MANAGEMENT & COST ACCOUNTING LO 2: BASIC ASPECTS OF COST ACCOUNTING

MANAGEMENT & COST ACCOUNTING LO 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. iii. 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. 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 Activity Cost unit Brick-making 1,000 bricks Credit control Account maintained Electricity Kilowatt-hour (KwH) Selling Customer call Professional service Chargeable hour Education Enrolled student

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 will be USD 100 per unit. Production overhead cost relating to the machine shop

COST CENTRE CLASSIFICATIONS Illustration: Sales representative as a cost centre Type of cost centre Service location Function Activity Item of equipment Examples Stores, canteen Sales representative Quality control Packing machine 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. iii. iv. The cost of delivering the food products to the customer The cost of holding any inventories for the supermarket The salary cost of the account manager responsible for the supermarket s account

CLASSIFICATION OF COSTS ARRANGING 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 Direct Materials Timber, Screws and Metal drawer handles Direct Labour Wages paid for machine operator, assembler and finisher Illustration : Furniture Producer trying to determine the cost of a wooden table 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.

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