking into account the convenience of producing articles. The unit of cost is a batch or a group of identical products instead of a single job order or contract. This method is particularly suitable for general engineering factories which produce components in convenient economic batches and pharmaceutical industries. 

5. Process Costing 
If a product passes through different stages, each distinct and well defined, it is desired to know the cost of production at each stage. In order to ascertain the same, process costing is employed under which a separate account is opened for each process. 
This system of costing is suitable for the extractive industries, e.g., chemical manufacture, paints, foods, explosives, soap making etc. 

6. Operation Costing 
Operation costing is a further refinement of process costing. The system is employed in the industries of the following types: 
a) The industry in which mass or repetitive production is carried out 
b) The industry in which articles or components have to be stocked in semi-finished stage to facilitate the execution of special orders, or for the convenience of issue for later operations 
The procedure of costing is broadly the same as process costing except that in this case, cost unit is an operation instead of a process. For example, the manufacturing of handles for bicycles involves a number of operations such as those of cutting steel sheets into proper strips molding, machining and finally polishing. The cost to complete these operations may be found out separately. 

7. Unit Costing (Output Costing or Single Costing) 
In this method, cost per unit of output or production is ascertained and the amount of each element constituting such cost is determined. In case where the products can be expressed in identical quantitative units and where manufacture is continuous, this type of costing is applied. Cost statements or cost sheets are prepared in which various items of expense are classified and the total expenditure is divided by the total quantity produced in order to arrive at per unit cost of production. The method is suitable in industries like brick making, collieries, flour mills, paper mills, cement manufacturing etc. 

8. Operating Costing 
This system is employed where expenses are incurred for provision of services such as those tendered by bus companies, electricity companies, or railway companies. The total expenses regarding operation are divided by the appropriate units (e.g., in case of bus company, total number of passenger/kms.) and cost per unit of service is calculated. 

9. Departmental Costing 
The ascertainment of the cost of output of each department separately is the objective of departmental costing. In case where a factory is divided into a number of departments, this method is adopted. 

10. Multiple Costing (Composite Costing) 
Under this system, the costs of different sections of production are combined after finding out the cost of each and every part manufactured. The system of ascertaining cost in this way is applicable where a product comprises many assailable parts, e.g., motor cars, engines or machine tools, typewrite$, radios, cycles etc. 

As various components differ from each other in a variety of ways such as price, materials used and manufacturing processes, a separate method of costing is employed in respect of each component. The type of costing where more than one method of costing is employed is called multiple costing. 

It is to be noted that basically there are only two methods of costing viz. job costing and process costing. Job costing is employed in cases where expenses are traceable to specific jobs or orders, e.g., house building, ship building etc. In case where it is impossible to trace the prime cost of the items for a particular order because of the reason that their identity gets lost while manufacturing operations, process costing is used. For example, in a refinery where several tons of oil is being produced at the same time, the prime cost of a specific order of 10 tons cannot be traced. The cost can be found out only by finding out the cost per ton of total oil produced and then multiplying it by ten. 

It may, therefore, be concluded that the methods of batch contract and cost plus costing are only the variants of job costing whereas the methods of unit, operation and operating costing are the variants of process costing. 

Classification of cost
Elements of Cost: Following are the three broad elements of cost: 

1. Material 
The substance from which a product is made is known as material. It may be in a raw or a manufactured state. It can be direct as well as indirect. 

a. Direct Material 
The material which becomes an integral part of a finished product and which can be conveniently assigned to specific physical unit is termed as direct material. Following are some of the examples of direct material: 
• All material or components specifically purchased, produced or requisitioned from stores 
• Primary packing material (e.g., carton, wrapping, cardboard, boxes etc.) 
• Purchased or partly produced components 

Direct material is also described as process material, prime cost material, production material, stores material, constructional material etc. 

b. Indirect Material 
The material which is used for purposes ancillary to the business and which cannot be conveniently assigned to specific physical units is termed as indirect material. Consumable stores, oil and waste, printing and stationery material etc. are some of the examples of indirect material.

Indirect material may be used in the factory, office or the selling and distribution divisions. 

2. Labor 
For conversion of materials into finished goods, human effort is needed and such human effort is called labor. Labor can be direct as well as indirect.

a. Direct Labor 
The labor which actively and directly takes part in the production of a particular commodity is called direct labor. Direct labor costs are, therefore, specifically and conveniently traceable to specific products.

Direct labor can also be described as process labor, productive labor, operating labor, etc. 

b. Indirect Labor 
The labor employed for the purpose of carrying out tasks incidental to goods produced or services provided, is indirect labor. Such labor does not alter the construction, composition or condition of the product. It cannot be practically traced to specific units of output. Wages of storekeepers, foremen, timekeepers, directors’ fees, salaries of salesmen etc, are examples of indirect labor costs.

Indirect labor may relate to the factory, the office or the selling and distribution divisions. 

3. Expenses 
Expenses may be direct or indirect. 

a. Direct Expenses 
These are the expenses that can be directly, conveniently and wholly allocated to specific cost centers or cost units. Examples of such expenses are as follows:

• Hire of some special machinery required for a particular contract 
• Cost of defective work incurred in connection with a particular job or contract etc.

Direct expenses are sometimes also described as chargeable expenses. 

b. Indirect Expenses 
These are the expenses that cannot be directly, conveniently and wholly allocated to cost centers or cost units. Examples of such expenses are rent, lighting, insurance charges etc. 

4. Overhead 
The term overhead includes indirect material, indirect labor and indirect expenses. Thus, all indirect costs are overheads. 

A manufacturing organization can broadly be divided into the following three divisions:

• Factory or works, where production is done 
• Office and administration, where routine as well as policy matters are decided 
• Selling and distribution, where products are sold and finally dispatched to customers 
Overheads may be incurred in a factory or office or selling and distribution divisions. Thus, overheads may be of three types: 

a. Factory Overheads 
They include the following things: 
• Indirect material used in a factory such as lubricants, oil, consumable stores etc. 
• Indirect labor such as gatekeeper, timekeeper, works manager’s salary etc. 
• Indirect expenses such as factory rent, factory insurance, factory lighting etc. 

b. Office and Administration Overheads 
They include the following things: 
• Indirect materials used in an office such as printing and stationery material, brooms and dusters etc. 
• Indirect labor such as salaries payable to office manager, office accountant, clerks, etc. 
• Indirect expenses such as rent, insurance, lighting of the office 

c. Selling and Distribution Overheads 
They include the following things: 
• Indirect materials used such as packing material, printing and stationery material etc. 
• Indirect labor such as salaries of salesmen and sales manager etc. 
• Indirect expenses such as rent, insurance, advertising expenses etc. 

Elements of Cost
• Direct material 
• Direct labor 
• Direct expenses 
• Overheads 
• Factory overheads 
• Selling and distribution overheads 
• Office and administration overheads 
• Indirect material 
• Indirect labor 
• Indirect expenses 
• Indirect material 
• Indirect labor 
• Indirect expenses 
• Indirect material 
• Indirect labor 
• Indirect expenses 

Components of Total Cost
1. Prime Cost 
Prime cost consists of costs of direct materials, direct labors and direct expenses. It is also known as basic, first or flat cost. 

2. Factory Cost 
Factory cost comprises prime cost and, in addition, works or factory overheads that include costs of indirect materials, indirect labors and indirect expenses incurred in a factory. It is also known as works cost, production or manufacturing cost. 

3. Office Cost 
Office cost is the sum of office and administration overheads and factory cost. This is also termed as administration cost or the total cost of production. 

4. Total Cost 
Selling and distribution overheads are added to the total cost of production to get total cost or the 

Cost of sales
Various components of total cost can be depicted with the help of the table below: 
Components of total cost 
Direct material
Direct labor 
Direct expenses                     Prime cost or direct cost or first cost
Prime cost plus works overheads             Works or factory cost or production cost or manufacturing cost 
Works cost plus office and administration overheads    Office cost or total cost of production 
Office cost plus selling and distribution overheads    Cost of sales or total cost 

Cost Sheet 
Cost sheet is a document that provides for the assembly of an estimated detailed cost in respect of cost centers and cost units. It analyzes and classifies in a tabular form the expenses on different items for a particular period. Additional columns may also be provided to show the cost of a particular unit pertaining to each item of expenditure and the total per unit cost. 
Cost sheet may be prepared on the basis of actual data (historical cost sheet) or on the basis of estimated data (estimated cost sheet), depending on the technique employed and the purpose to be achieved.

The techniques of preparing a cost sheet can be understood with the help of the following examples. 

Example 1 
Following information has been obtained from the records of left center corporation for the period from June 1 to June 30, 1998. 
Cost of raw materials on June 1,1998    30,000
Purchase of raw materials during the month    4,50,000
Wages paid    2,30,000
Factory overheads    92,000
Cost of work in progress on June 1, 1998    12,000
Cost of raw materials on June 30, 1998    15,000
Cost of stock of finished goods on June 1, 1998    60,000
Cost of stock of finished goods on June 30, 1998    55,000
Selling and distribution overheads    20,000
Sales    9,00,000
Administration overheads    30,000
Prepare a statement of cost. 
Solution 

Statement of cost of production of goods manufactured for the period ending on June 30, 1998. 

Opening stock of raw materials
Add-- purchase     30,000
4,50,000
------------
4,80,000
15,000      
Less-- closing stock of raw material 
Value of raw materials consumed 
Wages
Prime cost
Factory overheads

Add-- opening stock of work in progress
Less-- closing stock of work in progress 
Factory cost
Add-- Administration overhead
Cost of production of goods manufactured
Add--opening stock of finished goods          4,65,000
2,30,000
6,59,000
92,000
7,87,000
12,000
7,99,000
---
7,99,000
30,000
8,29,000
60,000
8,89,000
Less-- closing stock of finished goods
Cost of production of goods sold
Add-- selling and distribution overheads
Cost of sales
Profit
Sales          55,000
8,34,000
20,000
8,54,000
46,000
9,00,000 

Example 2 
From the following information, prepare a cost sheet showing the total cost per ton for the period ended on December 31, 1998. 
Raw materials 
Productive wages 
Direct expenses 
Unproductive wages 
Factory rent and taxes 
Factory lighting 
Factory heating 
Motive power Haulage
Director’s fees (works) 
Directors fees (office) 
Factory cleaning 
Sundry office expenses 
Expenses
Factory stationery 
Office stationery 
Loose tools written off     33,000
35,000
3,000
10,500
2,200
1,500
4,400
3,000
1,000
2,000
500
200
800
750
900
600     Rent and taxes (office) 
Water supply
Factory insurance 
Office insurance 
Legal expenses 
Rent of warehouse 
Depreciation--
Plant and machinery 
Office building 
Delivery vans
Bad debt
Advertising
Sales department salaries 
Up keeping of delivery vans 
Bank charges
Commission on sales     500
1,200
1,100
500
400
300

2,000
1,000
200
100
300
1,500
700
50
1,500 
The total output for the period has been 10000 tons. 

Solution 
Cost sheet for the period ended on December 31, 1998 
Raw materials
Production wages
Direct expenses
Prime cost
Add--works overheads:
Unproductive wages
Factory rent and taxes
Factory lighting
Factory heating    $.
33,000
35,000
3,000 
________________________________________10,500
7,500
2,200
1,500
4,400    71,000 
Motive power
Haulage
Directors’ fees (works)
Factory cleaning
Estimating expenses
Factory stationery
Loses tools written off
Water supply
Factory insurance
Depreciation of plant and machinery 
Works cost
Add-- office overhead
Directors’ fees (office)
Sundry office expenses
Office stationery
Rent and taxes (office)
Office insurance
Legal expenses
Depreciation of office building
Bank charges 
Office cost
Add-- selling and distribution overheads
Rent of warehouse
Depreciation on delivery vans
Bad debts
Advertising
Sales department salaries
Commission on sales
Upkeep of delivery vans
Total cost
Cost per ton $. 1,18,200/10,000 = $. 11.82     3,000
1,000
500
800
750
600
1,200
1,100
2,000 
________________________________________
2,000
200
900
500
500
400
1,000
50 
________________________________________300
200
100
300
1,500
1,500
700 
________________________________________    37,050 
________________________________________
1,08,050 
5,550 
________________________________________1,13,600 
4,600 
________________________________________1,18,200 

Motive power
Haulage
Directors’ fees (works)
Factory cleaning
Estimating expenses
Factory stationery
Loses tools written off
Water supply
Factory insurance
Depreciation of plant and machinery 
Works cost
Add-- office overhead
Directors’ fees (office)
Sundry office expenses
Office stationery
Rent and taxes (office)
Office insurance
Legal expenses
Depreciation of office building
Bank charges 
Office cost
Add-- selling and distribution overheads
Rent of warehouse
Depreciation on delivery vans
Bad debts
Advertising
Sales department salaries
Commission on sales
Upkeep of delivery vans
Total cost
Cost per ton $. 1,18,200/10,000 = $. 11.82     3,000
1,000
500
800
750
600
1,200
1,100
2,000 
________________________________________
2,000
200
900
500
500
400
1,000
50 
________________________________________300
200
100
300
1,500
1,500
700 
________________________________________    37,050 
________________________________________
1,08,050 
5,550 
________________________________________1,13,600 
4,600 
________________________________________1,18,200 

Techniques of Costing
Besides the above methods of costing, following are the types of costing techniques which are used by management only for controlling costs and making some important managerial decisions. As a matter of fact, they are not independent methods of cost finding such as job or process costing but are basically costing techniques which can be used as an advantage with any of the methods discussed above. 

1. Marginal Costing 
Marginal costing is a technique of costing in which allocation of expenditure to production is restricted to those expenses which arise as a result of production, e.g., materials, labor, direct expenses and variable overheads. Fixed overheads are excluded in cases where production varies because it may give misleading results. The technique is useful in manufacturing industries with varying levels of output. 

2. Direct Costing 
The practice of charging all direct costs to operations, processes or products and leaving all indirect costs to be written off against profits in the period in which they arise is termed as direct costing. The technique differs from marginal costing because some fixed costs can be considered as direct costs in appropriate circumstances. 

3. Absorption or Full Costing 
The practice of charging all costs both variable and fixed to operations, products or processes is termed as absorption costing. 

4. Uniform Costing 
A technique where standardized principles and methods of cost accounting are employed by a number of different companies and firms is termed as uniform costing. Standardization may extend to the methods of costing, accounting classification including codes, methods of defining costs and charging depreciation, methods of allocating or apportioning overheads to cost centers or cost units. The system, thus, facilitates inter- firm comparisons, establishment of realistic pricing policies, etc. 

Systems of Costing 
It has already been stated that there are two main methods used to determine costs. These are: 
A. Job cost method 
B.  Process cost method 

It is possible to ascertain the costs under each of the above methods by two different ways: 
1. Historical costing 
2. Standard costing 

1. Historical Costing 
Historical costing can be of the following two types in nature: 
a) Post costing 
b) Continuous costing 

a) Post Costing 
Post costing means ascertainment of cost after the production is completed. This is done by analyzing the financial accounts at the end of a period in such a way so as to disclose the cost of the units which have been produced. 

For instance, if the cost of product A is to be calculated on this basis, one will have to wait till the materials are actually purchased and used, labor actually paid and overhead expenditure actually incurred. This system is used only for ascertaining the costs but not useful for exercising any control over costs, as one comes to know of things after they had taken place. It can serve as 
guidance for future production only when conditions in future continue to be the same. 

b) Continuous Costing 
In case of this method, cost is ascertained as soon as a job is completed or even when a job is in progress. This is done usually before a job is over or product is made. In the process, actual expenditure on materials and wages and share of overheads are also estimated. Hence, the figure of cost ascertained in this case is not exact. But it has an advantage of providing cost information to the management promptly, thereby enabling it to take necessary corrective action on time. However, it neither provides any standard for judging current efficiency nor does it disclose what the cost of a job ought to have been. 

2. Standard Costing 
Standard costing is a system under which the cost of a product is determined in advance on certain pre-determined standards. With reference to the example given in post costing, the cost of product A can be calculated in advance if one is in a position to estimate in advance the material labor and overheads that should be incurred over the product. All this requires an efficient system of cost accounting. However, this system will not be useful if a vigorous system of controlling costs and standard costs are not in force. Standard costing is becoming more and more popular nowadays.



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