COST AND MANAGEMENT ACCOUNTING NOTES (BMB 207) – UNIT I

Management Accounting and Cost Accounting - Meaning, Nature and Scope

1. Management Accounting

Meaning: Management Accounting means providing financial and other information to managers to help them plan, control, and make
decisions for the business.

Nature:

 Internal Use: It is used by managers, not outsiders like investors.

 Future-Oriented: It focuses on what will happen (planning), not just what has happened.
 Flexible: It uses both financial (money-based) and non-financial (like number of units, labour hours) data.
 No fixed rules: It is to be noted that, unlike financial accounting, it doesn’t follow strict rules or formats.

Scope:

 Budgeting and Forecasting: Planning future income and expenses.

 Cost Control: Finding ways to reduce or control costs.
 Performance Measurement: Checking how well employees or departments are doing.
 Decision Making: Helps in choosing between options (like buying vs. making).
 Financial Analysis: Analyzing data to understand the business better.

2. Cost Accounting

Meaning: Cost Accounting is about recording and analyzing all costs involved in making a product or providing a service. It helps find the
cost per unit.

Nature:

 Helps in Cost Control: It helps identify and reduce unnecessary costs.

 Product Focused: It tells how much it costs to make a product or service.
 Supports Pricing: It helps decide the selling price of products.
 Mostly Internal: Mainly used by internal managers.

Scope:

 Determining Cost: Calculating material, labour, and overhead costs.

 Cost Control and Cost Reduction: Finding ways to save money.
 Standard Costing: Comparing actual costs with expected (standard) costs.
 Marginal Costing: Studying the effect of producing one more unit.
 Budgetary Control: Comparing actual spending with planned budget.

Difference between Management Accounting and Financial Accounting

Management accounting focuses on providing detailed, relevant information to internal managers to help them make decisions, plan, and
control operations within the organization. It is forward-looking and often includes forecasts, budgets, and performance reports tailored for
internal use.

Financial accounting, on the other hand, is concerned with preparing financial statements that reflect the overall financial position and
performance of the company. These statements are created for external users such as investors, creditors, and regulators and follow
standardized rules and principles to ensure consistency and comparability.

Management accounting is primarily aimed at helping internal management with decision-making, planning, and controlling business
operations. It includes detailed reports on costs, budgets, and forecasts that are customized to meet the specific needs of managers. This
type of accounting is usually more flexible and does not need to follow any external rules or standards, as it is meant for internal use only. It
often focuses on future projections and helps in improving efficiency and effectiveness within the organization.

Financial accounting, in contrast, is designed to provide a clear and accurate picture of a company’s financial performance and position to
external parties such as investors, creditors, government agencies, and other stakeholders. It follows established accounting standards (like
GAAP or IFRS) to ensure consistency and reliability in the financial statements. These statements include the balance sheet, income
statement, and cash flow statement, and they reflect the company’s past performance over a specific period. Unlike management
accounting, financial accounting is historical and less detailed regarding internal operations.
 Aspects Management Accounting Financial Accounting

Helps managers make decisions within the Provides financial info to outsiders like investors,
Purpose organization govt

Users Internal (managers, executives) External (shareholders, creditors, government)

Focuses on future plans and internal Focuses on past performance and overall financial
Focus Area operations position

Reporting Frequency As needed (daily, weekly, monthly) Usually periodic (quarterly or annually)

Rules/Standards No strict rules; flexible and customized Must follow rules like GAAP or IFRS

Very detailed (product cost, department Summarized (balance sheet, income statement,
Level of Detail performance, etc.) etc.)

Audit Requirement Not required to be audited Usually audited for accuracy

Time Orientation Future-oriented (forecasts, budgets) Historical (records of past transactions)

Cost concepts: Cost Unit

A Cost Unit is a unit of product or service for which costs are measured and assigned. It acts as a standard measurement to calculate and
control costs related to production or services. For example, in a manufacturing company, the cost unit could be “per kilogram of steel,” “per
litre of milk,” or “per piece of furniture.” In service industries, it might be “per hour of service” or “per customer served.”

Cost units help businesses determine the cost incurred in producing a single unit of output, which is essential for pricing, budgeting, and cost
control. It provides a basis to compare costs across different periods, departments, or products, helping management make informed
decisions.

A Cost Unit is a unit of product or service for which costs are calculated and measured. It’s basically a standard measure that helps
businesses determine the cost incurred in producing one unit of output. For example:

 In a steel plant, the cost unit might be “per ton of steel.”

 In a hospital, it could be “per patient treated.”
 In a transport company, it might be “per kilometre travelled.”

Using cost units helps in pricing, controlling costs, and comparing efficiency across different products or services.

Difference between Cost and Costing

Cost refers to the actual amount of money spent or incurred to produce a product or provide a service. It represents the value of resources
used, such as materials, labour, and overheads.

Costing is the process or technique of determining, analyzing, and recording the cost of a product or service. It involves methods and
procedures to calculate costs accurately for decision-making and control purposes.

In simple terms, cost is the final result (the actual amount spent), while costing is the method or system used to find out that cost.

Examples for both Cost and Costing:

 Cost example:
A company spends $500 on raw materials, $200 on labour, and $100 on overheads to manufacture one chair. The cost of making
that chair is $800.
 Costing example:
The Company uses a method to calculate the total cost of producing chairs by adding raw materials, labour, and overheads for each
unit. This method of calculating the $800 for each chair is called costing.

Significance of Cost and Costing

Cost represents the amount spent to produce a product or deliver a service, while costing is the process of determining and controlling
those costs. Both play a crucial role in business management:

1. Helps in Pricing: Knowing the cost helps set the right selling price to ensure profitability.
 2. Cost Control: Costing identifies where money is spent and helps find ways to reduce unnecessary expenses.
3. Budgeting and Planning: Accurate costing enables effective budgeting and financial planning.
4. Profit Measurement: Understanding costs helps measure and improve profit margins.
5. Decision Making: Management relies on cost information to make decisions about production, expansion, or discontinuing
products.
6. Performance Evaluation: Costing helps assess the efficiency of different departments or processes.

Cost Control and Cost Reduction

Cost Control:

 Meaning: Regulating costs through standards, budgets, and monitoring actual performance.
 Objective: Ensure that actual cost does not exceed the standard or budgeted cost.
 Tools: Standard costing, budgetary control.
 Nature: Preventive in nature.
 Focus: Existing cost levels.

Cost Reduction:

 Meaning: Real and permanent reduction in unit cost of goods/services without affecting quality.
 Objective: Improve efficiency and productivity.
 Tools: Value analysis, work study, redesigning processes.
 Nature: Corrective and continuous.
 Focus: Reducing cost below current level.

Components of Total Cost

1. Prime Cost
= Direct Material + Direct Labour + Direct Expenses
➤Basic cost of manufacturing.
2. Factory/Works Cost
= Prime Cost + Factory Overheads
➤Includes indirect production costs (electricity, depreciation, etc.)
3. Cost of Production
= Factory Cost + Administration Overheads (related to production)
4. Total Cost / Cost of Sales
= Cost of Production + Selling & Distribution Overheads
➤Final cost incurred to make and sell the product.

Cost Sheet: A statement showing the item-wise breakup of total cost incurred in producing a product during a specific period.

Purpose:

 To ascertain cost per unit

 Aid in pricing, cost control, and decision making

Format (Simple):

Particulars Amount (₹)

Direct Material
Direct Labour
Direct Expenses
➤Prime Cost XXXX
Add: Factory Overheads
➤Factory/Works Cost XXXX
Add: Administration Overheads
➤Cost of Production XXXX
Add: Selling & Distribution Overheads
➤Total Cost (Cost of Sales) XXXX
Add: Profit (if required)
➤Sales Price XXXX
Cost Classification or Classification of Costs

Cost Classification is the process of grouping costs into different categories based on their common characteristics.

This helps in better cost control, analysis, and decision-making. There are several ways costs can be classified:

1. By Nature or Element

 Material Cost: Cost of raw materials and components used in production.

Example: Cost of steel in a car manufacturing plant.
 Labour Cost: Wages and salaries paid to workers directly involved in production.
Example: Payment to assembly line workers.
 Overhead Cost: Indirect costs related to production but not directly traceable to a product.
Example: Electricity bills, depreciation of machinery, factory rent.

2. By Function

 Production Cost: Costs incurred to manufacture a product.

Example: Raw materials, labour, and factory overheads.
 Administration Cost: Expenses related to general management and administration.
Example: Salaries of office staff, office rent.
 Selling and Distribution Cost: Costs of marketing and delivering the product to customers.
Example: Advertising expenses, shipping charges.
 Research and Development Cost: Expenses for developing new products or improving existing ones.
Example: Cost of materials and labour used in R&D labs.

3. By Behaviour

 Fixed Cost: Costs that remain constant regardless of production volume.

Example: Rent, salaries of permanent staff.
 Variable Cost: Costs that vary directly with production levels.
Example: Raw materials, direct labour wages.
 Semi-variable Cost (Mixed Cost): Costs having both fixed and variable components.
Example: Electricity bill that has a fixed base charge plus a variable charge based on usage.

4. By Traceability

 Direct Cost: Costs that can be directly traced to a specific product or job.
Example: Cost of wood in furniture making.
 Indirect Cost: Costs that cannot be directly traced to a product.
Example: Factory lighting, maintenance expenses.

5. By Controllability

 Controllable Cost: Costs which can be influenced or controlled by a manager at a given level.
Example: Cost of raw materials ordered by a production manager.
 Uncontrollable Cost: Costs which cannot be influenced by a manager.
Example: Depreciation decided by accounting policies.

6. By Time

 Historical Cost: Costs that have already been incurred in the past.
Example: Last month’s electricity bill.
 Pre-determined Cost: Estimated or standard costs set in advance for planning purposes.
Example: Standard cost set for raw materials per unit.

Why is Cost Classification important?

 Helps in budgeting and cost control

 Facilitates decision-making about pricing, production, and cost reduction
 Enables profit analysis by segregating costs by function or behaviour
 Assists in financial reporting and compliance
Cost Centre: A Cost Centre is a specific department, section, or location within an organization where costs are accumulated and
controlled. It doesn’t directly generate profits but is responsible for managing and controlling costs efficiently. Cost centres help in better
budgeting, cost control, and performance evaluation of different parts of a business.

Examples of cost centres include the production department, maintenance department, or the human resources department. By assigning
costs to cost centres, management can track expenses accurately and identify areas where cost savings are possible.

Costing System

A Costing System is a method or set of procedures used by a business to record, classify, and allocate costs to products, services, or
departments. It helps the company keep track of how much money is being spent and where, so they can manage expenses and make
better decisions.

Why is a Costing System Important?

 To find out the actual cost of producing each product or service.

 To help set the right price to sell the product.
 To control costs by identifying areas where money can be saved.
 To assist in budgeting and financial planning.
 To measure profitability of different products or departments.

Types of Costing: These are based on nature of the industry or product:

1. Job Costing
➤Used where work is done on specific orders (e.g., furniture, printing).
➤Costs are calculated per job or project.
2. Batch Costing
➤Used when identical products are made in batches.
➤Cost is calculated per batch, then per unit.
3. Contract Costing
➤Used in construction and civil works (e.g., roads, buildings).
➤Each contract is treated as a separate cost unit.
4. Process Costing
➤Applied where production is continuous (e.g., chemicals, oil).
➤Costs are collected for each process or department.
5. Operation Costing
➤A refined version of process costing.
➤Used when production involves repetitive operations.
6. Unit (Output) Costing
➤Used for uniform, single products (e.g., bricks, cement).
➤Cost per unit = Total cost ÷ Total units.
7. Service Costing
➤Used by service industries (e.g., transport, hospitals).
➤Cost unit may be per km, per bed, per passenger etc.

Methods of Costing: These are techniques used to ascertain cost:

1. Historical Costing
➤Costs are recorded after they are incurred.
2. Standard Costing
➤Predetermined costs are set as benchmarks; variances are analyzed.
3. Marginal Costing
➤Considers only variable costs for decision-making; fixed costs are ignored.
4. Absorption Costing
➤Both fixed and variable costs are allocated to products.
5. Uniform Costing
➤Different firms in the same industry use standardized costing methods.
6. Direct Costing
➤Only direct costs (materials, labour) are considered.

Inventory Management
Meaning: Controlling and overseeing raw materials, work-in-progress, and finished goods.

Objectives:

 Avoid overstocking or under stocking

 Ensure smooth production
 Minimize storage cost
 Improve cash flow

Techniques:

 EOQ (Economic Order Quantity): Ideal order size to minimize cost

 ABC Analysis: Classifies items as A (high value), B (medium), C (low)
 FIFO & LIFO: Methods to issue materials
 Reorder Level: Level at which new stock is ordered

Labour Cost

Meaning: Cost of human effort used in production.

Types:

 Direct Labour: Involved in making the product

 Indirect Labour: Support work (e.g., supervisors, cleaners)

Control Measures:

 Timekeeping & Time Booking

 Incentive Schemes (Bonus plans)
 Labour Turnover Analysis

Calculation:

 Time wage (based on hours)

 Piece wage (based on output)

Overheads

Meaning: All indirect costs (not directly traceable to a product).

Types:

 Factory Overheads: Indirect materials, power, depreciation

 Office Overheads: Salaries, admin costs
 Selling & Distribution Overheads: Advertising, delivery charges

 Apportionment: Dividing overheads across departments based on a fair basis.

 Absorption: Charging overheads to each product (e.g., per hour or per unit)

Activity-Based Costing (ABC)

Activity-Based Costing (ABC) is a costing method that assigns overhead and indirect costs to products or services based on the actual
activities that generate those costs. Unlike traditional costing methods, which often allocate overheads based on a single factor like direct
labour hours or machine hours, ABC looks deeper into what causes costs and assigns expenses more accurately.

How Does ABC Work?

1. Identify Activities
Determine all the activities involved in production or service delivery, such as machine operation, setup, inspection, packaging, and
order processing.
2. Assign Costs to Activities
Calculate the total cost associated with each activity. For example, total costs of inspections or machine setups.
3. Determine Cost Drivers
Find measurable factors that cause the costs, like the number of setups, inspection hours, or machine hours.
 4. Calculate Activity Rates
We need to divide the total cost of each activity by its total cost driver units to get a rate.
Example: Cost per machine hour or cost per inspection.
5. Assign Costs to Products
Use the activity rates and the number of cost driver units consumed by each product to assign overhead costs accurately.

Simple Example of ABC

Imagine a company manufactures two products: Product A and Product B.

 Activities and Costs:

o Machine setups cost $10,000
o Inspections cost $5,000
 Cost Drivers:
o Product A requires 100 machine setups and 50 inspections
o Product B requires 200 machine setups and 150 inspections
 Activity Rates:
o Machine setup cost per setup = $10,000 ÷ (100 + 200) = $33.33 per setup
o Inspection cost per inspection = $5,000 ÷ (50 + 150) = $25 per inspection
 Assign Costs:
o Product A’s overhead = (100 setups × $33.33) + (50 inspections × $25) = $3,333 + $1,250 = $4,583
o Product B’s overhead = (200 setups × $33.33) + (150 inspections × $25) = $6,666 + $3,750 = $10,416

So, ABC shows that Product B consumes more overhead costs because it requires more setups and inspections, which might not have
been clear under traditional costing.

Benefits of ABC

 More accurate product costing

 Helps identify inefficient activities and cost-saving opportunities
 Assists in pricing strategies and product mix decisions
 Improves budgeting and cost control

What is Inventory Valuation

Inventory valuation is the process of assigning monetary value to the inventory (stock of materials) a company holds. It affects cost of goods
sold (COGS), profits, and taxation.

LIFO & FIFO

1. FIFO – First In, First out - Meaning: The materials purchased first are issued (used/sold) first.

Features

 Oldest inventory cost is charged to production.

 Ending inventory is valued at latest prices.

Advantages

 Logical and systematic.

 Closing stock reflects current market prices.
 Suitable in inflationary periods to show higher profits.

Disadvantages

 COGS based on outdated prices.

 Higher taxes due to higher profits in times of rising prices.

2. LIFO – Last In, First out - Meaning: The materials purchased last are issued (used/sold) first.

Features

 Latest inventory cost is charged to production.

 Closing inventory is valued at older prices.

Advantages
  Matches current costs with current revenues.
 Lower taxable income during inflation (due to higher COGS).

Disadvantages

 Closing stock is undervalued (not at current prices).

 Not allowed under some international accounting standards (e.g., IFRS).

Difference b/w LIFO & FIFO

Basis FIFO (First-In, First-Out) LIFO (Last-In, First-Out)

Meaning Oldest items (first in) are issued first Newest items (last in) are issued first

Cost of Closing Stock Based on latest prices (recent purchases) Based on old prices (older purchases)

Reflects older costs (may be lower if prices Reflects recent costs (may be higher if prices
Cost of Goods Sold are rising) are rising)

In times of inflation Profit appears higher (older costs are low) Profit appears lower (recent costs are high)

Stock Valuation Higher value of closing stock Lower value of closing stock
Used where stock moves in regular order Used where recent stock is issued first (e.g.,
Suitability (e.g., perishable goods) sand, coal)

Accepted by most accounting standards Not accepted under IFRS; allowed under
Accounting Standard (e.g., IFRS, AS) some national GAAPs

Difference between Cost Accounting and Management Accounting

Aspect Cost Accounting Management Accounting

Purpose Ascertain cost of production/services Help in planning, decision-making, and control
Focus Historical cost data Future projections and strategic decisions
Users Mostly internal Internal (management level)
Scope Narrow (only cost data) Broad (cost + financial + statistical data)
Legal requirement May be required in some industries Not mandatory by law

Cost Centre vs. Cost Unit

Term Meaning
Cost Centre A location, person, or item of equipment for which costs are ascertained.
Cost Unit A unit of product/service for which cost is measured (e.g., per kg, per km).

Example:

 In a car factory:
o Cost Centre = Paint Department
o Cost Unit = Cost per car