CHAPTER ONE: THE SCOPE OF COST AND MANAGEMENT ACCOUNTING

CHAPTER ONE:

THE SCOPE OF COST AND MANAGEMENT ACCOUNTING

Management Accounting seeks to provide information to managers which will be used for decision making purposes (e.g. pricing, investment) for planning and control.

Cost accounting is concerned with cost accumulation for stock valuation to meet  the requirements of  external reporting.

Financial Accounting is concerned with the provision of information to parties outside the organization.

Users of Accounting Information

Managers require information that will assist them in their decision-making and  control activities, for example , information is needed on the estimated selling prices, costs, demand, competitive position and profitability of various products that are made by the organization.

Shareholders require information on the value of their investment and the income that is derived from their shareholding.

Employees require information on the ability of the firm to meet wage demands and avoid redundancies.

Creditors and the providers of loan capital require information on a firm’s ability to meet its financial obligations.

Government agencies like the Central Bank and Central Statistics Department collect accounting information.

Tax Authority needs information on the amount of profit that are subject to taxation.

Meaning of Information

Most of the time data and information are considered to mean the same thing when in actual sense the two have quite different in meaning.

Data refers to raw facts with very little or no meaning unless they are process. (Accounting) information is a processed data and therefore has meaning attached to it. Information is that which bears upon or is useful to the action it is designed to facilitate or the  result  it is desired to produced.

Measurement Theory

This is important to accountants since  it is concerned with the problem of assessing or evaluating data so that its significance is  correctly stated. Measurement is concerned with assigning numbers to objects or events. Accountants play a major role in this measurement process by quantifying data. The quantification of data adds usefulness and conveys more information than strictly qualitative statements.

Attributes of  Measurement Unit / Accounting Information

An essential requirement of any measurement is that it should remain stable. Unfortunately, the monetary unit of measurement is not a stable measure in times of inflationary  or deflationary price changes. Because of this instability, it is difficult to compare objects and events  that are measured in one period  of time with  similar  objects and event s that are measured in subsequent periods. Consequently, some adjustments to the unit of measurement  are necessary to overcome the problem.

The cost measurement system should not be unreasonable. In other words, the benefits from adopting the measurement system should be  greater than the costs of operating  the system.

Also, the measurement unit should be  understandable to the users.

The basis of measurement should also be relevant to the decision.

Differences Between Management Accounting and Cost Accounting

Management Accounting	Cost Accounting
Management accounting relates  to the provision of appropriate information for people within the organization to help them make better decisions.	Cost accounting is concerned with  cost accumulation for stock valuation to meet  the requirements of  external reporting.

Differences Between Financial Accounting and Management Accounting

Financial Accounting	Management Accounting
1. Financial report are governed by the Company Act and Accounting Standards. Thus, financial reports are prepared as per given format (Law).	1. Management report are not governed by any law or standards. Thus, they takes any format that suits management.
2. Financial reports concern themselves with monetary matters.	2. Management reports deals with both monetary and no-monetary issues.
3. Financial reports are for both internal and external users.	3. Management reports are only for internal use.
4. Financial reports only report on past events.	4. Management reports report on both past and expected future events.

Why organizations use costing systems?

An organization’s costing system is the foundation of the internal financial information system for managers. It provides the information that management needs to plan and control the organization’s activities and to make decisions about the future.

Some Definitions:

- The word ‘cost’ can be used in two contexts. It can be used as a noun, for example, when referring to the cost of an item. When it is used as a  noun it means: ‘the amount of expenditure (actual or notional) incurred on, or attributable to a specified thing or activity’.

Alternatively, it can be used as a verb, for example, we can say that we are attempting to cost an activity. When used as a verb it means ‘to ascertain the cost of a specified thing or activity’.

- A cost unit  is defined as ‘a unit of product or service in relation to which costs are ascertained’. This means that a cost unit can be anything for which it is possible to ascertain the cost.

-  Historical cost refers to the purchase price for which an item was bought for.

-  Standard Cost is a technique which establishes predetermined estimates of the costs of products and services and then compares these predetermined costs with actual costs as they are incurred.

The predetermined costs are known as standard costs and the difference between the standard cost and actual is known as a variance.

The process by which the total difference between  actual cost and standard cost is broken down into its different elements is known as variance analysis.

- Marginal cost is the cost incurred  either to produce or acquire additional unit of a product.

- Average cost is the cost per unit. That is it is the total cost divided by total output.

- A cost centre is defined as ‘a production or service location, function, activity or 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.

For instance, an example of a production cost centre could be the machine shop

in a factory. The production overhead cost for the machine shop might be GMD100,000 for the period. If 1,000 cost units have passed through this cost centre we might say that the production overhead cost relating to the machine shop was GMD100 for each unit.

ELEMENTS OF COST

There are three main elements of cost:

Ø  Material

Ø  Labour

Ø  Expenses

For manufacturing costs can be divided further. Direct costs are traceable to one unit  of product.

Direct materials – which form part of the end product.

Direct Labour – involved directly in making the product.

Direct Expense – it is rare for expenses to be directly traceable to the product.

The total of direct cost is sometimes called Prime Cost. That is,

Prime Cost = Direct Material + Direct Labour -  Direct Expenses

PRACTICE QUESTIONS

1. Distinguish between:

(a)   Cost Accounting and Management Accounting

(b)   Financial Accounting and Management Accounting.

                                                                                                                    (10 Marks)

2.  Cost centres are:                                                                               (2 Marks)

(A) units of output or service for which costs are ascertained.

(B) functions or locations for which costs are ascertained.

(C) a segment of the organisation for which budgets are prepared.

(D) amounts of expenditure attributable to various activities.

3. Prime cost is:                                                                                     ( 2 Marks)

(A) all costs incurred in manufacturing a product.

(B) the total of direct costs.

(C) the material cost of a product.

(D) the cost of operating a department.

4.  Outline and define the various elements of cost.                                      (10 Marks)

5. Define the following :

a)    Cost centre

b)    Marginal cost

c)    Average cost

d)    Historical cost

e)    Prime cost

                                                                                                            (2 Marks each)

6. How relevant is costing system to an organization?                                    (5 Marks)

7. (a) Data is the same as an information. Discuss.                                        (2 Marks)

   

     (b) Outline the users of accounting information.                                         (8 Marks)

CHAPTER TWO: CLASSIFICATION OF COSTS

Similar costs are grouped together to assist managerial decision making and to produce analysis needed for external financial reporting. The criteria used for the classification will depend on the information being collected.

CLASSIFICATION OF COSTS ACCORDING TO THEIR NATURE

This means grouping costs according to whether they are materials, labour or expense cost.

Material costs include the cost of obtaining the materials and receiving them within the organisation. The cost of having the materials brought to the organisation is known as carriage inwards.

Labour costs are those costs incurred in the form of wages and salaries, together with related employment costs. In The Gambia, there is an additional cost borne by the employer in respect of employees which is paid to the government: this is called National Provident Fund. These costs are documented internally, the amount of the wages and salary costs being determined by reference to agreed grade of the employee.

Type of Cost Centre	Example
Service Location Stores	Canteen
Function Sales	Representative

Expense costs are external costs such as rent, business rates, electricity, gas, postages, telephones and similar items which will be documented by invoices from suppliers.

Within each of these classifications there is a number of subdivisions; for example, within the materials classification the subdivisions might include the following:

(a) Raw materials, that is, the basic raw material used in manufacture.

(b) Components, that is, complete parts that are used in the manufacturing process.

(c) Consumables, that is, cleaning materials, etc.

(d) Maintenance materials, that is, spare parts for machines, lubricating oils, etc.

CLASSIFICATION OF COSTS ACCORDING TO THEIR PURPOSE

When costs are classified having regard to their purpose, they are grouped according to the reason for which they have been incurred. The broadest classification of this type is to divide costs into direct costs and indirect costs.

A direct cost is one that can be clearly identified with whatever we are trying to cost. For example, suppose that a furniture maker is determining the cost of a wooden table. The manufacture of the table has involved the use of timber, screws and metal drawer handles.

These items are classified as direct materials. The wages paid to the machine operator, assembler and finisher in actually making the table would be classified as direct labour costs.

The designer of the table may be entitled to a royalty payment for each table made, and this would be classified as a direct expense.

Other costs incurred would be classified as indirect costs. They cannot be directly attributed to a particular cost unit, although it is clear that they have been incurred in the production of the table. Examples of indirect production costs are as follows:

It is important for you to realise that a particular cost may sometimes be a direct cost and sometimes an indirect cost. It depends on what we are trying to cost.

For example, the salary of the machining department supervisor is a direct cost of that department because it can be specifically identified with the department. However, it is an indirect cost of each of the cost units processed in the machining department because it cannot be specifically identified with any particular cost unit.

OTHER EXAMPLES OF COST CLASSIFICATION

(a) Fixed and variable costs. This classification is made according to whether a cost varies in total when the activity level changes. A fixed cost remains unaltered when activity varies. The total expenditure on variable costs will change in line with changes in the level of activity.

This particular classification can be especially useful if we are classifying costs for decision-making purposes.

(b) Production, selling and distribution, and administration costs. This classification is based on a functional analysis of costs. It groups costs according to the function of the business which has incurred them. Although there are other functional groups of costs, these are the main classifications. This sort of analysis is particularly useful for inventory (stock) valuation purposes. For example, selling overheads should not be included in the valuation of stock because an item which is still held in stock would not yet have incurred any selling overheads.

(c) Controllable and non-controllable costs. Costs may be classified in management reporting systems according to whether they are controllable or non-controllable. This means that the costs which are within the control of management are highlighted in the reports so that management action is directed where it is most worthwhile.

(d) Normal and abnormal costs. A normal cost is one which management was expecting to incur and which is of the expected order of magnitude. An abnormal cost is one which was not expected or which is larger or smaller than expected. This type of classification is used to draw managers’ attention to the cost of abnormal events.

 (e) Relevant and non-relevant costs. This method of classification divides costs according to whether they are relevant to a decision being taken, or not relevant to the decision.

Examples of non-relevant costs are sunk costs or past costs.

COST BEHAVIOUR

Many factors affect the level of costs incurred; for instance inflation will cause costs to increase over a period of time. In management accounting, when we talk about cost behaviour we are referring to the way in which costs are affected by fluctuations in the level of activity.

The level of activity can be measured in many different ways. For example, we can record the number of units produced, miles travelled, hours worked, percentage of capacity utilised and so on

In this section we will look at the most common cost behaviour patterns and we will consider some examples of each.

Fixed cost

A fixed cost is ‘a cost which is incurred for an accounting period, and which, within certain output or turnover limits, tends to be unaffected by fluctuations in the levels of activity (output or turnover)’.

Another term that can be used to refer to a fixed cost is a period cost. This highlights the fact that a fixed cost is incurred according to the time elapsed, rather than according to the level of activity.

A fixed cost can be depicted graphically as shown below:

Examples of fixed costs are rent, rates, insurance and executive salaries. The graph shows that the cost is constant (in this case at GMD5,000) for all levels of activity. However, it is important to note that this is only true for the relevant range of activity. Consider, for example, the behaviour of the rent cost. Within the relevant range it is possible to expand activity without needing extra premises and therefore the rent cost remains constant. However, if activity is expanded to the critical point where further premises are needed, then the rent cost will increase to a new, higher level.

This cost behaviour pattern can be described as a stepped fixed cost  as shown below:

The cost is constant within the relevant range for each activity level but when a critical level of activity is reached, the total cost incurred increases to the next step.

.

When you are drawing or interpreting graphs of cost behaviour patterns, it is important that you pay great attention to the label on the vertical axis.

The fixed cost per unit reduces as the activity level is increased. This is because the same amount of fixed cost is being spread over an increasing number of units.

Variable cost

A variable cost as ‘a cost which varies with a measure of activity’. Examples of variable costs are direct material, direct labour and variable overheads.

Below is graph of variable cost per unit:

The above graph depicts a linear variable cost. It is a straight line through the origin, which means that the cost is nil at zero activity level. When activity increases, the total variable cost increases in direct proportion, that is, if activity goes up by 10 per cent, then the total variable cost also increases by 10 per cent, as long as the activity level is still within the relevant range.

The gradient of the line will depend on the amount of variable cost per unit.

An example of a variable cost which follows this pattern could be the cost of direct material where quantity discounts are available.

Exercise

Can you think of other variable costs which might follow the behaviour patterns depicted in the variable cost per unit graph above?

Semi-variable cost

A semi-variable cost is also referred to as a semi-fixed or mixed cost. It is defined as ‘a cost containing both fixed and variable components and which is thus partly affected by a change in the level of activity’.

A graph of a semi-variable cost  look like this:

 Examples of semi-variable costs are gas and electricity. Both of these expenditures consist of a fixed amount payable for the period, with a further variable amount which is related to the consumption of gas or electricity.

This cost remains constant up to a certain level of activity and then increases as the variable cost element is incurred. An example of such a cost might be the rental cost of a photocopier where a fixed rental is paid and no extra charge is made for copies up to a certain number. Once this number of copies is exceeded, a constant charge is levied for each copy taken.

Analysing semi-variable costs

When managers have identified a semi-variable cost they will need to know how much of it is fixed and how much is variable. Only when they have determined this will they be able to estimate the cost to be incurred at relevant activity levels. Past records of costs and their associated activity levels are usually used to carry out the analysis. The three most common methods used to separate the fixed and variable elements are as follows:

(a) The high–low method.

(b) The scattergraph method.

(c) The least squares method of regression analysis.

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: The highest activity level occurred in February and the lowest in May. Since the amount of fixed cost incurred in each month is constant, the extra cost resulting from the activity increase must be the variable cost.

Month	Activity Level (Units)	Cost Incurred (GMD)
January	1,800	36,600
February	2,450	41,150
March	2,100	38,700
April	2,000	38,000
May	1,750	36,250
June	1,950	37,650

The following equation will be used:

Total Cost, y = Variable Cost per Unit x Activity (X) + Fixed Cost

The extra variable cost for 700 units is GMD4,900. We can now calculate the variable cost per unit: Variable cost  GMD4;900 / 700 =  GMD7 per unit.

Substituting back in the above equation for February, we can determine the amount of fixed cost:

From the above equation:

Fixed Cost = Total Cost – Variable Cost per Unit x Activity (X)

Fixed Cost =GMD 41,150 - (2,450 x GMD7) = GMD41,150 - GMD17,150 = GMD24,000

Now that the fixed and variable cost elements have been identified, it is possible to estimate the total cost for any activity level within the range 1,750 units to 2,450 units.