Lecture No. 1

OBJECTIVE
Objective of cost accounting is computation of cost per unit, whereas the objective of management accounting is to provide information to the management for decision making purposes.

INTRODUCTION

Cost Accounting Cost Accounting is an expanded phase of financial accounting which provides management promptly with the cost of producing and/or selling each product and rendering a particular service.             Management Accounting Management accounting is application of professional knowledge and skill in the preparation and presentation of financial information in such a way as to assist management in decision making and in the planning and control of operations of the entity Objectives Objective of cost accounting is computation of cost per unit, whereas the objective of management accounting is to provide information to the management for decision making purposes. Users Users of cost & management accounting are the decision makers and the managers of the entity/organization for which all this exercise is undertaken. Uses of Cost and Management Accounting It determines total cost of production and cost of sales It determines appropriate selling price It discloses the profitable products, areas and activity/capacity levels It is used to decide whether to manufacture or purchase for outside It helps in planning and controlling the cost of production

ELEMENTS OF COST

Any product that is manufactured is the result of consumption of some resources. The management, for its planning and controlling functions, must know the cost of using these resources. The constituent elements of cost are broadly classified into three distinct elements:

1        Direct Material Cost

2        Direct Labor Cost

3        Other Production Cost

• Direct Cost
• Indirect Cost

  CLASSIFICATION OF COST

  
  
  Elements of cost (Direct Material, Direct Labor, Other Production costs) can be classified as direct cost or indirect cost.
  
  
  Direct Cost
  A direct cost is a cost that can be traced in full to the product or service for which cost is being determined.
  Costs that can be economically identified with a specific saleable product or service (cost unit).
  a)      Direct material costs are the costs of materials that are known to have been used in producing and selling a product or rendering a service.
  b)      Direct labor costs are the specific costs of the workforce used to produce a product or rendering a service.
  c)      Other direct production costs are those expenses that have been incurred in full as a direct consequence of producing a product, or rendering a service.
  
  
  Indirect Cost/Overhead Cost
  An indirect cost or overhead cost is a cost that is incurred in the course of producing product or rendering service, but which cannot be traced in the product or service in full.
  Expenditure incurred on labor, material or other services which cannot be economically identified with a specific cost product or service (cost unit).
  Examples include:
              Wages of supervisor, cleaning material, workshop insurance.
  
  

  Material Cost	Labor Cost	Other Production Cost	Total Production Cost
  Direct	Direct	Direct	Price Cost
  Indirect	Indirect	Indirect	Factory Overhead Cost

  
  
  
  
  1. Prime Cost    
    Direct Material
  +Direct Labor
  +Other direct production cost
     Prime cost                          .      
  
  
  2. Total Production Cost
    Prime Cost
  +Factory overhead cost
    Total production cost      .
  
  
  3. Conversion Cost
    Direct labor cost
  +Factory overhead cost
    Conversion cost        .

  COST BEHAVIOR
  Cost behavior is the way in which total production cost is affected by fluctuations in the activity (production) level. Activity level The activity level refers to the amount of work done, or the number of events that have occurred. Depending on circumstances, the level of activity may refer to the volume of production in a period, the number of items sold, the value of items sold, the number of invoices issued, the number of invoices received, the number or units of electricity consumed, the labor turnover etc. etc. Basic principle The basic principle of cost behavior is that as the level of activity rises, costs will usually raise. For example; it will cost more to produce 500 units of output than it will cost to produce 100 units; it will usually cost more to travel 10 km than to travel 2 km. Although the principle is based on the common sense, but the cost accountant has to determine, for each cost elements, whether which cost rises by how much by the change in activity level. Division of cost by its behavior Basically the cost of production has two behaviors: Fixed Cost Variable Cost Fixed Cost It is a cost which tends to be constant by increases or decreases in the activity level. Graph of Fixed Cost     This graph shows that the cost remains fixed regard less of the volume of output. Examples include: Salary of the production manager (monthly/annual) Insurance premium of factory work shop Depreciation on straight line method Variable Costs A variable cost is a cost which tends to very directly with the change in activity level. The variable cost per unit is the same amount for each unit produced whereas total variable cost increases as volume of output increases. Graph of Variable Cost Rs.   Volume of output   This graph shows a proportionate increase in the cost by the increase in the activity level. Examples include: Cost of raw-material consumed Direct labor cost Selling commission Further division of cost behavior Step fixed cost Semi variable cost Step fixed cost A step fixed cost is the cost which is constant for a specific range of activity and rises to a new constant level once the range exceeds. The range over which the fixed cost remains constant is known as the relevant range. For example; the depreciation of a machine may be fixed if production remains below 100 number of units per month, but if the production exceeds 100 number of units, a second machine may now be required, and the cost of depreciation would go up a step. Other examples include: a.       Rent of workshop (in case of increase in the production one needs to rent one more workshop) b.      Salary of supervisor (increase in output will be supervised by increased number of supervisors)                                                 Graph of Step fixed Cost Rs.                                                                                                                             This graph shows a stepwise increase in the total cost. Relevant range in this graph is of 100 numbers of units. Semi Variable Cost It is also known as mixed cost. It is the cost which is part fixed and par variable. It is in fact the mixture of both behaviors. Examples include: Utility bills – there is a fixed line rent plus charges for units consumed. Salesman’s salary – there is a fixed monthly salary plus commission per units sold.             The graph of semi variable cost is as follow: Rs. Cost                              100      200       300       400      500                            Output This graph shows a fixed cost of Rs. 2,000 and there after the cost is variable. COST BEHAVIOR PER UNIT OF PRODUCTION Cost per unit behaves differently than the total cost of production. Following tables show the difference in behavior. Increasing Production Volume Situation Decreasing Production Volume Situation Per Unit Total Fixed Cost Increase Constant Variable Cost Constant Decrease Total Cost Increase Decrease Increase or decrease in production volume causes no change to the variable cost per unit it remains constant, assuming there is not rebate in case of bulk purchase and the labor receives constant rate despite change in production volume. Whereas, increase in production volume causes a decrease in fixed cost per unit and in the same way a decrease in production volume causes an increase in fixed cost per unit. Following example helps understanding this concept. Total fixed cost                                   = Rs. 4,000 Per unit variable cost                           = Rs. 3 Cost per unit at different activity levels 1000, 2000, 4000, and 5000 units 1000 units 2000 units 4000 units 5000 units Rs. Per Unit Total Rs. Rs. Per Unit Total Rs. Rs. Per Unit Total Rs. Rs. Per Unit Total Rs. Fixed Cost 4 4,000 2 4,000 1 4,000 0.8 4,000 Variable Cost 3 3,000 3 6,000 3 1,200 3 15,000 Total Cost 7 7,000 5 10,000 4 16,000 3.8 19,000