Lecture notes on Cost and management Accounting

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INTERMEDIATE GROUP - II PAPER 8 COST ANDDDDDDDDDD MANAGEMENT ACCOUNTING The Institute of Cost Accountants of India 12, SUDDER STREET, KOLKATA - 700 016Financial Accounting, Cost Accounting and Management Accounting 1.1 Introduction Accounting is a very old science which aims at keeping records of various transactions. The accounting is considered to be essential for keeping records of all receipts and payments as well as that of the income and expenditures. Accounting can be broadly divided into three categories. Financial Accounting, aims at fi nding out profi t or losses of an accounting year as well as the assets and liabilities position, by recording various transactions in a systematic manner. Cost Accounting helps the business to ascertain the cost of production/services offered by the organization and also provides valuable information for taking various decisions and also for cost control and cost reduction. Management Accounting helps the management to conduct the business in a more effi cient manner. The scope of management accounting is broader than that of cost accounting. In other words, it can be said that the management accounting can be considered as an extension of cost accounting. Management Accounting utilises the principles and practices of fi nancial accounting and cost accounting in addition to other modern management techniques for effi cient operation of a company. The main thrust in management accounting is towards determining policy and formulating plans to achieve desired objectives of management. Management Accounting makes corporate planning and strategies effective and meaningful. In the present chapter all these concepts are discussed in detail in order to make the concepts more clear. 1.2 Financial Accounting Financial Accounting aims at fi nding the results of an accounting year in terms of profi ts or losses and assets and liabilities. In order to do this, it is essential to record various transactions in a systematic manner. Financial Accounting is defi ned as, ‘Art and science of classifying, analyzing and recording business transactions in a systematic manner in order to prepare a summary at the end of the year to fi nd out the results of the concerned accounting year.’ The defi nition given above is self explanatory, however for understanding clearly, the following terms are explained below. A Business transactions :- A transaction means an activity, a business transaction means any activity which creates some kind of legal relationship. For example, purchase and sale of goods, appointing an employee and paying his salary, payment of various expenses, purchase of assets etc. B Classifi cation of transactions :- Before recording any transaction, it is essential that it is to be classifi ed. A transaction can be classifi ed as cash transaction and credit transaction. Similarly transactions of receiving income and payment of expenditure can be segregated. Even in case of expenditure, transactions involving revenue expenditure and capital expenditure can be segregated. C Recording of transactions :- The essence of fi nancial accounting is recording of transaction. In accounting language, recording of the transaction is known as entry. There are well defi ned rules for recording various transactions in books of accounts. As per the rules of fi nancial accounting, each and every transaction is recorded at two places and hence it is called as ‘Double Entry’ system of accounting. 2Cost and Management Accounting D Summary of transactions :- After recording all transactions, it is essential to prepare a summary of them so as to draw meaningful conclusions. The summary will help in fi nding out the Profi t/Loss of a particular year and also ascertaining Assets and Liabilities on a particular date. In fact, the very purpose of fi nancial accounting is to know the results of a particular year. From this angle, the process of preparing the summary is extremely important. 1.2.1 Concepts and conventions of Financial Accounting :- There are some well defi ned concepts and conventions of fi nancial accounting system. Concepts can also be termed as ‘principles’ while conventions are those which have been followed over a period of time and are accepted as norms to be followed in fi nancial accounting systems. The concepts and conventions of fi nancial accounting are explained in the following paragraphs. 1.2.2 Concepts of Financial Accounting:- The following are the concepts of fi nancial accounting. A. Separate Entity :- This concept implies that the businessman is different from business. Thus if X starts his business known as X and Sons, X as a person shall be different from his fi rm, i.e. X and Sons. Actually in Law, separate entity concept is recognized only in the case of joint stock companies registered under Companies Act, 1956. In case of partnerships and sole proprietorship business, separate entity concept is not recognized under Law. However in accounting, separate entity concept is recognized and the accounting entries are passed in the books of the business and not in the books of the proprietor as such. Thus when X starts his business and invests his own money as capital, it is shown as liability in the Balance Sheet of the business. On the other hand, if the proprietor incurs any private expenditure from the resources of the business, it is shown as recoverable in the books of accounts of the business. Thus the principle of separate entity is applied in practice. B. Double Entry :- This principle can be called as ‘Heart’ of the entire accounting mechanism. Double entry means a transaction is recorded at two places in the books of accounts, the reason being that any transaction has two fold effects and hence it is to be recorded at two places. The following example will clarify the point. 1. If goods are purchased for cash, the cash goes out and goods come in. Thus one effect is the cash going out and the second effect is that goods come in. 2. When goods are sold for cash, the fi rst effect is that the cash comes in and the second one is that the goods are going out. 3. In case of credit transactions like purchase of goods, one effect is that goods come in and the person from whom the goods are purchased becomes the creditor of the business. Thus in double entry system, each and every transaction has the two fold effects. There is another system of recording the transactions, which is known as single entry system. In single entry system, every transaction is recorded only once and hence no double effect is given. There are very few organizations where single entry system is still implemented. However the double entry system is now being accepted everywhere. C. Money Measurement Concept :- Another important concept of fi nancial accounting is the money measurement concept. This concept means that only the transactions which are capable of being expressed in monetary terms will be recorded in the books of accounts. In other words, transactions which cannot be expressed in monetary terms cannot be recorded 3Financial Accounting, Cost Accounting and Management Accounting in the books of accounts. For example, in books of accounts monetary value of assets or goods will be recorded and not the quantity of the same. Furniture will not be recorded as 1 table or 12 chairs or 100 cupboards, but the values of the same in monetary terms will be recorded. This principle means that items like Human Resources will not be recorded in the books of accounts as they cannot be converted into monetary terms. This principle is important as it brings uniformity in recording transactions in the books of accounts. D. Going Concern Concept :- As per Glossary of terms, International Accounting Standards, 1999, the defi nition of ‘Going Concern’ is as follows ‘That enterprise is normally viewed as a going concern, that is as continuing in operation for the foreseeable future. It is assumed that the enterprise has neither the intention nor the necessity of liquidation or curtailing materially the scale of its operations.’ The implications of this concept is that the fi nancial statements, fi xed assets are shown at the cost of acquisition less depreciation accumulated up to the date of closure. The reason is that it is assumed that the enterprise is going to continue for a long period of time and there is no intention to close it down in the near future. Therefore the market values of the same are not relevant at all, the cost prices are relevant and hence the assets should be shown at the cost value. E. Matching Concept :- Matching of costs and revenues concept is explained below in the International Accounting Standards ‘Expenses are recognized in the income statement on the basis of a direct association between the costs incurred and the earnings of specifi c items of income. This process involves the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same association or other events. However, the application of the matching concept does not allow the recognition of items in the Balance Sheet which do not meet the defi nition of assets or liabilities.’ In other words, matching concept means that it is necessary to periodically match the costs and revenues in order to fi nd out the results of a particular period. This period is called as accounting year. For any business it is essential to fi nd out the profi t or loss after periodic intervals. Actually, real profi t or loss can be found out only after the business is closed down. But in the earlier concept we have seen that any business organization is a going concern and not likely to shut down in the near future. Therefore it is necessary to match the revenue and expenditure on periodic basis. This period is normally for one year and is called as accounting year. In case of limited companies established under the Companies Act, 1956, fi rst accounting year in case of a company can be of 18 months but subsequent accounting years must be of 12 months duration. A business organization is free to choose the accounting year, i.e. a calendar year can be adopted as accounting year or fi nancial year starting from 1st April to 31st March can be an accounting year. The assessment year for income tax purpose is always from 1st April to 31st March and hence many organizations adopt this period as accounting year. 1.2.3 Accounting Cycle : It is essential to describe the accounting cycle in brief. The cycle commences with the happening of a transaction and ends with the preparation of fi nal accounts, i.e. Profi t and Loss Account and Balance Sheet. The following chart will show the accounting cycle. 4Cost and Management Accounting Transaction Entry Books of Prime Entry – Journal and Subsidiary Books Posting in Ledger – Book of Secondary Entry Trial Balance Final Accounts – Profi t and Loss Account and Balance Sheet As mentioned above, the accounting cycle starts with a transaction. As soon as a transaction takes place, it is recorded in the books of Prime Entry, i.e. either Journal or subsidiary books. After recording the same in these books, the transaction is posted in the ledger which is called as book of secondary entry. All ledger accounts are closed and a list of the same is prepared which is called as ‘Trial Balance’. From the trial balance, fi nal accounts, Profi t and Loss Account and Balance Sheet are prepared. 1.2.4 Utility of Financial Accounting : The utility of fi nancial accounting can be explained in the following manner. A. Financial Accounting provides well defi ned rules and principles of recording business transactions. This provides uniformity in recording the transactions and thus results of various organizations become comparable. B. For any organization, whether it is profi t making or non-profi t making, it is essential to fi nd out the results of a particular accounting period, i.e. accounting year. Financial accounting mechanism enables them to prepare Profi t and Loss Account and Balance Sheet at the end of the fi nancial year. C. Financial Accounting helps the taxation authorities for determining the tax liability in a fair manner. Income Tax is levied on the profi ts and fi nancial accounting helps to disclose true and fair view of the business as regards to profi ts. Thus the assessment of tax liability becomes rational and free from any controversies. D. Financial Accounting is also helpful for the investors who are interested in fi nding out the profi tability of the business in which they want to invest the money. Financial accounting information helps in ascertaining profi tability so that decision-making is easier. E. In the course of the business, a fi rm has to borrow money for various objectives such as expansion, diversifi cation, modernization and so on. The lenders have to ensure that the money lent by them will be repaid back. For this, they study fi nancial statements viz. Profi t and Loss Account and Balance Sheet to ascertain the fi nancial condition of the business. Thus the fi nancial accounting helps them in decision-making regarding granting of loan. 5Financial Accounting, Cost Accounting and Management Accounting F. Financial accounting also provides useful information for the purpose of valuation of business during merger and acquisition process. 1.3 Cost Accounting As compared to the fi nancial accounting, the focus of cost accounting is different. In the modern days of cut throat competition, any business organization has to pay attention towards their cost of production. Computation of cost on scientifi c basis and thereafter cost control and cost reduction has become of paramount importance. Hence it has become essential to study the basic principles and concepts of cost accounting. These are discussed in the subsequent paragraphs. 1.3.1 Cost :- Cost can be defi ned as the expenditure (actual or notional) incurred on or attributable to a given thing. It can also be described as the resources that have been sacrifi ced or must be sacrifi ced to attain a particular objective. In other words, cost is the amount of resources used for something which must be measured in terms of money. For example – Cost of preparing one cup of tea is the amount incurred on the elements like material, labor and other expenses, similarly cost of offering any services like banking is the amount of expenditure for offering that service. Thus cost of production or cost of service can be calculated by ascertaining the resources used for the production or services. 1.3.2 Costing :- Costing may be defi ned as ‘the technique and process of ascertaining costs’. According to Wheldon, ‘Costing is classifying, recording, allocation and appropriation of expenses for the determination of cost of products or services and for the presentation of suitably arranged data for the purpose of control and guidance of management. It includes the ascertainment of every order, job, contract, process, service units as may be appropriate. It deals with the cost of production, selling and distribution. If we analyze the above defi nitions, it will be understood that costing is basically the procedure of ascertaining the costs. As mentioned above, for any business organization, ascertaining of costs is must and for this purpose a scientifi c procedure should be followed. ‘Costing’ is precisely this procedure which helps them to fi nd out the costs of products or services. 1.3.3 Cost Accounting :- Cost Accounting primarily deals with collection, analysis of relevant of cost data for interpretation and presentation for various problems of management. Cost accounting accounts for the cost of products, service or an operation. It is defi ned as, ‘the establishment of budgets, standard costs and actual costs of operations, processes, activities or products and the analysis of variances, profi tability or the social use of funds’. 1.3.4 Cost Accountancy :- Cost Accountancy is a broader term and is defi ned as, ‘the application of costing and cost accounting principles, methods and techniques to the science and art and practice of cost control and the ascertainment of profi tability as well as presentation of information for the purpose of managerial decision making.’ If we analyze the above defi nition, the following points will emerge, A. Cost accounting is basically application of the costing and cost accounting principles. B. This application is with specifi c purpose and that is for the purpose of cost control, ascertainment of profi tability and also for presentation of information to facilitate decision making. 6Cost and Management Accounting C. Cost accounting is a combination of art and science, it is a science as it has well defi ned rules and regulations, it is an art as application of any science requires art and it is a practice as it has to be applied on continuous basis and is not a one time exercise. 1.3.5 Objectives of Cost Accounting :- Objectives of Cost Accounting can be summarized as under 1. To ascertain the cost of production on per unit basis, for example, cost per kg, cost per meter, cost per liter, cost per ton etc. 2. Cost accounting helps in the determination of selling price. Cost accounting enables to determine the cost of production on a scientifi c basis and it helps to fi x the selling price. 3. Cost accounting helps in cost control and cost reduction. 4. Ascertainment of division wise, activity wise and unit wise profi tability becomes possible through cost accounting. 5. Cost accounting also helps in locating wastages, ineffi ciencies and other loopholes in the production processes/services offered. 6. Cost accounting helps in presentation of relevant data to the management which helps in decision making. Decision making is one of the important functions of Management and it requires presentation of relevant data. Cost accounting enables presentation of relevant data in a systematic manner so that decision making becomes possible. 7. Cost accounting also helps in estimation of costs for the future. 1.3.6 Essentials of a good Costing system :- For availing of maximum benefi ts, a good costing system should possess the following characteristics. A. Costing system adopted in any organization should be suitable to its nature and size of the business and its information needs. B. A costing system should be such that it is economical and the benefi ts derived from the same should be more than the cost of operating of the same. C. Costing system should be simple to operate and understand. Unnecessary complications should be avoided. D. Costing system should ensure proper system of accounting for material, labor and overheads and there should be proper classifi cation made at the time of recording of the transaction itself. E. Before designing a costing system, need and objectives of the system should be identifi ed. F. The costing system should ensure that the fi nal aim of ascertaining of cost as accurately possible should be achieved. 1.3.7 Certain Important Terms :- It is necessary to understand certain important terms used in cost accounting. A. Cost Center :- Cost Center is defi ned as, ‘a production or service, function, activity or item of equipment whose costs may be attributed to cost units. A cost center is the smallest 7Financial Accounting, Cost Accounting and Management Accounting organizational sub unit for which separate cost allocation is attempted’. To put in simple words, a cost center is nothing but a location, person or item of equipment for which cost may be ascertained and used for the purpose of cost control. For example, a production department, stores department, sales department can be cost centers. Similarly, an item of equipment like a lathe, fork-lift, truck or delivery vehicle can be cost center, a person like sales manager can be a cost center. The main object of identifying a cost center is to facilitate collection of costs so that further accounting will be easy. A cost center can be either personal or impersonal, similarly it can be a production cost center or service cost center. A cost center in which a specifi c process or a continuous sequence of operations is carried out is known as Process Cost Center. B. Profi t Center :- Profi t Center is defi ned as, ‘a segment of the business entity by which both revenues are received and expenses are incurred or controlled’. (CEMA) A profi t center is any sub unit of an organization to which both revenues and costs are assigned. As explained above, cost center is an activity to which only costs are assigned but a profi t center is one where costs and revenues are assigned so that profi t can be ascertained. Such revenues and expenditure are being used to evaluae segmental performance as well as managerial performance. A division of an organization may be called as profi t center. The performance of profi t center is evaluated in terms of the fact whether the center has achieved its budgeted profi ts. Thus the profi t center concept is used for evaluation of performance. 1.3.8 Costing Systems :- There are different costing systems used in practice. These are described below. A. Historical Costing :- In this system, costs are ascertained only after they are incurred and that is why it is called as historical costing system. For example, costs incurred in the month of April, 2007 may be ascertained and collected in the month of May. Such type of costing system is extremely useful for conducting post-mortem examination of costs, i.e. analysis of the costs incurred in the past. Historical costing system may not be useful from cost control point of view but it certainly indicates a trend in the behavior of costs and is useful for estimation of costs in future. B. Absorption Costing :- In this type of costing system, costs are absorbed in the product units irrespective of their nature. In other words, all fi xed and variable costs are absorbed in the products. It is based on the principle that costs should be charged or absorbed to whatever is being costed, whether it is a cost unit, cost center. C. Marginal Costing :- In Marginal Costing, only variable costs are charged to the products and fi xed costs are written off to the Costing Profi t and Loss A/c. The principle followed in this case is that since fi xed costs are largely period costs, they should not enter into the production units. Naturally, the fi xed costs will not enter into the inventories and they will be valued at marginal costs only. D. Uniform Costing :- This is not a distinct method of costing but is the adoption of identical costing principles and procedures by several units of the same industry or by several undertakings by mutual agreement. Uniform costing facilitates valid comparisons between organizations and helps in eliminating ineffi ciencies. 8Cost and Management Accounting 1.3.9 Classifi cation of Costs :- An important step in computation and analysis of cost is the classifi cation of costs into different types. Classifi cation helps in better control of the costs and also helps considerably in decision making. Classifi cation of costs can be made according to the following basis. A. Classifi cation according to elements :- Costs can be classifi ed according to the elements. There are three elements of costing, viz. material, labor and expenses. Total cost of production/ services can be divided into the three elements to fi nd out the contribution of each element in the total costs. B. Classifi cation according to nature :- As per this classifi cation, costs can be classifi ed into Direct and Indirect. Direct costs are the costs which are identifi able with the product unit or cost center while indirect costs are not identifi able with the product unit or cost center and hence they are to be allocated, apportioned and then absorb in the production units. All elements of costs like material, labor and expenses can be classifi ed into direct and indirect. They are mentioned below. i. Direct and Indirect Material :- Direct material is the material which is identifi able with the product. For example, in a cup of tea, quantity of milk consumed can be identifi ed, quantity of glass in a glass bottle can be identifi ed and so these will be direct materials for these products. Indirect material cannot be identifi ed with the product, for example lubricants, fuel, oil, cotton wastes etc cannot be identifi ed with a given unit of product and hence these are the examples of indirect materials. ii. Direct and Indirect Labor :- Direct labor can be identifi ed with a given unit of product, for example, when wages are paid according to the piece rate, wages per unit can be identifi ed. Similarly wages paid to workers who are directly engaged in the production can also be identifi ed and hence they are direct wages. On the other hand, wages paid to workers like sweepers, gardeners, maintenance workers etc are indirect wages as they cannot be identifi ed with the given unit of production. iii. Direct and Indirect Expenses :- Direct expenses refers to expenses that are specifi cally incurred and charged for specifi c or particular job, process, service, cost center or cost unit. These expenses are also called as chargeable expenses. Examples of these expenses are cost of drawing, design and layout, royalties payable on use of patents, copyrights etc, consultation fees paid to architects, surveyors etc. Indirect expenses on the other hand cannot be traced to specifi c product, job, process, service or cost center or cost unit. Several examples of indirect expenses can be given like insurance, electricity, rent, salaries, advertising etc. It should be noted that the total of direct expenses is known as ‘Prime Cost’ while the total of all indirect expenses is known as ‘Overheads’. C. Classifi cation according to behavior :- Costs can also be classifi ed according to their behavior. This classifi cation is explained below. i. Fixed Costs :- Out of the total costs, some costs remain fi xed irrespective of changes in the production volume. These costs are called as fi xed costs. The feature of these costs is that the total costs remain same while per unit fi xed cost is always variable. Examples of these costs are salaries, insurance, rent, etc. 9Financial Accounting, Cost Accounting and Management Accounting ii. Variable Costs :- These costs are variable in nature, i.e. they change according to the volume of production. Their variability is in the same proportion to the production. For example, if the production units are 2,000 and the variable cost is Rs. 5 per unit, the total variable cost will be Rs. 10,000, if the production units are increased to 5,000 units, the total variable costs will be Rs. 25,000, i.e. the increase is exactly in the same proportion of the production. Another feature of the variable cost is that per unit variable cost remains same while the total variable costs will vary. In the example given above, the per unit variable cost remains Rs. 2 per unit while total variable costs change. Examples of variable costs are direct materials, direct labor etc. iii. Semi-variable Costs :- Certain costs are partly fi xed and partly variable. In other words, they contain the features of both types of costs. These costs are neither totally fi xed nor totally variable. Maintenance costs, supervisory costs etc are examples of semi-variable costs. These costs are also called as ‘stepped costs’. D. Classifi cation according to functions :- Costs can also be classifi ed according to the functions/ activities. This classifi cation can be done as mentioned below. i. Production Costs :- All costs incurred for production of goods are known as production costs. ii. Administrative Costs :- Costs incurred for administration are known as administrative costs. Examples of these costs are offi ce salaries, printing and stationery, offi ce telephone, offi ce rent, offi ce insurance etc. iii. Selling and Distribution Costs :- All costs incurred for procuring an order are called as selling costs while all costs incurred for execution of order are distribution costs. Market research expenses, advertising, sales staff salary, sales promotion expenses are some of the examples of selling costs. Transportation expenses incurred on sales, warehouse rent etc are examples of distribution costs. iv. Research and Development Costs :- In the modern days, research and development has become one of the important functions of a business organization. Expenditure incurred for this function can be classifi ed as Research and Development Costs. E. Classifi cation according to time :- Costs can also be classifi ed according to time. This classifi cation is explained below. I. Historical Costs :- These are the costs which are incurred in the past, i.e. in the past year, past month or even in the last week or yesterday. The historical costs are ascertained after the period is over. In other words it becomes a post-mortem analysis of what has happened in the past. Though historical costs have limited importance, still they can be used for estimating the trends of the future, i.e. they can be effectively used for predicting the future costs. II. Predetermined Cost :- These costs relating to the product are computed in advance of production, on the basis of a specifi cation of all the factors affecting cost and cost data. Pre determined costs may be either standard or estimated. Standard Cost is a predetermined calculation of how much cost should be under specifi c working conditions. It is based on technical studies regarding material, labor and expenses. The main purpose of standard 10Cost and Management Accounting cost is to have some kind of benchmark for comparing the actual performance with the standards. On the other hand, estimated costs are predetermined costs based on past performance and adjusted to the anticipated changes. It can be used in any business situation or decision making which does not require accurate cost. F. Classifi cation of costs for Management decision making :- One of the important function of cost accounting is to present information to the Management for the purpose of decision making. For decision making certain types of costs are relevant. Classifi cation of costs based on the criteria of decision making can be done in the following manner I. Marginal Cost :- Marginal cost is the change in the aggregate costs due to change in the volume of output by one unit. For example, suppose a manufacturing company produces 10,000 units and the aggregate costs are Rs. 25,000, if 10,001 units are produced the aggregate costs may be Rs. 25,020 which means that the marginal cost is Rs. 20. Marginal cost is also termed as variable cost and hence per unit marginal cost is always same, i.e. per unit marginal cost is always fi xed. Marginal cost can be effectively used for decision making in various areas. II. Differential Costs :- Differential costs are also known as incremental cost. This cost is the difference in total cost that will arise from the selection of one alternative to the other. In other words, it is an added cost of a change in the level of activity. This type of analysis is useful for taking various decisions like change in the level of activity, adding or dropping a product, change in product mix, make or buy decisions, accepting an export offer and so on. III. Opportunity Costs :- It is the value of benefi t sacrifi ced in favor of an alternative course of action. It is the maximum amount that could be obtained at any given point of time if a resource was sold or put to the most valuable alternative use that would be practicable. Opportunity cost of goods or services is measured in terms of revenue which could have been earned by employing that goods or services in some other alternative uses. IV. Relevant Cost :- The relevant cost is a cost which is relevant in various decisions of management. Decision making involves consideration of several alternative courses of action. In this process, whatever costs are relevant are to be taken into consideration. In other words, costs which are going to be affected matter the most and these costs are called as relevant costs. Relevant cost is a future cost which is different for different alternatives. It can also be defi ned as any cost which is affected by the decision on hand. Thus in decision making relevant costs play a vital role. V. Replacement Cost :- This cost is the cost at which existing items of material or fi xed assets can be replaced. Thus this is the cost of replacing existing assets at present or at a future date. VI. Abnormal Costs :- It is an unusual or a typical cost whose occurrence is usually not regular and is unexpected. This cost arises due to some abnormal situation of production. Abnormal cost arises due to idle time, may be due to some unexpected heavy breakdown of machinery. They are not taken into consideration while computing cost of production or for decision making. 11Financial Accounting, Cost Accounting and Management Accounting VII. Controllable Costs :- In cost accounting, cost control and cost reduction are extremely important. In fact, in the competitive environment, cost control and reduction are the key words. Hence it is essential to identify the controllable and uncontrollable costs. Controllable costs are those which can be controlled or infl uenced by a conscious management action. For example, costs like telephone, printing stationery etc can be controlled while costs like salaries etc cannot be controlled at least in the short run. Generally, direct costs are controllable while uncontrollable costs are beyond the control of an individual in a given period of time. VIII. Shutdown Cost :- These costs are the costs which are incurred if the operations are shut down and they will disappear if the operations are continued. Examples of these costs are costs of sheltering the plant and machinery and construction of sheds for storing exposed property. Computation of shutdown costs is extremely important for taking a decision of continuing or shutting down operations. IX. Capacity Cost :- These costs are normally fi xed costs. The cost incurred by a company for providing production, administration and selling and distribution capabilities in order to perform various functions. Capacity costs include the costs of plant, machinery and building for production, warehouses and vehicles for distribution and key personnel for administration. These costs are in the nature of long-term costs and are incurred as a result of planning decisions. X. Urgent Costs :- These costs are those which must be incurred in order to continue operations of the fi rm. For example, cost of material and labor must be incurred if production is to take place. 1.3.10 Costing Methods and Techniques :- Introduction :- It is necessary to understand the difference between the costing methods and techniques. Costing methods are those which help a fi rm to compute the cost of production or services offered by it. On the other hand, costing techniques are those which help a fi rm to present the data in a particular manner so as to facilitate the decision making as well as cost control and cost reduction. Costing methods and techniques are explained below. Methods of Costing :- The following are the methods of costing. I. Job Costing :- This method is also called as job costing. This costing method is used in fi rms which work on the basis of job work. There are some manufacturing units which undertake job work and are called as job order units. The main feature of these organizations is that they produce according to the requirements and specifi cations of the consumers. Each job may be different from the other one. Production is only on specifi c order and there is no pre demand production. Because of this situation, it is necessary to compute the cost of each job and hence job costing system is used. In this system, each job is treated separately and a job cost sheet is prepared to fi nd out the cost of the job. The job cost sheet helps to compute the cost of the job in a phased manner and fi nally arrives the total cost of production. II. Batch Costing :- This method of costing is used in those fi rms where production is made on continuous basis. Each unit coming out is uniform in all respects and production is made prior to the demand, i.e. in anticipation of demand. One batch of production consists of the units produced from the time 12Cost and Management Accounting machinery is set to the time when it will be shut down for maintenance. For example, if production commences on 1st January 2007 and the machine is shut down for maintenance on 1st April 2007, the number of units produced in this period will be the size of one batch. The total cost incurred during this period will be divided by the number of units produced and unit cost will be worked out. Firms producing consumer goods like television, air-conditioners, washing machines etc use batch costing. III. Process Costing :- Some of the products like sugar, chemicals etc involve continuous production process and hence process costing method is used to work out the cost of production. The meaning of continuous process is that the input introduced in the process I travels through continuous process before fi nished product is produced. The output of process I becomes input of process II and the output of process II becomes input of the process III. If there is no additional process, the output of process III will be the fi nished product. In process costing, cost per process is worked out and per unit cost is worked out by dividing the total cost by the number of units. Industries like sugar, edible oil, chemicals are examples of continuous production process and use process costing. IV. Operating Costing :- This type of costing method is used in service sector to work out the cost of services offered to the consumers. For example, operating costing method is used in hospitals, power generating units, transportation sector etc. A cost sheet is prepared to compute the total cost and it is divided by cost units for working out the per unit cost. V. Contract Costing :- This method of costing is used in construction industry to work out the cost of contract undertaken. For example, cost of constructing a bridge, commercial complex, residential complex, highways etc is worked out by use of this method of costing. Contract costing is actually similar to job costing, the only difference being that in contract costing, one construction job may take several months or even years before they are complete while in job costing, each job may be of a short duration. In contract costing, as each contract may take a long period for completion, the question of computing of profi t is to be solved with the help of a well defi ned and accepted method. 1.3.11 Technique of Costing :- As mentioned above, costing methods are for computation of the total cost of production/services offered by a fi rm. On the other hand, costing technique help to present the data in a particular format so that decision making becomes easy. Costing techniques also help for controlling and reducing the costs. The following are the techniques of costing. I. Marginal Costing :- This technique is based on the assumption that the total cost of production can be divided into fi xed and variable. Fixed costs remain same irrespective of the changes in the volume of production while the variable costs vary with the level of production, i.e. they will increase if the production increases and decrease if the production decreases. Variable cost per unit always remains the same. In this technique, only variable costs are taken into account while calculating production cost. Fixed costs are not absorbed in the production units. They are written off to the Costing Profi t and Loss Account. The reason behind this is that the fi xed costs are period costs and hence should not be absorbed in the production. Secondly they are variable on per unit basis and hence there is no equitable basis for charging them to the products. This technique is effectively used for decision making in the areas like make or buy decisions, optimizing of product mix, key factor analysis, fi xation of selling price, accepting or rejecting an export offer, and several other areas. II. Standard Costing :- Standard costs are predetermined costs relating to material, labor and overheads. Though they are predetermined, they are worked out on scientifi c basis by 13Financial Accounting, Cost Accounting and Management Accounting conducting technical analysis. They are computed for all elements of costs such as material, labor and overheads. The main objective of fi xation of standard cost is to have benchmark against which the actual performance can be compared. This means that the actual costs are compared with the standards. The difference is called as ‘variance’. If actual costs are more than the standard, the variance is ‘adverse’ while if actual costs are less than the standard, the variance is ‘favorable’. The adverse variances are analyzed and reasons for the same are found out. Favorable variances may also be analyzed to fi nd out the reasons behind the same. Standard costing, thus is an important technique for cost control and reduction. III. Budgets and Budgetary Control :- Budget is defi ned as, ‘a quantitative and/or a monetary statement prepared to prior to a defi ned period of time for the policies during that period for the purpose of achieving a given objective.’ If we analyze this defi nition, it will be clear that a budget is a statement, which may be either in monetary form or quantitative form or both. For example, a production budget can be prepared in quantitative form showing the target production, it can also be prepared in monetary terms showing the expected cost of production. Some budgets can be prepared only in monetary terms, e.g. cash budget showing the estimated receipts and payments in a particular period can be prepared in monetary terms only. Another feature of budget is that it is always prepared prior to a defi ned period of time which means that budget is always prepared for future and that too a defi ned future. For example, a budget may be prepared for next 12 months or 6 months or even for 1 month, but the time period must be certain and not vague. One of the important aspect of budgeting is that it lays down the objective to be achieved during the defi ned period of time and for achieving the objectives, whatever policies are to be pursued are refl ected in the budget. Budgetary control involves preparation of budgets and continuous comparison of actual with budgets so that necessary corrective action can be taken. For example, when a production budget is prepared, the production targets are laid down in the same for a particular period. After the period is over, the actual production is compared with the budget and the deviation is found out so that necessary corrective action can be taken. Budget and Budgetary Control is one of the important techniques of costing used for cost control and also for performance evaluation. The success of the technique depends upon several factors such as support from top management, involvement of employees and co- ordination within the organization. 1.3.12 Cost Sheet Cost Sheet is a statement of cost showing the total cost of production and profi t or loss from a particular product or service. A Cost Sheet shows the cost in a systematic manner and element wise. A typical format of the Cost Sheet is given below. 14Cost and Management Accounting Cost Sheet for the period......................................... Production ............................... units Particulars Amount (Rs.) Amount (Rs.) A. Direct Materials Opening Stock + Purchases + Carriage inwards - Closing Stock B. Direct Wages C. Direct Expenses I. Prime Cost ( A + B + C ) D. Factory Overheads- Indirect materials Loose Tools Indirect wages Rent and Rates ( Factory) Lighting and heating ( F ) Power and fuel Repairs and Maintenance Drawing offi ce expenses Research and experiment Depreciation – Plant ( F ) Insurance – ( F ) Work Manager’s salary II. Factory Cost/Works Cost ( I + D ) E. Offi ce and Administrative Overheads Rent and Rates – offi ce Salaries – offi ce Insurance of offi ce building and equipments Telephone and postage Printing and Stationery Depreciation of furniture and offi ce equipments Legal expenses Audit fees Bank Charges III. Cost of Production ( II + E ) F. Selling and Distribution Overheads Showroom rent and rates Salesmen’s salaries and commission Traveling expenses Printing and Stationery – Sales Department Advertising Bad debts Postage Debt collection expenses Carriage outwards 15Financial Accounting, Cost Accounting and Management Accounting Particulars Amount (Rs.) Amount (Rs.) Depreciation of delivery van Debt collection expenses Samples and free gifts IV. Cost of Sales ( III + F ) V. Profi t/Loss VI. Sales ( IV + V) A glance at the above cost sheet will reveal that it works out the total cost of production/service in a phased manner. In other words, total costs are segregated into elements like Prime Cost, Factory or Works Cost, Cost of Production, Cost of Sales and fi nally the profi t/loss is worked out by comparing the total cost with the selling price. Appropriate adjustments are made for opening and closing stock of Work in Progress and also opening and closing stock of fi nished goods. The format of cost sheet may be suitably changed according to the requirements of each fi rm but the basic form remains the same. 1.3.13 Cost Control and Reduction :- One of the important functions of cost accounting is cost control and cost reduction. Cost control implies various actions taken in order to ensure that the cost do not rise beyond a particular level while cost reduction means reducing the existing cost of production. Both these concepts are discussed below. Cost Control :- As mentioned above, cost control means keeping the expenses within limits or control. Cost control has the following features. A. Cost control is a continuous process. It involves setting standards and budgets for deciding targets of different expenses and constant comparison of actual the budgeted and standards. B. Cost control involves creation of responsibilities center with clearly defi ned authorities and responsibilities. C. It also involves, timely cost control reports showing the variances between standard and actual performance. D. Motivating and encouraging employees to accomplish budgetary goals is also one of the essential aspects of cost control. E. Actually cost control not only means monetary limits on cost but it also involves optimum utilization of resources or performing the same job at same cost. Cost Reduction :- Cost control means attempts to reduce the costs. For example, if the present costs are Rs. 1,000 per unit, attempts can be made to reduce it to bring it down below Rs. 1,000. For doing this, all out efforts will have to be made for achieving this target. The goal of cost reduction can be achieved in two ways, fi rst is reducing the cost per unit and the second one is increasing productivity. Reducing wastages, improving effi ciency, searching for alternative materials, and a constant drive to reduce costs, can effect cost reduction. The following tools and techniques are normally used for cost reduction. A. Value analysis or value engineering. B. Setting standards for all elements of costs and constant comparison of actual with standard and analysis of variances. 16Cost and Management Accounting C. Work study D. Job evaluation and merit rating E. Quality control F. Use of techniques like Economic Order Quantity G. Classifi cation and codifi cation H. Standardization and simplifi cation I. Inventory management J. Benchmarking K. Standardization L. Business Process Re-engineering. 1.3.14 Cost Management :- The term ‘Cost Management’ has not been defi ned as such. However it can be said that cost management identifi es, collects, measures, classifi es and reports information that is useful to managers and other internal users in cost ascertainment, planning, controlling and decision making. Cost management aims to produce and provide information to internal users and personnel working in the organization. Need for Cost Management :- Effective management of cost makes an organization more strong, more stable and helps in improving the potentials of a business. The organization calls for a system that would monitor the full economic impact of the business, on resource acquisition and consumption. This provides supplying of information to the top management for exploring various alternatives by which cost effectiveness can be improved. Cost management also helps in optimizing resources which will improve overall effi ciency of the organization and help the fi rm to achieve its objectives. 1.3.15 Difference between Cost Accounting and Financial Accounting The distinguishing features of fi nancial accounting and cost accounting are given below. Financial Accounting Cost Accounting 1. It aims at fi nding out results of accounting 1. It aims at computing cost of production/ year in the form of Profi t and Loss Account service in a scientifi c manner and then cost and Balance Sheet. control and cost reduction. 2. It is more attached with reporting the 2. It is an internal reporting system for an results and position of business to persons organization’s own management for and authorities other than management decision making. like government, creditors, investors, owners etc. 3. Financial Accounting data is historical in 3. It not only deals with historical data but is nature also futuristic in approach. 4. In fi nancial accounting, the major 4. In cost accounting, classifi cation is basically emphasis is in cost classifi cation based on on the basis of functions, activities, type of transactions, e.g. salaries, repairs, products, process and on internal planning insurance, stores etc. and control and information needs of the organization. 17Financial Accounting, Cost Accounting and Management Accounting Financial Accounting Cost Accounting 5. In fi nancial accounting, only those 5. Cost accounting uses both monetary as transactions are recorded which can be well as quantitative information. expressed in monetary terms. 6. It aims at presenting ‘true and fair’ view 6. It aims at computing ‘true and fair’ view of of the profi t and loss position as well as the cost of production/services offered by fi nancial position. the fi rm. 7. Financial Accounts are subject to statutory 7. Cost accounts are subject to cost audit audit to verify whether they disclose a which verifi es whether the cost accounts true and fair view of the profi t and loss as disclose true and fair view of the cost of well as fi nancial position production of the company. 1.3.16 Installation of a Costing System :- As explained above, cost accounting system is a system that accumulates costs, assigns them to cost objects and reports cost information. In addition to this, a proper cost accounting system assists management in the planning and control of the business operations as well as in analyzing product profi tability. There are several other advantages of a well defi ned costing system in an organization like generating information for decision making, supplying information to the management for internal control, detailed analysis of costs like fi xed costs, variable costs, controllable costs, labor costs, material costs, overheads etc. However it is necessary that the cost accounting system is properly installed in an organization. Costing system installed in an organization should be simple to understand, easy to operate, highly reliable and suitable to the organization. The following factors should be taken into consideration while designing a costing system. I. Size of the fi rm :- Size of the fi rm is an extremely important factor in designing a cost accounting system. As the size of the fi rm and its business grows, the volume and complexity of the cost data also grows. In such situation, the cost accounting system should be capable of supplying such information. II. Manufacturing Process :- Process of manufacturer changes from industry to industry. In some industries, there may be a continuous process of production while in some batch or job type of production may be in operation. A cost accounting system should be such that the manufacturing process is taken into consideration and cost data is collected accordingly. III. Nature and Number of Products :- If a single product is produced, all costs like material, labor and indirect expenses can be directly allocated to that product. But if more than one product is manufactured, the question of allocation and apportionment as well as absorption of indirect expenses ( Overheads ) arises and hence the cost accounting system should be designed accordingly as more complex data will be required. IV. Management Control Needs :- The designing of a cost accounting system in a business organization is guided by the management control requirements. The costing system should supply data to persons at different levels in the organization to take suitable action in their respective areas. V. Raw Materials :- The designing of a cost accounting system in a business is also guided by the raw materials required for the production. The nature of raw materials and the degree of waste therein infl uence the designing of costing system. There are some materials which have a high degree of spoilage. The costing system should be such that identifi cation of spoilage, keeping records of materials, pricing of the issues etc are taken into consideration. 18Cost and Management Accounting VI. Organization Structure :- The structure of the organization also plays a vital role in designing a costing system. The system should correspond to the hierarchy of the organization. VII. External Factors :- External factors are also important in designing of a costing system. For example, Cost Accounting Record Rules have been mandatory for certain types of industries. For the sake of compliance of the same, costing system should be designed. 1.3.17 Practical Diffi culties in Installation of Costing system :- The practical diffi culties expected at the time of installation of costing system are given below. I. Top Management of an organization may not give necessary support and recognition to the costing system installed in an organization. Due to lack of support, this system may not give desired results. II. There may be resistance from existing accounting staff due to fear of losing job recognition and importance after the implementation of the system. III. Employees of other departments may not co-operate for installation of costing system due to fear of increase in workload or revealing of ineffi ciency. IV. The foremen, supervisors, workers and other operating level staff may resent the introduction of costing system due to the fear on increasing of workload. V. Shortage of qualifi ed and effi cient staff may be another diffi culty in installing and operating a costing system. VI. Sometimes fi rms resist a costing system due to the heavy cost of installation and operating of the same. The cost may be more than the benefi ts of the same. 1.4 Management Accounting Introduction :- The scope of Management Accounting is broader than the scope of cost accounting. In cost accounting, as we have seen, the primary emphasis is on cost and it deals with collection, analysis, relevance, interpretation and presentation for various problems of management. Management Accounting is an accounting system which will help the Management to improve its effi ciency. The main thrust of Management Accounting is towards determining policy and formulating plans to achieve desired objectives of management. It helps the Management in planning, controlling and analyzing the performance of the organization in order to follow the path of continuous improvement. Management Accounting utilizes the principle and practices of fi nancial accounting and cost accounting in addition to other modern management techniques for effective operation of a company. In fact there is an overlapping in various areas of cost accounting and management accounting. However, the distinguishing features of Management Accounting are given below. 1.5 Features of Management Accounting The features of Management Accounting are given below. 1. The Management Accounting data are derived from both, the fi nancial accounting and cost accounting. 2. The main thrust in management accounting is towards determining policy and formulating plans to achieve desired objectives of management. 3. Management Accounting makes corporate planning and strategy effective and meaningful. 4. It is concerned with short and long range planning and uses highly sophisticated techniques like 19Financial Accounting, Cost Accounting and Management Accounting sensitivity analysis, probability techniques, decision tree, ratio analysis etc for planning, control and evaluation. 5. It is futuristic in approach and predictive in nature. 6. Management Accounting system cannot be installed without proper cost accounting system. 7. Management Accounting systems generate various reports which are extremely useful from the Management point of view. 1.6 Management Accounting Information and their use In the above paragraphs, we have seen the utility of Management Accounting. One of the distinguishing factors between the fi nancial accounting and management accounting is that the management accounting does not have a unifi ed structure. The format in which it is prepared varies widely according to the circumstances in each case and the purpose for which the information is being summarized. The management accounting generates information, which is used for three different purposes. I Measurement II Control and III Decision making Alternative choice problems For each of these purposes, management accounting generates vital information. The uses of information for each of the three purposes of management accounting is explained below. I. Measurement: For measurement of full costs, the management accounting system focuses on the measurement of full costs. Full costs are the total costs required for producing goods or offering services. These costs are divided into A Direct costs and B Indirect costs. Direct costs are identifi able or traceable to the products or services offered while indirect costs are not traceable to the products or services. Full cost accounting measures not only the total costs direct plus indirect costs required for producing products or services but also the full costs required to run other activity like conducting a research project or running a welfare scheme and so on. Thus full cost accounting is not restricted to solely to measure the cost of manufacturing. II. Control: An important aspect of the management accounting information is to provide information, which can be used for ‘Control’. The management accounting system is structured in such a manner that information is generated for each ‘Responsibility Center’. A responsibility center is an organization unit headed by a manager who is responsible for its operations and performance. Management accounting helps to prepare budget for each responsibility center and also facilitates comparison between the budgeted and actual results. A report is prepared for each responsibility center, which shows the budgeted and actual performance and also the difference between the two. This enables the performance analysis of each responsibility center so that proper corrective action can be taken in this respect. III. Decision Making: Management accounting generates useful information for decision making. Management has to take several decisions in the course of business. Some of the major decisions are, Make or Buy, Accepting or rejecting of an Export Order, Working of second shift, Fixation of selling price, Capital expenditure decisions, Increasing production capacity, Optimizing of Product Mix and so on. For all these decisions, providing of information is necessary and the management accounting generates this information, which enables the management to take such decisions. 20

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