Chapter 1

The fundamentals of costing

1. What is cost accounting?
2. Basic cost accounting concepts
3. Cost classification for inventory valuation and profit measurement
4. Product costs and period costs
5. Cost classification for control
6. Ethics
1. What is cost accounting?

• Financial accounting is for external reporting whereas cost and

management accounting is for internal reporting

• The financial accounting and cost accounting systems both record the
same basic data but each set of records may analyse the data in a
different way
1.1. The cost accountant

• The cost accountant is the one having access to cost information

• The cost accountant should be able to answer historical questions

regarding cost and revenue information

• The cost accountant should also be able to provide information for

forecasts or estimates for the future
1.1. The cost accountant

Historical questions regarding cost and revenue information such as:

• What was the cost of goods produced or services provided last week?

• What was the cost of operating a department last month?

• What revenues were earned last year?

1.1. The cost accountant

By answering those historical questions, management should be able to

• Assess the profitability of a product, a service, a department, or the

whole organisation.

• Determine appropriate selling price

• Put a value on inventory

1.1. The cost accountant

Information for forecasts and estimates for the future should be

provided by answering questions such as:

• What are the future costs of goods and services likely to be?

• What information does management need in order to make sensible

decisions about future profits and costs?

• What financial resources will be needed to fund future growth or

activities?
1.2. Cost accounting and management
accounting
Cost accounting is a part of management accounting. However, in
today’s environment, the roles of cost accounting and management
accounting are almost indistinguishable from each other as they both are
basically concerned with provision of information to help
management with planning, control and decision making.
1.3. Cost accounting systems
• Cost accounting is concerned with providing information to help the
following.
‐ Establishing inventory valuations, profits or losses and balance sheet
items
‐ Planning
‐ Control
‐ Decision making
1.4. Financial accounting versus cost
accounting
Financial accounting Management accounting
Financial accounts detail the performance of Management accounts are used to aid
an organisation over a defined period, management to record, plan and control the
including its cash flows and the state of affairs organisation's activities and to help the
at the end of that period decision-making process.
In the UK, limited companies must, by law, There is no legal requirement to prepare
prepare financial accounts management accounts
The format of published financial accounts is The format of management accounts is entirely
determined by law (mainly the Companies at management discretion: no strict rules
Acts), by Statements of Standard Accounting govern the way they are prepared or presented.
Practice and by Financial Reporting Standards. Each organisation can devise its own
In theory the accounts of different management accounting system and format of
organisations can therefore be easily compared reports
1.4. Financial accounting versus cost
accounting
Financial accounting Management accounting
Financial accounts often concentrate on the Management accounts can focus on specific areas
business as a whole, aggregating revenues and of an organisation's activities such as operating
costs from different operations, and are departments, individual sites or business streams.
wholly historical. Information may be produced to aid a decision
rather than to be an end product of a decision.
Most financial accounting information is of a Management accounts incorporate nonmonetary
monetary nature measures. Management may need to know, for
example, tonnes of product produced, monthly
machine hours, or miles travelled by sales
representatives. These are often called 'Key
Performance Indicators'.
Financial accounts present an essentially Management accounts are both a historical record
historical picture of past operations. and a future planning tool, linking to budgets and
forecasts.
2. Basic cost accounting concepts
• A cost object is anything for which we are trying to ascertain the cost.
• Cost units are the basic control units for costing purposes.
• The term 'cost' can be used as a noun or as a verb.
• Costs need to be arranged into logical groups or classified in order to
facilitate an efficient system for collecting and analysing costs.
2.1. Functions and departments
• Every organisation can be divided into a number of different
functions, within which there are a number of departments.
• The structure of a manufacturing company might be as follow

Board of directors

Production Administration Marketing

2.1. Functions and departments
For example, if the company above is a watch manufacturer. The
production function is involved with the production of watches, the
administration function with the financial issues, warehouse and the
employment of staff, and the marketing function with the selling and
distribution of watches and R&D.
Within the production function, there are four departments which are
watch accessories production, assembly department, IQC department
and packing department.
2.1. Functions and departments
The structure of a service organisation might be as follow

Board of directors

Service personnel Administration Marketing

2.1. Functions and departments
For example, the service business is a hotel. Within the service
personnel function, there are front office, housekeeping, maintenance
and catering departments.
2.2. Cost objects
Definition:
A cost object is anything for which we are trying to ascertain the
cost. It could be a cost unit or a cost centre.
Examples:
• a unit of product (e.g., a cake, a table)
• a unit of service (e.g., a painting service of a table)
• a department or function (e.g., the packing department)
• a project (e.g., the installation of a new camera system)
• a new product or service
2.3. Cost units

Definition:

A cost unit is the basic measure of product or service for which

costs are determined. In other words, it refers to the unit of quantity of
product, service or time (or combination of these) in relation to which
costs may be ascertained or expressed.
2.3. Cost units
Examples:
Organisation Possible cost unit
Steelworks Tonne of steel produced
Tonne of coke used
Hospital Patient/day
Operation
Out-patient visit
Freight organisation Tonne/kilometre
Passenger transport Passenger/kilometre
organisation
Accounting firm Audit performed
Chargeable hour
Restaurant Meal served
2.4. Composite cost units

• Composite cost units are cost units being made up of two parts.

• They are used most often in service organisations.

• For example, the patient/day cost unit for the hospital.

• Composite cost units are used because in some particular situations,

they would be more useful for monitoring and controlling costs.
2.5. The concept of cost
• The term 'cost' can be used as a noun when describing the amount of
money incurred in producing a product
• Alternatively, 'cost' can be used as a verb, for example when
describing the act of determining the amount of money incurred in
operating a department
• Costs need to be classified in some way so that they can be arranged
into logical groups in order to facilitate an efficient system for
collecting and analysing costs
2.6. Direct v indirect costs and cost objects
• Direct costs are costs identified with a cost object. In other words, it is
a cost that can be directly identifiable with a specific cost unit or cost
centre. Examples: material used in production, worker paid for making
units, etc.
• Indirect costs are costs that cannot be identified with a particular cost
object. Examples: supervisor salaries, rent of the building, etc.
3. Cost classification for inventory valuation
and profit measurement
3.1. Cost elements
3.2. Direct cost and prime cost
3.3. Indirect cost and overhead
3.4. Product cost and period cost
3.1. Cost elements
• The total cost of a cost unit of product or service is made up of three
elements of cost:
‐ Materials
‐ Labour
‐ Other expenses
• Cost elements can be classified as direct costs or indirect costs.
3.2. Direct cost and prime cost
• Direct costs are costs that can be traced in full to the cost unit. There
are three types of direct cost:
• Direct material costs
• Direct labour costs
• Other direct expenses
• Examples: Material used in production, Worker paid for making units,
etc.
3.2. Direct cost and prime cost
• Total direct cost is called prime cost
• Prime cost = Total direct cost
= Direct material cost + Direct labour cost + Direct expenses
3.3. Indirect cost and overhead
• Indirect cost (or overhead) is a cost that is incurred which cannot be
traced directly and in full to the cost unit.
• It is jointly incurred and must be shared out on an equitable basis
3.3. Indirect cost and overhead
• Total cost may be analysed as follows

Materials cost = Direct materials cost + Indirect materials cost

+ + +
Labour cost = Direct labour cost + Indirect labour cost
+ + +
Expenses = Direct expenses + Indirect expenses
Total cost = Direct cost/prime cost + Indirect cost/overhead
3.3.1. Production overhead
• Production (or manufacturing) overhead includes all indirect
material costs, indirect wages and indirect expenses incurred in the
factory from receipt of the order until its completion, including:
‐ Indirect material (e.g. material used across several different
products)
‐ Indirect wages (e.g. supervisors’ salaries)
‐ Indirect expenses (e.g. depreciation of plan and buildings)
3.3.2. Administration overhead
• Administration overhead is all indirect material costs, wages and
expenses incurred in the direction, control and administration of
an undertaking, including:
‐ Depreciation of office equipment
‐ Office salaries, including the salaries of secretaries and accountants
‐ Rent, rates, insurance, telephone, heat and light cost of general
offices
3.3.3. Selling overhead
• Selling overhead is all indirect materials costs, wages and expenses
incurred in promoting sales and retaining customers, including:
‐ Advertising cost
‐ Sales promotion
‐ Printing of catalogues and price list
‐ Salaries and commissions of salesmen
‐ Sales department’s costs like staff, rent, rates and insurance of showroom
‐ Cost of free samples to customers
3.3.4. Distribution overhead
• Distribution overhead is all indirect material costs, wages and
expenses incurred in making the packed product ready for
despatch and delivering it to the customer, such as:
‐ Packing cost
‐ Wages of packing staff, drivers, dispatch clerks
‐ Rent and rates, insurance and depreciation of finished goods
warehouse
‐ Cost of delivery of finished goods
3.4. Product costs and period costs
• Product costs are costs of making or buying an item of inventory.
(such as materials, labour and other expenses)
• Period costs are costs deducted as expenses during a particular period.
Those costs relate to the passage of time rather than the output of
individual product or service and often presented on Income
Statement. (salaries, rent of the building, etc.)
4. Cost classification for planning and
decision making
• Costs can be classified according to how they vary in relation to the
level of activity.
• A knowledge of how the cost incurred varies at different activity levels
is essential to planning and decision making.
4.1. Cost behavior patterns
• A knowledge of how the cost incurred varies at different levels of
activity is essential to planning and decision making.
• Cost behaviour patterns are the way that costs vary in relation to the
level of activity.
• The level of activity can be measured in different ways depending on
the circumstances. For example:
‐ The number of products produced in a period
‐ The number of items sold
‐ The number of machine hours
4.2. Fixed costs
• Fixed cost is a cost, within a relevant range of activity levels and a
particular period of time, is not affected by changes in the level of
activity.
4.2. Fixed costs
• Examples:
‐ The rental cost of business premises is a constant amount, at least
within a stated time period, and so it is a fixed cost.
‐ Straight-line depreciation.
4.3. Variable costs
• Variable cost is a cost that changes as the level of activity increases or
decreases.
4.3. Variable costs
• Examples:
‐ Direct material costs are variable costs because they rise as more
units of a product are manufactured.
‐ Sales commission is often a fixed percentage of sales turnover, and
so is a variable cost that varies with the level of sales
4.4. Semi-variable costs
• Semi-variable, semi-fixed or mixed costs are costs that are part-fixed
and part-variable and are therefore partly affected by changes in the
level of activity.
4.4. Semi-variable costs
• Examples:
‐ Bills (electricity, gas…)
‐ Guaranteed wage
‐ Cost of running car
4.5. Cost behaviour and total and unit costs
• As the level of activity increases the total costs per unit (fixed cost
plus variable cost) will decrease.
4.5. Cost behaviour and total and unit costs
 Summary of cost behaviour patterns:
- If activity is increase:
+ VC per unit are constant
+ FC per unit will fall
+ TC per unit will fall
4.6. The relevant range
• The relevant range is the range of activity levels within which
assumed cost behaviour patterns occur.
5. Cost classification for control
• For control purposes the most effective classification of costs is by
responsibility
• A system of responsibility accounting segregates costs and revenues
into areas of personal responsibility in order to monitor and assess the
performance of each part of the organisation
5.1. Responsibility accounting
• Responsibility accounting is a system of accounting that segregates
revenue and costs into areas of personal responsibility in order to
monitor and assess the performance of each part of an organisation.
• A responsibility centre is a department or function whose
performance is the direct responsibility of a specific manager.
5.2. Controllable and uncontrollable costs
• Controllable costs are costs that can be influenced by managers
• Examples: Materials used for production, wages paid to production
workers, etc. can be controlled by production managers.
• Uncontrollable costs are costs that cannot be affected by managers or
some specific managers within a given time span.
• Examples: Production costs can be classified as uncontrollable costs
for sales managers.
5.2. Controllable and uncontrollable costs
A cost that is not controllable by a manager in one department may be
controllable by a manager in another department
A cost that is not controllable by a junior manager might be
controllable by a senior manager
6. Ethics
• A professional accountant is defined by ICAEW as ‘an individual
who is a member of an IFAC member body’.
• A professional accountant in business is defined as ‘a professional
accountant employed or engaged in an executive or non-executive
capacity in such areas as commerce, industry, service, the public
sector, education, the not for profit sector, regulatory bodies or
professional bodies, or a professional accountant contracted by such
entities.’
6. Ethics

• ICAEW provides ethical guidance that will ensure professional

accountants in business prepare and report information fairly,
honestly and in accordance with relevant professional standards so
that the information will be understood in its context.
6. Ethics
• Fundamental Principle 1 – ‘Integrity’
• Fundamental Principle 2 – ‘Objectivity’
• Fundamental Principle 3 – ‘Professional competence and due care’
• Fundamental Principle 4 – ‘Confidentiality’
• Fundamental Principle 5 – ‘Professional behaviour’
Summary