lOMoARcPSD|34893885
Chapter no 1(type of costs)
Auditing (National College of Business Administration and Economics)
Scan to open on Studocu
Studocu is not sponsored or endorsed by any college or university
Downloaded by Ahsan Jamshed (ahsanjamshed72@gmail.com)
lOMoARcPSD|34893885
Introduction to Cost and Management Accounting
Chapter 1
1.
Introduction to Cost
and Management
Accounting
CAF3-Cost and Management Accounting
Downloaded by Ahsan Jamshed (ahsanjamshed72@gmail.com)
1
lOMoARcPSD|34893885
Introduction to Cost and Management Accounting
Chapter 1
Financial accounting:
Financial accounting is a branch of accounting that keeps track of a Company’s financial transactions.
Using standardized guidelines, the transactions are recorded, summarized, and presented in
a financial report or financial statement such as an income statement or a balance sheet (statement of
financial position).
Cost accounting:
Cost accounting is a branch of accounting that keeps track of a Company’s cost in such a manner that it
enables company to determine cost of product (it produces), services (it provides) or process (it performs).
Measuring cost of product or service is necessary for the purpose of determining price for customer.
Management accounting:
Management accounting provide critical information to management to be used in operational business
decision-making. It helps the management to perform all its functions including planning, organizing,
staffing, directing, controlling etc.
Cost:
In a business, cost expresses the amount of money that is spent on buying or producing or creating a good
or service. Cost does not include a markup/ margin for profit.
Cost classification:
Cost classification by element:
Material: The cost of commodities supplied to and used by an organization. e.g. Raw cotton used in a
textile mill, office stationery used in head office etc.
Labour: The cost paid by an organization to its employee against using their services. e.g. wages paid to
production worker, salary paid to storekeeper and accountant etc.
Other expenses: Any amount spent for purposes of business, which is neither for acquiring material nor
against services provided by an employee, is classified as expense. e.g. rent of factory, electricity bill of
factory/ head office etc.
Cost classification by function:
Production/ Manufacturing cost: It is a cost directly incurred by a business organization in the process
of producing a product (conversion of raw material into finished product) or providing a service (e.g. raw
material, labour etc.).
Non-production cost: Non-manufacturing costs refer to those costs incurred outside the factory
or production department. These are costs are not needed in transforming raw materials into finished
goods. Few examples of non-production cost are:
CAF3-Cost and Management Accounting
Downloaded by Ahsan Jamshed (ahsanjamshed72@gmail.com)
2
lOMoARcPSD|34893885
Introduction to Cost and Management Accounting
–
Selling costs
–
Administration costs
–
Distribution costs
–
Marketing costs and
–
Finance costs
Chapter 1
Non-production costs are also called as non-production overheads.
Activity:
Cost classification by nature:
Direct costs:
It is part of production cost that can be directly traced with accuracy to a specific cost object (Product). Its
examples are:
•
Raw Materials that are specifically used in production process
•
Labor which is directly involved in converting the raw material into finished good
CAF3-Cost and Management Accounting
Downloaded by Ahsan Jamshed (ahsanjamshed72@gmail.com)
3
lOMoARcPSD|34893885
Introduction to Cost and Management Accounting
•
Chapter 1
Other expenses like royalties paid to a designer or fees paid to a subcontractor for
a specific job can also be classified as direct costs.
Total of direct costs = Direct materials + Direct labour + Direct expenses = Prime cost
Indirect costs:
It is that part of cost that cannot be directly traced to a specific cost object (Product). Its examples are:
•
Tools, spares and materials that are used in the machinery or equipment used in
the production
•
Salary paid to storekeeper, accountant and CEO of company (not directly involved
in the conversion of raw material)
•
Factory rent if the factory premises are hired
•
Electricity and other utility expenses incurred for the production facilities
Sum of indirect costs is also known as overheads. These can further be classified into:

Production overheads,

Administrative overheads,

Selling and Distribution overheads etc.
Activity:
Activity:
Costs
Direct/ Indirect cost?
Category of overhead?
Production supervisor salary
Accounts manager salary
Depreciation of delivery vans
Depreciation of plant and equipment
Wages of production worker
CAF3-Cost and Management Accounting
Downloaded by Ahsan Jamshed (ahsanjamshed72@gmail.com)
4
lOMoARcPSD|34893885
Introduction to Cost and Management Accounting
Chapter 1
Cost classification by behaviors:
For the better understanding of different concepts in cost and management accounting, it is important to
understand different behaviors that different cost components show.
(i) Fixed cost
A fixed cost is a cost which is incurred for an accounting period, and which, remains constant with the
change in activity (production/ sales volume).
Fixed costs can be shown graphically as follows:
Examples of fixed costs:
 Rent
 Depreciation
 Executive salaries.
(ii) Variable cost
Variable costs are costs that tend to vary in total with the level of activity. As activity levels increase
then total variable costs will also increase.
Variable costs can be shown graphically as follows:
Examples of variable costs include direct costs such as raw materials and direct labour.
CAF3-Cost and Management Accounting
Downloaded by Ahsan Jamshed (ahsanjamshed72@gmail.com)
5
lOMoARcPSD|34893885
Introduction to Cost and Management Accounting
Chapter 1
(iii) Semi-variable cost
Semi-variable costs contain both fixed and variable cost elements and are therefore partly affected by
fluctuations in the level of activity.
Semi-variable costs can be shown graphically as follows:
Examples of semi-variable costs:

Electricity bills (fixed standing charge plus variable cost per unit of electricity consumed)

Telephone bills (fixed line rental plus variable cost per call)
(iv) Stepped fixed cost
This is a type of fixed cost that is only fixed within certain levels of activity. Once the upper limit of an
activity level is reached then a new higher level of fixed cost becomes relevant.
Stepped fixed costs can be shown graphically as follows:
Examples of stepped fixed costs:
 Warehousing costs (as more space is required, more warehouses must be purchased or rented)
 Supervisors’ wages (as the number of employees increases, more supervisors are required).
Segregating fixed and variable costs from semi-variable costs – High-Low method:
Semi variable costs are analysed into variable & fixed elements using the hi-lo method. This analysis is
based on following two basic assumptions:
i.
Variable cost per unit will stay constant at all activity levels.
ii.
Total fixed cost will stay constant at all activity levels.
CAF3-Cost and Management Accounting
Downloaded by Ahsan Jamshed (ahsanjamshed72@gmail.com)
6
lOMoARcPSD|34893885
Introduction to Cost and Management Accounting
Chapter 1
Step 1: Analysing past data, select the activity (e.g. production volume) and cost for:
–
the highest activity level
–
the lowest activity level.
Step 2: The variable cost per unit can be calculated as:
The variable cost per unit = Difference in total costs ÷ Difference in the number of units.
Step 3: Calculate fixed cost by subtracting the total variable cost (variable cost per unit x total units
produced) from the total cost at either of the activity (highest or lowest) level selected in step 1.
Illustration 1:
Hi-Lo method
Alpha Ltd wishes to develop a method of predicting its total costs in a period. The following data have
been recorded.
Month
Activity level
(Units)
Cost
(Rs.)
January
1,600
281,000
February
2,300
296,000
March
1,900
289,000
April
1,800
286,000
May
1,500
280,000
June
1,700
283,000
Required:
Calculate:
(i)
Variable cost per unit
(ii)
Monthly fixed cost
Illustration 2:
Hi-Lo method
Beta Ltd wishes to develop a method of predicting its total costs in a period. The following data have
been recorded.
Month
Activity level
(Units)
Cost
(Rs.)
July
3,200
112,800
August
4,600
118,400
September
3,800
115,200
October
3,600
114,400
November
3,000
112,000
December
3,400
113,600
Required:
Calculate:
(i)
Variable cost per unit
CAF3-Cost and Management Accounting
Downloaded by Ahsan Jamshed (ahsanjamshed72@gmail.com)
7
lOMoARcPSD|34893885
Introduction to Cost and Management Accounting
(ii)
Chapter 1
Monthly fixed cost
Cost equation:
CAF3-Cost and Management Accounting
Downloaded by Ahsan Jamshed (ahsanjamshed72@gmail.com)
8
lOMoARcPSD|34893885
Introduction to Cost and Management Accounting
Chapter 1
Activity:
Activity:
Hi-Lo with stepped fixed costs:
If fixed cost changes between lowest and highest activity level (due to step), the hi-lo method can still be
used to estimate fixed and variable costs.
In this situation calculate variable cost per unit comparing the two levels where the fixed cost is the same
(i.e. not necessarily the highest and lowest levels).
Illustration 3:
Hi-Lo with stepped fixed costs
An organization has the following total costs at three activity levels:
Activity level (units)
4,000
6,000
7,500
Total cost (Rs.)
40,600
50,000
54,800
Variable cost per unit is constant within this activity range and there is a step up of 10% in the total
fixed costs when the activity level exceeds 5,500 units.
Required:
Calculate the total cost of an activity of 5,000 units.
Hi-Lo with varying variable costs:
If variable cost per unit is not constant between the highest and lowest activity level, the hi-lo method can
still be used to estimate fixed and variable costs.
In this situation calculate variable cost per unit comparing the two levels where the variable cost per unit
is constant (i.e. not necessarily the highest and lowest levels).
Illustration 4:
Hi-Lo with changing variable costs
CAF3-Cost and Management Accounting
Downloaded by Ahsan Jamshed (ahsanjamshed72@gmail.com)
9
lOMoARcPSD|34893885
Introduction to Cost and Management Accounting
Chapter 1
Total cost incurred during the 20X5 at various output level is as under:
Output
Total cost
(units)
(Rs.)
200
7,000
300
8,000
400
8,800
When the output is over 350 units the variable cost per unit falls by 10% for all the units produced due
to bulk discount offered by a supplier.
Required:
Estimate the cost of producing 450 units of product MM in 20X6.
CAF3-Cost and Management Accounting
Downloaded by Ahsan Jamshed (ahsanjamshed72@gmail.com)
10
lOMoARcPSD|34893885
Introduction to Cost and Management Accounting
Chapter 1
Answers to Illustrations
Illustration 1:
High/low method
The highest activity level is in February and the lowest in May.
Total cost at highest activity level = Rs. 296,000
Total cost at lowest activity level = Rs. 280,000
Total units at highest activity level = 2,300
Total units at lowest activity level = 1,500
Variable cost per unit = (296,000 – 280,000) ÷ (2,300 – 1,500) = Rs. 20
Fixed costs = 296,000 – (2,300 X 20) = Rs. 250,000
Total costs = 250,000 + 20X
Illustration 2:
High/low method
The highest activity level is in August and the lowest in November.
Total cost at highest activity level = Rs. 118,400
Total cost at lowest activity level = Rs. 112,000
Total units at highest activity level = 4,600
Total units at lowest activity level = 3,000
Variable cost per unit = (118,400 – 112,000) ÷ (4,600 – 3,000) = Rs. 4
Fixed costs = 118,400 – (4,600 X 4) = Rs. 100,000
Total costs = 100,000 + 4X
Illustration 3:
High/Low with Stepped Fixed Costs
Two activity levels selected are 6,000 units and 7,500 as fixed cost is same at these two levels.
Total cost at high activity level = Rs. 54,800
Total cost at low activity level = Rs. 50,000
Total units at high activity level = 7,500
Total units at low activity level = 6,000
Variable cost per unit = (54,800 – 50,000) ÷ (7,500 – 6,000) = Rs. 3.20
Fixed costs at 7,500 units = 54,800 – (7,500 X 3.2) = Rs. 30,800
Fixed costs at units less than 5,500 units = Rs. 30,800 ÷ 1.10 = Rs. 28,000
Total cost at 5,000 units = 28,000 + (5,000 X 3.20) = Rs. 44,000
Illustration 4:
High/Low with changing variable costs
Two activity levels selected are 200 units and 300 as variable cost per unit is same at these two levels.
Total cost at high activity level = Rs. 8,000
Total cost at low activity level = Rs. 7,000
CAF3-Cost and Management Accounting
Downloaded by Ahsan Jamshed (ahsanjamshed72@gmail.com)
11
lOMoARcPSD|34893885
Introduction to Cost and Management Accounting
Chapter 1
Total units at high activity level = 300
Total units at low activity level = 200
Variable cost per unit = (8,000 – 7,000) ÷ (300 – 200) = Rs. 10
Fixed costs at 300 units = 8,000 – (300 X 10) = Rs. 5,000
Variable cost per unit with 450 units = Rs. 10 X 90% = Rs. 9
Total cost at 450 units = 5,000 + (450 X 9) = Rs. 9,050
CAF3-Cost and Management Accounting
Downloaded by Ahsan Jamshed (ahsanjamshed72@gmail.com)
12