MANAGEMENT & COST ACCOUNTINGLO 2: BASIC ASPECTS OF COST ACCOUNTING

LEARNING GOALS

After completing this chapter you should be able to;

1) Explain why organizations need to know how much products, processes and services cost and why they need a costing system

2) Explain the idea of ‘cost object’

3) Explain the concept of direct and indirect cost

4) Explain why the concept of cost need to be qualified as direct, full, marginal, etc. in order to be meaningful

5) Explain how costs behave as product, service or activity levels increase or decrease

6) Distinguish between fixed, variable and semi-variable costs

7) Explain step costs and the importance of time-scales in their treatment as either variable or fixed

8) Compute the fixed and variable elements of a semi-variable cost using the high-low method

PURPOSE OF COSTING SYSTEMS IN ORGANIZATIONS

An organization's costing system is the foundation of the internal financial information system for managers.

This will provide the information for the management to plan and control the organization’s activities to make

decisions about the future.

Type of information provided by the costing system:

i. Actual unit cost for the latest period: Cost controlling by comparing with the predetermined unit standard

cost; Basis for planning future unit costs and for decisions about pricing and production levels.

ii. Actual cost of operating a department for the latest period: Could facilitate cost controlling by comparing

with the predetermined budget for the department; Basis for preparing future budgeted costs and for

decisions such as outsourcing.

iii. To identify the forecasted costs to be incur at different levels of activity

MEANING OF COST

The word ‘cost’ can be used in two contexts;

i. As a noun : When it is referring to the cost of an item : Cost of purchasing a blue pen is LKR 15.00

ii. As a verb : When it is referred in the context of costing an activity : Cost of organizing BMS Graduation Ceremony

COST UNITS

A unit of product or service in relation to which costs are ascertained (CIMA)

The cost unit selected in each situation depends on number of factors such as the purpose of cost

ascertainment and the amount of information available.

Cost units can be developed for all kinds of organizations, whether manufacturing or service based.

Industry sector Cost unit

Brick-making 1,000 bricks

Electricity Kilowatt-hour (KwH)

Professional service Chargeable hour

Education Enrolled student

Activity Cost unit

Credit control Account maintained

Selling Customer call

COMPOSITE COST UNITS

The cost units for services are usually intangible and they are often composite cost units, that is, they are often

made of two parts.

For example, if we were attempting to monitor and control the costs of a delivery service we might measure

the cost per tonne delivered. However, ‘ tonne delivered ’ would not be a particularly useful cost unit because it

would not be valid to compare the cost per tonne delivered from Colombo to Kandy with the cost per tonne

delivered from Colombo to Jaffna. The latter journey is much longer and it will almost certainly cost more to deliver

a tonne over the longer distance

Composite cost units assists in overcoming the above problem, we could replace tonne delivered perhaps with

‘tonne-mile’. This means that we would record and monitor the cost of carrying one tonne for one mile.

The cost per tonne-mile would be a comparable measure whatever the length of journey and this is therefore a

valid and useful cost unit for control purposes

COMPOSITE COST UNITS ILLUSTRATIONS

Hotel : Bed night

Bus company : Passenger mile

Hospital : In patience day

COST CENTRES

A cost centre is a production or service location, a function, an activity or an item of equipment for which costs

are accumulated.

A cost centre is used as a ‘ collecting place ’ for costs. The cost of operating the cost centre is determined for

the period, and then this total cost is related to the cost units which have passed through the cost centre.

Example:

Cost centre : Machine shop in a factory.

Overhead cost of the machine shop : USD 100,000 for the period

If 1,000 units have passed through this cost centre Production overhead cost relating to the machine shop

will be USD 100 per unit.

COST CENTRE CLASSIFICATIONS

Type of cost

centre

Examples

Service

location

Stores, canteen

Function Sales representative

Activity Quality control

Item of

equipment

Packing machine

Illustration: Sales representative as a cost centre

1. Costs that might be incurred in ‘operating’ a sales representative for one

period : The representative’s salary cost, the cost of running a company car, the

cost of any samples given away by the representative and so on. Assume this is

USD 40,000

2. Determination of cost units that can be related to the sales representative: The

cost unit selected might be USD100 of sales achieved. If the representative has

achieved USD400,000 of sales, then we could say that the representative’s costs

amounted to USD10 per USD100 of sales. The representative has thus been

used as a cost centre or collecting place for the costs, which have then been

related to the cost units

COST OBJECTS

A cost object is anything for which costs can be ascertained.

For example a product, service, centre, activity, customer or distribution channel in relation to which costs are ascertained

All of the cost units and cost centres are therefore types of cost object

Illustration: If the Keells supermarket chain is considered as a customer and is treated as a cost object by a supplier of

processed food, the costs those are attributable would be;

i. The cost of the food products supplied to the customer (Keells supermarket)

ii. The cost of delivering the food products to the customer

iii. The cost of holding any inventories for the supermarket

iv. The salary cost of the account manager responsible for the supermarket’s account

CLASSIFICATION OF COSTSARRANGING COSTS INTO LOGICAL GROUPS

01 CLASSIFICATION OF COSTS ACCORDING TO THEIR NATURE

Grouping costs according to whether they are material, labour or expense cost.

1) Material costs include the cost of obtaining the materials and receiving them within the

organisation.

2) Labour costs are those costs incurred in the form of wages and salaries together with related

employment costs (EPF, ETF)

3) Expense costs are external costs such as rent, electricity, postage, telephone and similar items

02. CLASSIFICATION OF COSTS ACCORDING TO THEIR PURPOSE

This is where the costs will be grouped based on the reason which they were incurred

1) Direct cost is one that can be clearly identified with the cost object attempted to cost

2) Indirect costs would be the other associated costs incurred during the manufacturing process which cannot be directly

ascertained to the cost object

Illustration : Furniture

Producer trying to

determine the cost of

a wooden table

Direct Materials

Timber, Screws and

Metal drawer handles

Direct Labour

Wages paid for machine

operator, assembler and finisher Direct Expenses

Royalty payment to the

original designer

Indirect Costs

Lubricating oils and cleaning

materials : Indirect material

Salaries of supervisory labour :

Indirect labour

Factory rent and electricity :

Indirect expenses

TEST YOUR KNOWLEDGE

State whether each of the following costs would be a direct cost or an indirect cost of the quality

control activity which is undertaken in a company’s factory.

The salary of the quality control supervisor

The rent of the factory

The cost of samples destroyed during the testing

The insurance of the factory

COST BEHAVIOUR

COST BEHAVIOUR

Many factors such as inflation will drive the costs to fluctuate.

In management accounting only the cost fluctuations based on the level of activity would be

considered.

There are various cost behaviour patterns:

Fixed costs

Variable costs

Semi-variable costs

01. FIXED COSTS

Cost incurred for an accounting period, that, within certain output or turnover limits, tends to be

unaffected by fluctuations in the levels of activity.

Examples include rent, rates and insurance

02. VARIABLE COSTS

Cost that varies with a measure of activity

E.g. Direct material, direct labour and variable overheads

03. SEMI-VARIABLE COST

This is also referred to as a semi-fixed or mixed cost

This is the cost containing both fixed and variable components and thus, partly affected by the change in the level

of activity

E.g. electricity

03. SEMI-VARIABLE COSTS

Analysing semi-variable costs: to determine how much is variable and how much is fixed.

Past records of costs and their associate activity levels are usually used to carry out this analysis

Common method for distinguishing between fixed and variable costs : The High-Low Method

THE HIGH LOW METHOD

This method picks out the highest and lowest activity levels from the available data and

investigates the change in cost which has occurred between them.

The highest and lowest points are selected to try to use the greatest possible range of data. This

improves the accuracy of the result

EXAMPLE: THE HIGH LOW METHOD

A company has recorded the following data for a semi-variable cost: Identify the variable cost per unit and fixed

cost

PRACTICE QUESTION

The cost of operating the maintenance department of a hotel, KMSRS LTD. for the last four months have been as

follows,

Month Cost ($) Activity level

1 110,000 7,000

2 115,000 8,000

3 111,000 7,700

4 97,000 6,000

Calculate the costs that should be expected in the month five, when output is expected to be 9,150 units.

THANK YOU!